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Who benefits the most from non-transparent ETFs?

Look past the opaqueness of the portfolio and think of them as better than mutual funds

Apr 12, 2019 @ 1:53 pm

By Jeff Benjamin

After years of scrambling and determination, it looks like the actively managed mutual fund industry might finally get its wish to manage exchange-traded funds without having to publish daily investing positions like all other ETFs.

The question now is, who benefits from this much-coveted nontransparent ETF structure?

The short answer is, it could be investors.

The preliminary nod of approval by the Securities and Exchange Commission earlier this week for a new type of ETF by Precidian Funds has been interpreted by some as an opening of the flood gates for big brand-name fund complexes that haven't yet climbed aboard the fast-moving ETF bandwagon.

It has long been argued that concerns over exposing portfolio positions through traditional active ETFs have kept such major active managers as T. Rowe Price and Capital Group from entering the ETF space.

(More:Demand for growth stocks produces record inflows for ETF)

That fear of "front-running" by traders taking advantage of a portfolio manager's expertise is often cited as the reason there are less than 300 actively managed ETFs out of a total universe of more than 2,300 ETFs.

But to poke a hole in that front-running argument, Todd Rosenbluth, director of mutual fund and ETF research at CFRA, points to Davis Funds, which for years has been managing near-identical strategies in active mutual funds and active ETFs.

"Front-running is a fear, but there's no data showing it's happening with existing products," Mr. Rosenbluth said.

Morningstar analyst Ben Johnson is even more dismissive of the front-running phobias.

"I would argue, money managers are flattering themselves that there are in-home gamers out there looking into what portfolio managers are doing," he said.

Regardless of why active managers are seeking nontransparent ETF approval, the appeal seems real.

The fact that Precidian's new ActiveShares have already been licensed by the likes of American Century, BlackRock, Capital Group, JPMorgan and Legg Mason suggests active managers are revving their engines and rolling toward the starting line, with full SEC approval expected sometime this year.

Running slightly behind the Precidian application process, Fidelity Investments has also spent more than four years trying to get SEC approval for nontransparent ETFs, and Fidelity already manages three active bond ETFs.

In theory, a less transparent portfolio could benefit investors if it prevents front-runners from diluting a portfolio manager's efforts. But the real advantage for investors is increased access to active strategies in what is essentially still an ETF wrapper.

This means, all the benefits of the active mutual fund strategy without those pesky capital gains distributions, 12b-1 fees and the performance drag that can come from a portfolio manager holding cash to meet redemptions.

(More: You won't believe how some advisers are hedging market risk)

And let's not forget lower fees relative to mutual funds, even though those fees will still likely be higher than passive ETFs.

As currently proposed, nontransparent ETFs would come with certain restrictions, including limiting portfolio trading to securities that are trading at the same time as the fund is trading — in other words, restricting securities trading on exchanges that don't run in sync with U.S. markets.

The nontransparency factor will rub some investors and financial advisers the wrong way. But instead of comparing them to the transparency of traditional ETFs, just think of them as less expensive, more liquid and more tax-efficient mutual funds.


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