Push for "non-transparent" active ETFs gains steam

NEW YORK Fri Dec 13, 2013 7:53am EST

NEW YORK Dec 13 (Reuters) - Exchange-traded funds have traditionally been touted for their transparency, with their portfolio holdings disclosed daily. But the push for a new breed of ETFs that can hide their specific holdings for months at a time is gaining momentum.

Several large asset managers, including BlackRock Inc , State Street Corp, and Eaton Vance Corp have asked the U.S. Securities and Exchange Commission to let them market actively managed ETFs that would be permitted to report their portfolio holdings quarterly. That would put their reporting requirements on par with traditional mutual funds.

Firms say these so-called "non-transparent" ETFs will allow them to use sophisticated investment strategies without having to reveal the fund manager's secret sauce. The SEC currently has proposals from at least seven firms under consideration, and many others are on the drawing board.

Some of these funds could launch as early as 2014, if the SEC grants approval. "It's certainly one of our highest priorities," said Laura Morrison, who heads exchange-traded product trading and listing at NYSE Arca, the New York Stock Exchange's trading platform which has the lion's share of U.S.-listed ETFs. She told Reuters that NYSE Arca is staffing up to work with potential issuers and has been in active conversations with the SEC, market makers and several large issuers about bringing the funds to market.

THE CASE FOR NON-TRANSPARENT ETFs

All ETFs currently on the market, including so-called "active" ETFs run by managers as well as the more common index-tracking funds - are required to disclose their underlying holdings on a daily basis.

This allows the funds' market makers (large investors who trade to stabilize share prices) to make trades that keep the fund's share price in line with the value of its underlying assets. But for actively managed funds, which often gain a reputation based on a manager's winning investment philosophy, daily transparency could allow others to "front-run" the active manager.

"You don't want everyone and his brother knowing what changes you made in your portfolio so they can front run you," said Gary Gastineau, who developed several patents for proposed ways to enable non-transparent ETFs.

Some of those patents have been used in filings by Eaton Vance, which purchased his firm, Managed ETFs LLC, and its intellectual property.

One key element proposed by Gastineau is to allow market makers to base their buy and sell decisions on the fund's net asset value (NAV) at the end of the day, even though individual investors would still be able to trade the ETF throughout the day on the open market. A fund's NAV is based on the closing prices of the fund's underlying securities at the end of each trading day, so it would help the market makers understand the value of the ETF's portfolio without knowing exactly what was in it.

Precidian Investments, a Bedminster, New Jersey-based ETF intellectual property shop and industry consultant, is another firm that has developed patented ideas for opaque ETFs. They have been used in filings by large firms including BlackRock and State Street. BlackRock declined to comment on the filing currently under review. A spokesman for State Street was not immediately available for comment.

Stuart Thomas, a principal at Precidian, said he views non-transparent active ETFs as the successor of traditional mutual funds - essentially combining the low cost, intraday trading and tax efficiencies of an ETF with the strategic approach of mutual funds.

"We're not changing the way you manage your fund - you will still have the ability to do everything you do today," Thomas said.

The Precidian model includes a "blind trust" through which a market maker or authorized participant could execute orders, without the manager having to disclose the fund's holdings on a daily basis.

"I like the fact that there's competing structures, that everyone is trying to solve the same problem," Thomas said.

DISTRIBUTION, MARKETING THE NEXT BIG HURDLE

The next big challenge for ETF providers hoping to create these funds may be finding a way to attract investors, suggests Dave Nadig, chief investment officer at San Francisco-based IndexUniverse.

"We're in a market now where distribution is what's driving assets," Nadig said. He said he believes the technical issues have been resolved and the SEC will greenlight the funds. "My concern is more about the marketing," he said.

For that reason, Nadig expects it will be at least a couple of years after they launch before such funds actually start to gain any significant market share. And the early participants will likely be limited to the very large firms with established names.

"For someone to be successful and garner assets here, I think they would have to be a Fidelity Contrafund, or Magellan, or a Growth Fund of America-type of product, or a Gabelli," Nadig said, referring to funds with strong track records and followings, or else have "substantial marketing prowess behind them."

If and when the SEC grants approval for firms to be able to launch such funds, the ones that follow will have to be approved before they can begin trading - a process that can already be lengthy, especially for funds that are considered more exotic than plain vanilla index-tracking ETFs.

"Each fund would have to go through its own order the way they do now," said Kathleen Moriarty of Katten Muchin Rosenman LLP a longtime ETF industry attorney who was involved in the development of State Street's original SPDR funds. "That's just the nature of the beast of the way the approval process goes."

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