What are semi-transparent ETFs?
Active equity managers embrace new semi-transparent ETFs
After years spent largely on the sidelines, active equity fund managers appear poised to enter the ETF arena in droves, in part thanks to newly relaxed transparency rules. In approving the first “semi-transparent” ETF structures, the Securities and Exchange Commission has removed the requirement to disclose portfolio holdings daily, opening the door to more product innovations and introductions.
Before the SEC decisions, active managers had primarily offered market cap-weighted and factor-based ETFs to avoid revealing the “secret sauce” behind their stock selection processes. As semi-transparent ETFs come to market and gain traction, it’s important to understand how they differ from each other and from their fully transparent forerunners.
What’s the difference between transparent and semi-transparent ETFs?
Regardless of their investment approach, nearly all existing ETFs must publish a daily list of what securities they own, and in what amounts. In comparison, the new breed of semi-transparent offerings will have less disclosure, either revealing the portfolio less frequently or masking the true holdings via proxy securities or weightings.
From an investor’s perspective, that’s essentially where the differences end. Both types of ETFs trade on exchanges at prices that fluctuate throughout the day. Semi-transparent versions will continue to offer the cost and tax efficiencies ETF investors have come to expect.
Behind the scenes, however, semi-transparent managers must operate differently to keep their stock picks confidential while also keeping the ETF running properly. How are shares accurately priced and effectively created/redeemed when the underlying basket of securities isn’t public knowledge? The short answer is, it depends on the ETF structure. Let’s dive deeper into the longer answer.
Five types of semi-transparent ETF structures
In its rulings, the SEC approved three firms to license their semi-transparent ETF structures to asset managers – Precidian Investments, Blue Tractor Group and the New York Stock Exchange. In addition, Fidelity Investments and T. Rowe Price received regulatory go-ahead on their proprietary structures. Each varies in how portfolio composition is protected and what information is provided each day to market participants.
1. Precidian Investments: Actual holdings disclosed daily, but not publicly
Precidian adds a new player to the existing ETF ecosystem, known as an “authorized participant (AP) representative.” As a refresher, with transparent ETFs, an AP knows what’s inside the portfolio at all times and uses that information to create/redeem shares as needed. With Precidian’s model, underlying securities are disclosed only to a representative separate and independent from the AP.
The AP representative uses a confidential account to create/redeem shares on an in-kind basis, which replicates the tax efficiencies currently available through transparent ETFs. Share prices will be updated in real time every second, compared to the current standard of every 15 seconds. Full portfolio holdings are disclosed to the public each quarter.
2. Blue Tractor Group: Actual holdings disclosed daily, without actual weights
With Blue Tractor’s structure, an ETF publicly discloses all the names in its portfolio each day, but weightings will always vary slightly from actual allocations. An algorithm is used to randomly generate weightings while also reducing tracking error with the real portfolio. Because weightings change each day, outside observers can never be sure whether fluctuations are due to manager decisions or the algorithm.
Authorized participants use the substitute portfolio for intraday pricing and share creation/redemption. Actual ETF holdings – and their actual weightings – are revealed on a quarterly basis.
3. New York Stock Exchange: Proxy portfolio used to represent actual holdings
NYSE’s arrangement relies on a proxy portfolio made up of some stocks actually in the ETF and some that are not. Actual holdings are included on a five- to 15-day lag; non-actual holdings are selected by a factor analysis model. The proxy is constructed to closely mirror the real portfolio’s composition, price and performance.
Managers licensing this structure would disclose the proxy portfolio each day, along with historical tracking error to the ETF’s NAV and standard deviation to its return spread. The real portfolio is made public once a quarter.
4. Fidelity Investments: Daily proxy combined with full disclosure monthly
In its model, Fidelity uses a mathematically generated proxy portfolio as a stand-in for the real ETF basket. Built for intraday pricing and share creation/redemption, the proxy consists of actual holdings with modified weightings, as well as substitute ETFs and cash.
Fidelity will publish its proxy portfolio each day, along with the percentage overlap and return deviation between it and the ETF’s actual securities. Unlike the quarterly schedule of other semi-transparent structures, real holdings and weights are disclosed each month, though with a 30-day lag.
5. T. Rowe Price: At least 80% overlap between proxy and actual portfolios
Similar to Fidelity and the NYSE, T. Rowe Price uses a proxy portfolio to shield its stock picks while facilitating share pricing and creation/redemption. To closely match the NAV of actual holdings, there will be at least an 80% overlap between the proxy portfolio and an ETF’s underlying basket.
Daily disclosures include the contents of the proxy portfolio as well as the return deviation, tracking error and percentage overlap with actual holdings. The real ETF portfolio is revealed quarterly, with a 15-day lag.
Semi-transparent ETFs at a glance
|Precidian Investments||Blue Tractor Group||New York Stock Exchange||Fidelity Investments||T. Rowe Price Group|
|What makes it semi-transparent?||Actual ETF holdings disclosed daily, but only to “authorized participant representative”||Actual ETF holdings disclosed daily, but weightings altered by algorithm||Proxy portfolio disclosed daily, made up of actual and non-actual ETF holdings||Proxy portfolio disclosed daily, made up of actual holdings, substitute ETFs and cash||Proxy portfolio disclosed daily, with at least 80% overlap between actual ETF holdings|
|What’s used to create/redeem shares?||Actual ETF holdings||Altered ETF portfolio||Proxy portfolio||Proxy portfolio||Proxy portfolio|
|How often are actual holdings publicly disclosed?||Quarterly||Quarterly||Quarterly||Monthly, with 30-day lag||Quarterly, with 15-day lag|
|How to access?||Licensed to asset managers||Licensed to asset managers||Licensed to asset managers||Proprietary ETF offerings||Proprietary ETF offerings|
Source: U.S. Securities and Exchange Commission, ETF.com, P&I Online, J.P. Morgan Asset Management.
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