On November 7, 2014, the SEC announced its intention to accept the proposal by Eaton Vance to offer actively managed ETFs without requiring daily information on the holdings of securities. Instead, Eaton Vance will provide the information every quarter, similar to mutual funds. This is in contrast to the SEC’s decision a few weeks earlier when it rejected proposals by Blackrock and Precidian that would have also provided information quarterly on portfolio holdings. The primary reason cited for denying Blackrock’s proposal was that the applicant did not provide “an adequate substitute for portfolio transparency” for ETFs to trade close to their actual values. They were also concerned that a breakdown “in the arbitrage mechanism could result in material deviations between market price and NAV per share of the ETF.”

What was different in the Eaton Vance model that allowed the SEC to accept their application? The answer is that Eaton Vance’s ETF will trade only at the closing NAV. This feature makes it a cross between a regular ETF and a mutual fund and has been appropriately named an Exchange-Traded Mutual Fund (ETFM).

Firms have been designing actively-managed ETFs as early as 2000 when regular ETFs began to gain popularity in the U.S. Many portfolio managers were reluctant to list their mutual funds as ETFs because of the daily disclosure requirement, for fear of “front running” and “free riding.” As a result, a majority of the ETFs today are passively managed; most are tracked to indices where the portfolio composition is open information. The challenge for designers of actively managed portfolios is to provide information on the holdings without revealing the actual composition of the assets.

Two basic models have emerged in the ensuing years.

Blind Trust
The models by Blackrock and Precidian (as well as T. Rowe Price and State Street) rely on a blind trust to undertake the conversion of securities from and to Creation units in cash. The exchange will provide indicative intraday values (IIVs) of the portfolio every 15 seconds. However, it is unclear how market makers can arbitrage without information on portfolio holdings, even if IIVs are provided. The following explanation is provided in Blackrock’s proposal.

Applicants also expect, however, that market participants will quickly be able to determine, after gaining experience with how various market factors (e.g., general market movements, sensitivity or correlations of the IIV to intraday movements in interest rates or commodity prices, other benchmarks, etc.) affect IIV, how best to hedge long or short positions taken in Shares in a manner that will permit them to provide a Bid/Ask Price for Shares that is near to the IIV throughout the day. The ability of market participants to accurately hedge their positions should serve to minimize any divergence between the secondary market price of the Shares and the IIV, as well as create liquidity in the Shares.

That was not sufficient for the SEC and one reason for the denial.

In the case of Eaton Vance, trading of their ETFs will be NAV-based and all sale and purchase will take place at the closing NAV. They will provide IIVs (intraday indicative values) every 15 minutes during the day but its purpose is to primarily assist in determining the number of shares to purchase or sell. As a result, when a market maker trades ETMFs, there is no intraday market risk on inventory positions because all transaction prices are based on the ETMF’s end-of-day NAV. From their proposal:

Different from ETFs trading in conventional intraday markets, ETMFs offer market makers an arbitrage profit opportunity that does not depend on either corresponding intraday adjustments in ETF and portfolio securities positions or the use of a hedge portfolio to manage intraday market risk … A “perfect arbitrage” in an ETMF requires only that market makers holding short (or long) positions in Shares accumulated intraday transact with the ETMF to purchase (redeem) a corresponding number of Creation Units of Shares, buy (sell) the equivalent quantities of Basket securities at market-closing or better prices, and offload any remaining sub-Creation Unit Share inventory through market transactions prior to the close.

The SEC’s acceptance of the Eaton model suggests that full transparency is not required as long as the pricing is not impacted by the lack of information on portfolio holdings. We should get further clarification from the SEC when they rule on the applications of Guggenheim and Vanguard. Their models provide proxy stocks that mimic the actual holdings in the portfolio. If their applications are rejected, we can be sure that the SEC will not entertain any model that allows trading at intraday prices without information on portfolio holdings.

Overall, the news is good for the ETF industry. In our February 23, 2014 blog we speculated that if the SEC approves actively managed ETFs, it will spurt a growth in the industry, otherwise the pace will be slow. This approval should result in a surge of non-transparent ETFs in 2015. Eaton Vance has already announced they will introduce 18 new ETFs based on their current proposal and are willing to license their model to other firms. We expect a number of firms to take their offer.

However, it is still unlikely that ETFs will dominate the mutual fund industry. If investors are looking for value over the long-term, the benefits of intraday trading should not be a big concern. On the contrary, ETFs are likely to introduce more volatility as shares are redeemed or sold when creating and liquidating Creation units. The dominant factor is still going to be the expertise of the manager to deliver excess returns.

The likely scenario for the future is that ETFs will make up a small certain percentage of the total market. For example, the number of ETFs have remained steady this year at about 1600 in the U.S. Although actively managed ETFs increased from about 60 to 109 this year, it is not expected to grow further. With the new ruling, we expect an initial surge of actively managed non-transparent ETFs to increase by 100 or 200, but thereafter should remain steady. At the end, it’s the manager that matters, whether it is mutual funds or ETFs.