An ETF First Coming Soon: Non-Transparent Funds

by on November 10, 2014

The exchange-traded fund industry has certainly come a long way since the debut of SPY in 1993. Now there are over 1,600 products to choose from, with assets totaling over $2 trillion. The rise and popularity of these products are in part thanks to their key advantages over mutual funds, which include lower expenses, intra-day tradability, and perhaps most importantly, transparency. Last week, however, the ETF industry witnessed a game-changing decision made by the Securities and Exchange Commission (SEC) [see also How to Build an Income Portfolio with ETFs: Insights from David Fabian].

SEC Approves Eaton Vance’s “Non-Transparent” ETFs

Eaton Vance, a well-known asset manager and mutual fund provider, announced on Thursday that the SEC has approved its filing for a new type of exchange-traded fund structure that does not have to disclose its holdings. The firm plans to launch 18 of these non-transparent funds, under a new product label called “exchange-traded managed funds” (ETMF). 

The SEC’s approval comes after BlackRock and Precidian Investments attempted to seek approval for a similar non-transparent ETF design, which was rejected. 

Eaton Vance’s Navigate Fund LLC unit will offer ETMFs under the brand “NextShares.” The ETMFs will trade on an exchanges at prices directly linked to the fund’s next-determined daily net asset value (which is determined at the end of every trading session). The main difference from trading traditional ETFs and these new ETMFs, is that investors will be buying and selling these products at net asset value (NAV) plus or a minus a premium or discount to that NAV.  

The concerns and criticism over these new funds are primarily due to this trading issue, since investors and market makers may not have enough information to keep the ETF price within an acceptable range around its NAV. Just last month, the SEC rejected a proposal by the NYSE to list these types of funds, citing reasons like non-disclosed funds would lead to wide bid-ask spread, which could cause market prices to significantly deviate from the value of the underlying securities. 

Nonetheless, the SEC has allowed Eaton Vance to not only make its debut on the ETF scene, but also give it “first dibs” on a product the industry has long petitioned for. 

How ETMFs Work

According to the proposal, the new lineup of nontransparent funds will trade like the following:

“Unlike ETFs, NAV-based Trading would not offer investors the opportunity to transact intraday at prices based on current (versus end-of-day) determinations of  the Shares’ value. Instead, like intraday orders to buy or sell shares of mutual funds, an ETMF  investor would not know the NAV at the time the order is placed, but the levels of premium/discount would be fully transparent allowing investors to see the execution costs of buying or selling Shares.

Market Makers and other dealers, in turn, would compete for transactions in Shares at a profitable premium/discount level.”

Consequently, the actual creation and redemption process will also differ from traditional ETFs:

“Shares would not be individually redeemable and owners of Shares may acquire those Shares from an ETMF, or tender such shares for redemption to the ETMF, in Creation Units only.

Like ETFs, all orders to purchase Creation Units must be placed with a distributor (“Distributor”) that is a broker-dealer registered under the Securities Exchange Act of 1934 (“Exchange Act”) by or through a party (an “Authorized Participant”) that has entered into a participant agreement with the Distributor with respect to the creation and redemption of Creation Units.

Unlike ETFs, Authorized Participants would be required to purchase Creation Units by making an in-kind deposit of specified instruments (these instruments are referred to, in the case of either a purchase or redemption, as the “Basket Instruments,” and, together as the “Basket”), specified by the ETMF at the beginning of each Business Day and Authorized Participants redeeming their Shares would receive an in-kind transfer of Basket Instruments.The Basket would not necessarily include all Portfolio Positions of the applicable ETMF in order to protect the confidentiality of current Portfolio Positions.”

A Game-Changer for ETFs and Mutual Funds?

According to Eaton Vance CEO Thomas Faust, ETMFs will allow investors “to access active strategies through a structure that provides the cost and tax efficiencies of an exchange-traded fund, while protecting the confidentiality of fund trading information.” Essentially, many industry leaders believe this new ruling will unlock millions of dollars worth of opportunity for active managers [see also Invest Like a Billionaire: Under the Hood of the IBLN ETF].

Prior to this approval, active managers contended that the daily transparency of ETFs would allow other market participants to front-run their buying and selling. With this approval, however, active managers can benefit from the baked-in cost saving structure of the ETF wrapper, while at the same time preserving the “holy grail” of active investing, which is its nondisclosure. Given the rapid rise of the industry, active managers believe they have the potential to rake in even more investments from investors that prefer the ETF structure. 

Given the nuances and complexities of these non-transparent funds, it will be difficult to see just how successful these products will actually be. Furthermore, a vast majority of investors prefer passively-managed, indexed ETFs, as opposed to the active lineup that is currently on the market. Playing the devil’s advocate, these non-transparent funds could very well be the “next trend” in the industry, especially if those funds provide investors relatively cheaper access to a popular, well-known, and successful manager’s expertise.

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Disclosure: No positions at time of writing.