Everyone wants a safe and reliable vehicle. So, when buying a car, experts recommend that it’s a good idea to pop the hood and take a look inside. What you see may tell you a lot about the vehicle’s performance, cost and reliability for years to come. The same is true for active semi-transparent exchange-traded funds (ETFs). This is a new type of ETF that is built differently from a traditional ETF. Therefore, knowing what’s under the hood is more important than ever.
Most ETFs on the road today are based on the ’40 Act fund chassis (referring to the Investment Company Act of 1940). This means that they’re basically structured in the same way that traditional mutual funds are structured, but their sponsors have received permission from the U.S. Securities and Exchange Commission (SEC) to do things a little differently. For example, traditional ’40 Act mutual funds buy and sell shares at the end of each trading day, with investors of all sizes, at the fund’s net asset value (NAV). ETFs, on the other hand, have received permission from the SEC to transact only with large authorized participants (APs) in big bundles of shares (typically 50,000). Another difference between ETFs and mutual funds is the frequency of portfolio disclosure. While mutual funds typically disclose their holdings either monthly or quarterly with a significant lag (up to 60 days), most ETFs disclose complete holdings information every day the markets are open.1
Historically, most ETFs have operated with similar exemptions from the Investment Company Act of 1940, but new types of ETF structures began receiving approval from the SEC in 2019. These new ETF models are frequently referred to as “active semi-transparent,” and the first ETFs based on these models were launched in 2020. Although the details vary, the purpose behind all of these new models is to make ETFs friendlier to active managers by removing the daily disclosure of holdings. For years, active managers have largely avoided ETFs,2 because they’ve been worried that providing daily, full disclosure would allow traders to front-run their trades and competitors to steal their “secret sauce.”
However, daily disclosure has been a very important component of ETF mechanics. Knowing exactly what’s inside an ETF allows market makers and APs to efficiently value the portfolio and (for most large, liquid ETFs) they tend to conduct trades that keep the ETF’s price generally in line with its underlying value.
Because completely transparent, daily disclosure of holdings doesn’t come standard, active semi-transparent ETFs must offer a package of other features to keep the fund trading smoothly. For example, Precidian’s ActiveShares structure uses an additional intermediary to facilitate creations and redemptions. Sort of like APs for the APs, authorized participant representatives (APRs) are the only entities outside of the fund sponsor to know precisely what’s inside the portfolio.3