While non- and semi-transparent exchange-traded funds (“STETFs”) have been present since early 2016 with the introduction of NextShares by Eaton Vance, the past several years have not seen a warm embrace of this novel idea by fund families. Nonetheless, many have argued that for STETFs, the question was not “if,” but “when,” and it appears that the answer is now.
In the past few months, we have seen the launch of six STETFs using different technologies and methodologies, including: (i) two STETFs launched by American Century Investments in April and one launched by Legg Mason and ClearBridge Investments in May, both of which are licensed under the Precidian ActiveShares methodology; and (ii) three STETFs recently launched by Fidelity in mid-June under Fidelity’s own proprietary methodology. With other firms having also filed applications with the SEC to launch their own products, and the SEC appearing willing to move forward with the proposed STETF structures, it seems that STETFs are finally on the brink of their future.
For those not familiar with STETFs, think of them as a cross between the active management of many mutual funds and the exchange trading feature of ETFs. They operate much like typical passive ETFs, with the significant exceptions that they are actively managed and do not disclose on a daily basis all their portfolio holdings (as their names suggest). Instead, the STETFs rely on certain technologies or methodologies to disclose on a daily basis only certain aspects of their portfolio holdings to provide an indicative pricing, with the actual portfolio holdings publicly disclosed at a later time (usually monthly or quarterly). These limited daily disclosures ensure sufficient transparency for arbitragers, such as authorized participants, to maintain the fund’s net asset value close to the trading price of the STETFs, but not so much as to allow other market participants to replicate each manager’s trading technology and methodology.
As it currently stands, the new wave of STETFs are based on three models that have been developed: (i) the authorized participant representative (“APR”) model utilized by the Precidian ActiveShares methodology; (ii) variations of the proxy portfolio model utilized by a number participants, including Fidelity, T. Rowe Price, Natixis/NYSE, Invesco, as well as a new methodology developed by Eaton Vance; and (iii) the semi-full disclosure model utilized by the Blue Tractor Shielded Alpha methodology.
Precidian’s APR model introduces a new APR role to the ETF environment, which will be the only entity other than the fund’s manager and custodian with visibility into the STETF’s portfolio on a day-to-day basis. The APRs will then use confidential accounts to buy and sell the underlying securities on behalf of authorized participants to facilitate the arbitraging mechanism, while keeping the portfolio of the STETF private. The APR model also introduces an enhanced verified indicative intra-day value (“VIIV”) methodology that disseminates pricing information on one-second intervals, as compared to traditional ETFs that disseminate such information on 15-second intervals.
While several variations of the proxy portfolio model have been developed, the key aspect of these models allows managers to use proprietary technology to generate a proxy portfolio that tracks, but does not fully mimic, the actual holdings of the STETF. The proxy portfolio will include securities that both are and are not held by the STETF, and will disclose on a daily basis the percentage of overlap between the proxy portfolio and the actual portfolio. This model essentially attempts to duplicate the intraday performance of the STETF as close as possible to its actual performance to facilitate the arbitraging mechanism, while ensuring that the full composition of the STETF’s portfolio is kept private.
Lastly, the semi-full disclosure model acts similarly to the proxy portfolio model in that a portfolio that is not fully reflective of the actual portfolio held by a STETF is disclosed on a daily basis. The semi-full disclosure model, however, acts more like a traditional ETFs in that all underlying securities that are held by a STETF will be disclosed on a daily basis, but the model will utilize its cloud-based algorithm to generate random weightings on the underlying securities that are held. Again, this allows sufficient disclosure of the actual portfolio holdings of a STETF to facilitate the arbitraging mechanism, while ensuring that the actual STETF portfolio is kept private.
While this may be an exciting time for STETFs, a key question remains whether the various arbitraging mechanisms will work in practice as well as their designers believe, and whether the market will coalesce around one of these models. Nevertheless, we commend the SEC for its careful analysis of STETFs, and allowing the market to determine the viability of these products. Now the spotlight is on such funds to perform.
 While the SEC has approved the applications for exemptive relief filed by Fidelity, T. Rowe Price, and Natixis/NYSE, Eaton Vance’s application for its new “Clearhedge” methodology and Invesco’s application for its “Actively Managed Substitute Basket” methodology are still pending approval.