Unlike ordinary exchange-traded funds (ETFs), which disclose their underlying assets daily, non-transparent ETFs are only required to reveal their holdings on a quarterly or monthly cadence. This ability to conceal their assets can help active non-transparent ETF managers to cloak their strategies for longer periods, with the aim of maximizing performance.
To understand some of the advantages these funds may offer investors, it helps to compare them with standard ETFs.
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Why would you invest in non-transparent ETFs?
For nearly 30 years, ETFs have been a mainstay for big institutional investors as well as individuals thanks to their transparency, tax efficiency and low cost. Today, the ETF industry in the U.S. has over $6.5 trillion in assets under management.
Traditionally, investors have found ETFs an attractive option because of their liquidity, which has made ETFs more transparent than mutual funds. Unlike mutual funds, you can trade ETF shares throughout the day on an exchange, similar to stocks. And the way shares are created and redeemed gives investors more visibility into the funds’ underlying assets compared with mutual funds. This “transparency” has been true of both actively managed ETFs as well as passive ETFs, which track an index such as the S&P 500.
But the fundamental transparency of the ETF “wrapper” or fund structure has been a thorn in the side of some active ETF managers who may prefer less visibility around their holdings for strategic reasons, hence the appeal of non-transparent ETFs to active managers.
Active non-transparent ETFs, also called ANT ETFs, aren’t required to reveal their assets daily, as noted above. Rather, they report a snapshot of what they hold on a monthly or quarterly basis, similar to a mutual fund. In some cases they report the assets they hold, but not how much they hold.
How passive vs. active strategies can impact transparency
If you think about it, the evolution of active non-transparent ETFs makes sense in the larger context of the ETF universe, where passively managed ETFs comprise more than 90% of that market.
Passively managed ETFs offer some of the lowest fees in today’s market, which is one reason they’re typically cheaper to own than mutual funds. The overall tax efficiency of index ETFs also helps to lower investing costs and has contributed to their overall popularity with investors.
ETFs, of course, are also valued for their role in adding diversification to investors’ portfolios, with many ETFs invested in specific sectors (e.g. electric vehicles, pharmaceuticals) or securities (e.g. U.S. Treasuries, corporate bonds).
No matter whether an ETF is invested in a broader equity market or a niche sector, passive ETFs are designed to mirror or track the stocks in a certain index. Thus, the transparency of these funds is part of how they work.
That’s not true of active ETFs, which rely on the oversight of a fund manager to choose the underlying assets (just like an active mutual fund). But because ordinary ETFs require a daily disclosure of the fund’s holdings, this can hamper an active manager’s ability to execute their investment strategies.
When a fund’s assets are disclosed on a daily basis, the market can bid up the price for their holdings. And while in the short term this might be good (the assets could go up), in the long term it could disrupt the fund manager’s strategies. And if other investors try to anticipate the trades that active managers might make, sometimes called front running, that could cause asset prices to fluctuate and potentially impact the ETF’s performance.
The use of proxies in non-transparent ETFs
How might a non-transparent ETF solve this problem?
The way ETFs keep their price in line with their assets is that the sponsor of the ETF trades throughout the day with an “authorized participant.” These authorized participants will create and redeem “baskets” of securities, i.e. the stocks or bonds that the ETF holds, and then trade them to the ETF for shares of the fund, which allows the ETF to stay in line with the price of its underlying stocks.
This process obviously requires a great degree of transparency across the board. So, how does a non-transparent ETF obscure its holdings?
The answer is, by the use of “proxies.” These are baskets of stock that are similar to but not identical to the underlying holdings of the ETF. Thus, non-transparent ETFs are able to occupy a happy middle ground in the ETF world: They enable fund managers to conceal their strategies while keeping the liquidity of pricing that is core to trading ETFs overall.
The history of non-transparent ETFs
For years, the ETF industry was comprised mostly of index ETFs, which helps to explain why the universe of ETFs is primarily passive. But over time, some investment companies began seeking regulatory approval for non-transparent ETFs, also sometimes called semi-transparent ETFs, in order to pursue more active strategies. The approval for these funds and the technology underlying the non-transparent strategy began rolling out in late 2019, and ANT ETFs have seen steady inflows since then.
Though non-transparent ETFs are still a relatively small part of the overall ETF market, this sector is gaining traction and is now approaching $2 billion AUM. This reflects a similar trend among active ETFs, which have also seen more inflows this year.
Non-transparent ETFs may be a relative newcomer in the multi-trillion-dollar world of ETFs, but they offer an attractive new opportunity for investors who are interested in active investment styles — but still want the cost efficiency and liquidity of an ETF. Non-transparent ETFs also give active fund managers the ability to cloak their strategies, which may aid potential outcomes.
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