In 2020, the global U.S. ETF market saw assets rise to over $5 trillion. Beyond adding to its asset base, the ETF industry continued to innovate, introducing a new kind of vehicle for investors: the semitransparent ETF. Given its novelty, it’s important for investors to understand how these ETFs work and why a semitransparent structure is really designed for certain actively managed ETF strategies.
In previous posts, we’ve stressed the need to know what you own with ETFs. This time, we take a look at semitransparent ETFs, which are relatively new to the market and have key differences from conventional ETFs, most often associated with passive and smart beta strategies.
Based on record annual inflows in 2020, investors and financial professionals are clearly embracing the lower costs, tax efficiency, and intraday liquidity of ETFs.
Regulatory approval of semitransparent ETFs may compel more active managers to make their strategies available in the investor-friendly ETF structure. Yet to be clear, there are many actively managed ETFs that use the original, fully transparent ETF structure—and many have significant assets. In fact, 2020 was a record year for both active equity and bond ETFs, with the overall category gathering inflows of $59.3 billion.¹
Some investors like the daily portfolio disclosure of ETFs, so they know exactly what they’re buying. The introduction of semitransparent ETFs means more investor education is required on this key feature. And since there are several semitransparent ETF formats, it’s important to understand the differences and nuances.
It’s also important to keep in mind that the original, fully transparent ETF structure still works very well for passive, index-tracking strategies, as well as smart beta and some actively managed strategies.
Semitransparent ETFs vs. fully transparent ETFs at a glance
Source: John Hancock Investment Management, as of 1/31/21.
Why semitransparent ETFs?
There are only a handful of semitransparent actively managed ETFs so far, but that number could rise in the future.
That’s because semitransparent ETFs may offer solutions to two of the key issues that likely inhibited faster growth of actively managed ETFs. Semitransparency helps protect active ETF shareholders from:
- Risks of front-running the ETF’s trades, which could hurt performance
- Investors replicating the manager’s strategy
The main challenge of designing semitransparent ETFs was striking the right balance between the necessary portfolio transparency so the ETF functions properly, while not giving too much away so that investors don’t suffer from traders attempting to front-run the ETF’s moves. Also, active managers have never been enthusiastic about revealing their trades in real time.
How do semitransparent ETFs work?
I’ve previously explained why the creation and redemption process of ETFs is critical to their functioning and attractive features, including tax efficiency and intraday liquidity. ETFs can be bought and sold during the day, while mutual funds are priced once per day at the market close.
Portfolio transparency is required for the creation and redemption of ETF shares to work smoothly, based on supply and demand for the ETF shares. Transparency also helps keep the price of an ETF share in line with the net asset value (NAV) of the underlying portfolio to help ensure investors are getting a fair price. Most ETFs release an estimated NAV every 15 seconds throughout the trading day and disclose the portfolio holdings daily.
As their name suggests, semitransparent ETFs don’t reveal the entirety of their portfolio in real time–although they do typically disclose large portions of their holdings daily (80% as an example), and their full holdings on a periodic basis, such as quarterly.
AP reps and proxy portfolios
The big change for semitransparent ETFs is that they aren’t required to disclose their full holdings daily. However, they aim to reveal enough so that the ETF can trade properly. The challenge of shielding the remaining holdings has so far been addressed by two main approaches:
- The use of authorized participant (AP) representatives
- Disclosure of proxy portfolios
Let’s cover AP representatives first. APs are brokers, financial institutions, and market makers that facilitate the creation and redemption of ETF shares. Some semitransparent ETFs don’t disclose their holdings publicly, but rather only to what’s called an AP representative, on a daily basis. In other words, only the AP representative knows exactly what’s in the ETF, and is under contractual agreement to maintain confidentiality. When ETF shares need to be created or redeemed, the AP representative handles the task of buying (or selling) the entire portfolio holdings in a confidential account and delivers or takes ETF shares from the AP. This extra layer is designed to prevent any potential or even perceived conflicts of interest.
On the other hand, some semitransparent ETFs use proxy portfolios or limited portfolio disclosure. For example, some semitransparent ETFs release their portfolio holdings daily, but not the exact individual weightings of the securities. Other semitransparent ETFs disclose proxy portfolios that are designed to closely resemble the actual portfolio, and help market makers and APs manage risk and hedge positions in order to create or redeem ETF shares. These proxy portfolios are typically generated by computers, risk tools, and algorithms.
Putting it all together
There are different ETF structures and each one is designed to achieve its strategy—whether it’s active management, passive investing, or smart beta.
We believe fully transparent ETFs work just fine for passive and smart beta, and for some actively managed strategies. Meanwhile, semitransparent ETFs may be a better fit for a certain set of actively managed strategies. Therefore, we take a somewhat agnostic view on semitransparent or fully transparent ETFs—the “best” structure depends on what the ETF is trying to achieve.
1 ISS Market Intelligence/SIMFUND, as of 12/31/21.