Whether financial advisers are ready or not, 2020 will likely be the year of the nontransparent exchange-traded fund.
If your initial reaction is something along the lines of “What?” you’re in good company. While the awkwardly named new product is the latest darling of the asset management industry, it has yet to elicit much interest among advisers.
At least two dozen asset managers have signed licensing agreements with firms approved to offer nontransparent ETFs. But financial advisers, the largest consumers of ETFs, are barely paying attention so far.
A 2019 survey of more than 150 financial advisers by Cerulli Associates found that less than 16% plan to allocate client assets to nontransparent ETFs during the first year they’re on the market, while 31% said they would not use them. More than 35% of respondents said it would depend on the details and structure of the products.
More recently, a February survey of 571 advisers who custody assets at TD Ameritrade showed that an overwhelming 92% said they will not allocate assets to nontransparent ETFs.
That is the challenge the fund industry faces with its latest effort to rescue active asset management, as it continues to lose market share to cheaper, index-based strategies.
“I think there is an appetite for these products, but people certainly have a lot of questions,” said Tim Coyne, head of ETFs at T. Rowe Price Group Inc., one of the companies whose nontransparent ETF structure recently received approval from the Securities and Exchange Commission.
“Any time a new structure or asset class comes to market, there’s a learning curve,” Mr. Coyne added. “We know there’s a need for education, and we’re committed to that.”
The first nontransparent ETF is expected to launch by the end of the first quarter after more than a decade of regulatory tug-of-war.
The general concept is to put an ETF wrapper around an actively managed strategy without disclosing the underlying holdings on a daily basis, as all other ETFs do. But each nontransparent ETF structure that has passed SEC scrutiny so far is unique in the way it provides enough portfolio transparency and guidance to keep market-makers engaged for the sake of liquidity.
In most cases, the underlying holdings will be disclosed quarterly, which is the way active mutual funds report their holdings. In that sense, these products are part active mutual fund and part ETF.
The asset management industry is promoting nontransparent ETFs as the best of both worlds because they will offer access to tested active portfolio management at lower fees and without the tax inefficiencies that plague mutual funds.
The asset management industry is also betting that investors and advisers will accept mutual fund-level portfolio transparency in exchange for the more appealing ETF wrapper.
“People are searching for that ETF wrapper,” said Daniel McCade, chief executive at Precidian Investments, which received SEC approval for its nontransparent ETF structure in May and has licensing agreements with more than a dozen asset managers to launch products using its structure.
“It benefits the client and the asset manager,” Mr. McCade said.
Despite the meager early interest, there is no denying the benefits of the nontransparent ETF wrapper when compared to a traditional actively managed mutual fund.
American Century Investments, the fund company expected to be the first on the block with a nontransparent ETF product, is most of the way through the regulatory process with two funds, one with an expense ratio of 42 basis points and the other 45 bps — about half of what American Century charges for a mutual fund with a similar portfolio.
“If you expect a fair amount of assets in there, ETFs can be cheaper over time,” said Ed Rosenberg, head of ETFs at American Century. “Reasonably, it’s a different marketplace, and you have to price ETFs accordingly.”
In addition to lower fees, the new ETF structure should also deal with the unpredictable tax consequences that can hit mutual fund shareholders, regardless of a fund's performance.
“The nontransparent ETF notches some important wins, most notably with regard to taxes and fees, which [are] lowered by stripping out certain distribution expenses,” said Ben Johnson, ETF analyst at Morningstar Inc.
It all sounds like a clear path allowing the asset management industry to sit back and collect investor assets, except for that small matter of a lack of obvious buyers.
“It’s not immediately apparent to me that there is real demand for this, and it’s very clearly being pushed by the asset managers who will bring them to market,” Mr. Johnson said. “I’ve long been skeptical that you’ll see much adoption. The pressure is coming from the asset managers who have to do something, because the status quo is not sustainable at some of the large fund complexes that have been hemorrhaging assets for years.”
Hemorrhaging is not an exaggeration.
According to Morningstar Direct, actively managed U.S. equity mutual funds saw $1.387 trillion in net outflows over the past 10 years, while equity ETFs had net inflows of $1.412 trillion over the same period.
Currently, only about 2% of all ETF assets are in transparent actively managed strategies, which some say illustrates the low investor appetite for active management regardless of the wrapper.
But Mr. McCade of Precidian argued that the skeptics are missing the bigger picture of the ETF movement.
“There’s a whole host of new investors coming to market that really like exchange-traded products,” he said. “Millennials do not want mutual funds.”
While some look at the flow of assets and see a preference for index-based strategies instead of active management, Mr. McCade sees a thirst for simplicity and ease of use.
“I think investors are actually demanding efficiency and you can see that from the movement of asset flows,” he said. “The real movement has been to an exchange-traded vehicle.”
Greg Freidman, head of ETF management and strategy at Fidelity Investments, also describes nontransparent ETFs as more of an evolution than an either-or situation.
“There are certain clients that prefer mutual funds, but the growth of ETFs is important,” he said. “We’re wrapper-agnostic.”
Fidelity received SEC approval for its version of a nontransparent ETF in December and plans both to launch products and license the model to other asset managers.
While a handful of asset managers have launched transparent actively managed ETFs, most fund managers have resisted for fear of front-running by day traders who might try to capitalize on what they can glean from published portfolio holdings.
“The appeal for asset managers is that they have some products that have outperformed, but they’ve been hesitant to launch active ETFs on these strategies for fear of front-running,” said Todd Rosenbluth, director of mutual fund and ETF research at CFRA.
Thus, the nontransparent ETF wrapper is posited as the savior of active management by giving the ETF market access to strategies it has been denied.
“The one piece missing has been excess returns,” Mr. Freidman said, referencing the benefits of active management alpha over the pure market beta of the indexed strategies that currently dominate the ETF space.
“We found that the ETF user is different than the mutual fund investor,” he said. “I think we’ll draw from both groups.”
Kenneth Nuttall, director of financial planning at BlackDiamond Wealth Management, understands the impetus coming from the asset management industry but he is less convinced there is a measurable appetite for the new wrapper.
“It all goes back to the actual investment,” he said. “If you’re purely using mutual funds, this is the greatest thing in the world, but if you’re using a combination including passive strategies, you’re not going to be jumping up and down.”
Mr. Nuttall expects advisers like himself will be flooded with sales pitches for nontransparent.
“Mutual fund-only shops are missing the boat if they don’t have this, because they see where the world is going,” he said. “For them, this is a better product and a better idea, because the world has changed over the past few years. The only place mutual funds will still be able to win is in the 401(k) world.”
But you’re not likely to hear that kind of frank comment from the active mutual fund industry.
Most asset managers won’t even concede the potential for cannibalization of mutual fund assets by nontransparent ETFs offering the same strategy under the same roof, often for a lower fees.
When asked about the risk that nontransparent ETFs will steal assets away from its mutual funds, T. Rowe’s Mr. Coyne said it’s more likely the new wrapper will expand the active strategies to a wider market beyond current mutual fund investors. “I view this as additive, which is a positive for investors to be able to access some of our flagship strategies in an ETF,” he said.
Stephen Clarke, president of Advanced Fund Solutions, a subsidiary of Eaton Vance, is also viewing the glass as half full when it comes to nontransparent ETFs.
“We think there should be a strong appetite,” he said. “There’s a lot to be said about the power of wholesalers and the reach they have.”
Advanced Fund Solutions is still awaiting an SEC green light for a nontransparent ETF structure that it filed a year ago.
In some respects, this is a second effort by Eaton Vance, which launched a similar NextShares exchange-traded product in 2016 that briefly grew to 18 funds from eight different asset managers. Hindered by distribution challenges, NextShares now consists of three Eaton Vance products managing a total of $20.5 million.
Even as the list of fund companies betting on nontransparent ETFs grows, not all asset managers view the new fund wrapper as an automatic path to success.
“We’re not hearing a lot of demand for this,” said Michael Natale, head of intermediary distribution at Northern Trust Asset Management. He cited concerns about the lack of transparency, which some asset managers are hoping investors don’t care about.
“The three main advantages of an ETF are liquidity, tax efficiency and transparency,” Mr. Natale said. “When you take one of those away it’s difficult to tell how advantageous the vehicle is.”
Even though he hasn’t seen much in the way of demand from financial advisers, Mr. Natale said Northern Trust is keeping an open mind. “Right now, we don’t have any plans to launch one and we don’t have any plans to not launch one,” he said. “We’re going to listen to our clients.”
Based on the brief history of Eaton Vance’s NextShares, which was the initial effort to put nontransparent active management inside an exchange-traded product, it’s natural to be skeptical about the potential of similar products.
“Clearly, there is ample supply coming to market and it’s not clear whether the demand is there,” said Spencer Mindlin, capital markets analyst at Aite Group.
“We’re in the early days, but if you read the tea leaves and think about the value proposition and how it fits into the overall narrative of what advisers need to be selling, ETFs will eventually take over,” Mr. Mindlin added. “It will take a long time for people to get comfortable with them, but platforms will come to market that will adopt the active nontransparent product and it will slowly start becoming part of the investment package. You might even see some mutual fund houses that will make commitments to nontransparent wrappers and make it their primary investment vehicle.”
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