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The Timely, Bear Market, Non-Transparent ETF Launch 10 Years in the Making

From initial paperwork to regulatory approval, the long and winding road for actively managed vehicles sees the light amid dark days.

As head of exchange-traded funds at American Century, Ed Rosenberg knows it’s hard to pick the right moment to launch a product. But no one could have predicted that after 10 long years coming down the pipeline, non-transparent ETFs would arrive in the middle of the fastest bear market in history.

Non-transparent ETFs have showed up just as a decade long bull market has ended and whose spectacular run hastened the hemorrhaging of funds from active to passive strategies. ETFs have been a primary beneficiary. Unlike mutual funds, ETFs trade intraday and offer cheaper fees and tax efficiencies. But they have one major downside for the active manager: ETFs disclose their full portfolio every day in order for market makers to accurately quote prices in the secondary market. This requirement creates problems for managers who fear front-running and would-be copy cats who might dip a whisker into their “secret sauce.”

Until now. Non-transparent ETFs – which reveal their holdings at least once a quarter, rather than every day like conventional ETFs – are intended to strike the middle ground, allowing active managers to keep their portfolios secret while giving them access to the ETF boom. A slew of asset managers have been in the race to launch the first products after Precidian Investments, a minority investment of Legg Mason, won SEC approval for its ActiveShares structure – an actively managed, semi-transparent product, in April 2019. But Rosenberg wanted American Century to be first. “Being first is important,” he says. “We wanted to start the conversation.”

It took Precidian, which specializes in ETF and mutual fund development, more than 10 years to get exemptive relief for ActiveShares. Rosenberg knew it could take the SEC up to 270 days to approve the two ETFs that American Century had built using the ActiveShares structure, one focused on growth, the other on value. 

Unlike for mutual funds or closed-end funds, federal securities laws did not originally provide for ETFs. Until recently, ETFs have had to obtain an individualized exemptive order from the regulator before going to market. Now, the SEC has adopted an "ETF Rule" but ETFs that don’t fit within the rule, such as the American Century ETFs, still need an exemptive order.  

In addition, listing an ETF that does not fit within the ETF Rule requires the listing exchange to file a “proposed rule change” to the exchange’s listing rules with the SEC. The SEC posts notice of the filing in the federal register and solicits comments. But the actual approval can be lengthy, because the SEC can extend its 45-day deadline for a total of 270 days. In the end, the two American Century products took 232 days, with a final prospectus for the two products published on the SEC website on February 11.

By the end of February, stocks would have capped off their worst week since the 2008 financial crisis as investors braced for the spreading pandemic. “A less than ideal moment to launch a new product into a market,” reflects Ben Johnson from Morningstar. “Investors have been dialing down risk in their portfolios. We have seen record money flows into safer bond exposures, short duration government bonds in particular, and even investors that continue to add risk in equities are favoring safer assets.”

While demand for active strategies has been weak for years, did active strategies provide downside protection as  widely advertised? “The idea that active managers are going to reliably outperform in bear markets belongs with Santa Claus and the Easter Bunny,” Johnson says. “It’s a myth.”

Nonetheless, Rosenberg saw an opportunity for American Century. “Everyone has a story about a product: this is how it works, this is how it’s supposed to behave.” By launching in a moment of extreme volatility, he hoped to demonstrate the capabilities of the semi-transparent products in real time. “When the markets turn, let’s say we’re up 35-40 percent, [investors] will be able to say: ‘You were live and that’s what happened.’ You’re getting out and showing that your product behaves as you say it will.”

Rosenberg’s next challenge was on the backend. He had to smooth the paperwork with Citadel Securities, the lead market maker; State Street and Cantor Fitzgerald, which act as authorized participant representatives; and IHS Markit, which is appointed to calculate the verified intraday indicative value (VIIV).

He wanted to strike the right date between the worst of the market volatility and the end of March. “The goal is to launch and have the holdings come out not too far after, so market making firms can gain more information to make better quotes for clients in the long run. Let’s say a competitor launches next week, it’s going to be 75 days until their holdings are published, if they are quarterly with a 15-day lag, give or take.”

They just made it, launching on March 31. Todd Rosenbluth, director of mutual fund and ETF research at CFRA, says American Century judged the timing “pretty well,” noting that “they came to market at the tail end of the fastest bear market in history,” he says. “Now they will have a chance to have a live track record of trading, without as much of the spotlight that might have happened if they had come to market in normal times.”

Rosenberg says the funds, which started with $4 million, have grown in size to $10 million in the Dynamic Growth Fund (ticker: FDG) and just over $14 million in the Large Cap Value fund (FLV), with trading of around 20,000 shares a day for each product. The expense ratio for the growth fund, and value fund, is 0.45% and 0.42%, respectively.

American Century has further filed for two ESG-style products under the NYSE: a sustainable equity ETF and a mid-cap growth impact ETF. A slew of other firms are not far behind with semi-transparent products, including Legg Mason, which is launching an active ETF through ClearBridge, and T. Rowe Price Group, which has won approval for ETF versions of four large-cap mutual funds. 

Johnson says the real test will be when these like-for-like strategies are trading alongside one another. “The two products that are out there now are not direct clones of existing strategies. Not only is it a new form, it’s a brand new strategy.”

But the T. Rowe Price products will offer a comparison and choice for investors. “That will be the real test of whether the format can turn the tide for asset managers,” says Johnson.

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