SEC Poised to Permit ActiveShares ETF: First Non-Transparent Actively Managed ETF
ETF Reg Insights
Date: April 11, 2019
In our January 2019 ETF Reg Insights, “Preparing for the Next Generation of Actively Managed ETFs” (January Update), we alerted the ETF industry to the high probability of the advent of non-transparent actively managed ETFs (NTAM ETFs), and now that day is nearly here. The SEC recently issued a notice in response to an exemptive application filed by Precidian ETFs Trust that would permit ActiveShares, the first NTAM ETF. Based on the Notice’s return date, the order formally permitting ActiveShares ETFs could be issued as early as May 5, 2019.
As explained in the Notice, the lynchpin of an ETF is the mechanism that keeps the market prices of ETF shares at or close to the NAV per share of ETF. Since the first ETF was launched over 20 years ago, that mechanism has been the requirement that the ETF display its entire portfolio on a daily basis. Index ETFs have had no issue with this requirement since the indexes they track daily publish their constituents. Investment advisers to actively managed funds have in large part been reluctant to launch ETFs because of the fear that daily disclosure of their ETF holdings would allow competitors to figure out their proprietary stock-picking strategies by backtesting past daily portfolio holdings.
At least six financial firms or groups of firms have attempted to overcome the actively managed ETF barrier by devising acceptable alternatives to the requirement that an actively managed ETF expose its portfolio each trading day. As we noted in our January Update, this group of firms has developed ETFs that in lieu of daily exposing their portfolios make available enough information that theoretically allows arbitragers to exploit any discrepancy between the ETF’s NAV and share price without disclosing the ETF’s full portfolio to the public.
Note that the SEC’s notice does not grant exemptive relief – it only signals the SEC’s intention to grant the relief while giving the public an opportunity to request a hearing prior to May 5, 2019. Assuming that no one requests a hearing (which is a rare occurrence), Precidian, with its ActiveShares ETFs, will be the first sponsor through the gate.
The ActiveShares ETFs will utilize an “AP Representative Structure” approach. Unlike traditional ETF APs that transact directly with the ETF through the distributor or TA, APs for these NTAM ETFs will need to transact through an “AP Representative” that will be privy to the NTAM ETF’s creation basket but will be contractually required to maintain the confidentiality of the basket’s contents. The AP Representative will use a confidential brokerage account on behalf of each AP for this purpose. While creation and redemption transactions with the NTAM ETF will generally be on an in-kind basis, from the AP’s perspective, transactions will essentially be made on a cash basis because of the interposition of the AP Representative. The AP Representative will purchase securities in the basket (in the case of a creation) or liquidate securities transferred from the NTAM ETF’s custodian (in the case of a redemption).
Precidian will disseminate a verified intraday indicative value (VIIV) of the actual NTAM ETF’s portfolio throughout the trading day. The VIIV will be calculated every second throughout trading day and on a per share basis based on the value of the actual securities in the fund’s portfolio, cash and any accrued interest and declared but unpaid dividends, minus accrued liabilities. Using a current VIIV along with existing fund disclosures, APs are expected to do a regression analysis and construct dynamic hedge portfolios to hold shares and arbitrage the difference in the market price/NAV of shares when the opportunity arises.
The Notice summarizes Precidian’s application that was most recently amended on April 4, 2019. Below is a summary of some of the significant provisions that were added or changed compared to the application that was noticed and the prior application filed in May 2018 that we discussed in our January Update:
- NTAM ETFs will not be able to invest in illiquid securities (as defined in Rule 22e-4(a)(8) under the Investment Company Act of 1940) at the time of purchase.
- Each NTAM ETF is required to have a prominent legend in its prospectus that is more detailed about the additional risks to which a NTAM ETF is subject (specifically, increased trading costs and potential higher premiums/discounts).
- NTAM ETFs will not have the ability to rely on an exemption in Reg. FD regarding certain communications made in connection with an offering registered under the Securities Act of 1933.
- For at least three years after the initial launch of a NTAM ETF, the adviser must convene a board meeting to discuss options if, for 30 or more days in any quarter or 15 days in a row, the absolute difference between either the market closing price or the bid/ask price and NAV exceeds 1.00% or the bid/ask spread exceeds 1.00%.
The issuance of the Notice allowing ActiveShares ETFs is just the first chapter in the NTAM ETF story, as five other applications are still pending. Also, Precidian anticipates licensing the methodologies and technology behind ActiveShares ETFs to financial firms. It remains to be seen if and when financial firms will file applications seeking exemptive relief from the SEC for their versions of the AP Representative Structure.
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 We discussed five financial firms that were potential sponsors of NTAM ETFs in our January Update, which were Fidelity, NYSE/Natixis, T. Rowe Price and Blue Tractor, in addition to Precidian. Since that time, Eaton Vance has also filed an application for its version of NTAM ETFs (see https://www.sec.gov/Archives/edgar/data/1076598/000094039419000345/clearhedge40app.htm).