ETFs have frequently been described as democratic investment tools - institutional and retail investors have access to the same products, the same information and the trading flexibility. Investors have been the big winners from ETFs - being able to create highly diversified portfolio at extremely low costs.
The tremendous growth of ETFs, and the variety of new ideas coming to market demonstrates that advisers, model portfolio managers and end investors want a wide variety of tools, both active and passive, to help them meet their investment objectives, and they want them in an ETF format.
Many ETF investors and professional fund selectors prefer ETFs over mutual funds due to the ease of onboarding, automatability of processes and simplicity of comparisons.
If investors and fund selectors want active ETFs but asset managers are uncomfortable creating them due to fears of front-running then the whole market loses out: investors don't have the ability to get exposure to the great managers they want in the format they prefer; fund selectors face hurdles adding attractive strategies to their platforms; the market becomes less diverse and competitive and asset managers have one less option to expand their businesses.
The lessons from the last two decades of ETF development provide a strong investor-led argument to support the introduction of non-transparent active ETFs - value.
Over just a few years, ETFs have dramatically driven down the cost of creating a portfolio. By using ETFs, investors can now construct a diverse, multi-asset portfolio at a fraction of the cost of using equivalent mutual funds and, via fractional trading, can start investing with a very modest sum of money.
On the reasonable assumption that the same price pressure could be brought to bear on active strategies, the cost savings to the end investor will run into the billions over time.
The well-recognised advantages of ETFs - intra-day trading, shortability, lendability, having an ETF portfolio held in one venue, portability of positions between trading venues, low entry costs and diversification - can be retained in a non-transparent structure, meaning investors stand to benefit from more features, more choice and more flexibility for less cost and less complexity.
Convergence
When we discuss ETFs and active management, we cannot avoid the so-called active-passive debate - the idea that most active managers don't consistently outperform their benchmark.
We think this debate is focusing on the wrong issues. Far from being a world of opposites, where 'passive good, active bad' we are seeing convergence of trends across the range of investment management activity - human and machine, automation and customization, discretionary and systematic, active and passive, scale and personalization.
Giving investors the option to gain exposure to the same active investment strategies they already own via an ETF wrapper has the potential to offer significant improvements to their current experience.
Non-transparent ETFs are a great example of how the European ETF industry could extract the attractive features of active and passive and combine them into one innovative solution that solves a real need for investors and asset managers.
Addressing the disclosure issue
Regulators and stock exchanges across Europe have not yet grappled with the issue of non-transparent ETFs, and in fact there is little consistency in approaches towards conventional active ETF disclosure - for example London Stock Exchange and Borsa Italiana, both part of the same group have opposite approaches, full daily disclosure in Milan but not in London.
Regulators are also grappling with the issues around disclosure. There is a fear that the role of the Authorised Participant (AP) means they get privileged information through the PCF and there is a risk of market abuse. In my view, there is a relatively simple solution here. To be an AP you need to sign a detailed contract with the issuer and the terms and conditions cover off these risks.
Regardless of the contract, the APs themselves are highly regulated (most notably MiFID II and the transaction reporting regime) and this has provided the regulators with far more data so they can analyse and catch any entities that are engaging in market abusive behaviour. APs receive confidential information regularly and have strong internal controls and processes to deal with such information.
Part of the solution is also to redefine the role of the AP for non-transparent ETFs to include acting as a market maker. This would then allow APs to avail of the market making exemption within MiFID. This solution also allows issuers to control the flow of information by limiting its availability to essential trading counterparties. However, we would advise there should be at least a minimum of two APs for any ETF.
Exchanges stand to be one of the main beneficiaries of the next stage of the ETF revolution - active ETFs - but must play a proactive role in addressing the concerns of asset managers who want to leverage the disruptive distribution power of ETFs without sacrificing their investment IP.
The Best of Both Worlds
ETFs have driven down the cost of index investing, made it easier to construct portfolios and made it more convenient to take short-term positions on a theme, sector, market or strategy and allowed forward-thinking asset managers to build tremendous businesses. It's time to bring these benefits to the active management space, creating more choice and more opportunity for both institutional and retail investors.
