Fresh concerns raised on novel ETF structure

Following new approvals, regulatory officials argue that investors may be harmed

Fresh concerns raised on novel ETF structure

The case for non-transparent ETFs in the US got an additional boost last week when the Securities and Exchange Commission (SEC) revealed plans to approve applications from T. Rowe Price, Natixis, Fidelity and Blue Tractor to launch such products.

But that support may have lost some of its legitimacy as two SEC commissioners aired concerns on potential risks arising from the use of the new ETF structure.

In a statement issued shortly after the SEC’s announcement on the four applications, Commissioners Robert J. Jackson and Allison Herren Lee acknowledged important work done by the regulator’s Division of Investment Management. The work led to important guardrails that would help protect investors from risks of non-transparent ETFs, which prompted the two commissioners to support the firms’ applications.

“We write separately, however, to note our core concern regarding nontransparent ETFs: that, in times of stress, ordinary investors won’t be able to get a fair price for their shares in the funds,” the two said.

While active managers in the US have long been allowed to enter the ETF space, it has always been through the use of transparent ETF structures that disclose their holdings daily. That arrangement, many active firms believed, would blunt the effectiveness of their strategies as other traders and firms would be able to see the underlying portfolio holdings in real time.

As stock-picking managers chose to protect their “secret sauce,” active products have played a miniscule role in the ETF industry south of the border. With the approval of the non-transparent ETF structure, which allows funds to avoid providing full daily transparency, that obstacle to active participation is substantially cleared.

“[Authorized Participants] for these funds will have access to a ‘proxy’ portfolio that, the applicants say, gives them enough information to keep the fund’s price in line with asset values,” Jackson and Lee said, adding that each fund will include only publicly traded securities. Each fund will have established thresholds for tracking error and bid-ask spreads; should these threshold be closed, a board in charge of overseeing the ETF’s efficiency will step in and take needed action.

“But we would not be so sanguine without those protections,” they said. “Nontransparent ETFs come with real risk that, in moments of limited liquidity, ordinary investors will face wider spreads and hence get prices that do not accurately reflect the value of their shares.”

While the applications submitted to the commission have mitigated such concerns by targeting largely liquid assets and adopting guardrails, Jackson and Lee stressed that they’d be skeptical of any non-transparent funds focused on different asset classes, particularly if they lacked those characteristics.

“We also want to keep close watch over the appropriate disclosure regime for nontransparent ETFs,” they said. “In particular, we wonder whether additional disclosure of the risks, as well as enhanced board oversight of the efficiency of these ETFs, is necessary … We urge our colleagues to consider whether prospectus disclosure of these measures is necessary going forward.”


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