We’ve never really touched upon the issue of active ETFs at FT Alphaville, because quite honestly the subject makes our heads hurt.
But we’ve decided we’ve possibly dodged the issue for long enough.
Besides because Monday is unofficial “let’s focus on ETFs” day at the Financial Times, now is probably a good time as ever to bring the subject to your attention.
The first thing to understand with regards to active ETFs is that there are generally two schools of thought on their structuring — mostly because there’s an obvious inherent conflict that lies behind their raison d’etre.
ETFs by their nature are supposed to be transparent. Actively-managed funds, on the other hand, have much less of an incentive to reveal their holdings on a timely basis, for fear of being copied or outwitted by the market.
Marrying the two in a way that allows the share units to track the fund’s underlying assets in terms of net asset value, but in a way that doesn’t reveal holdings on a real-time basis, is thus a Sisyphean challenge.
Thomas Faust, chief executive of fund manager Eaton Vance, has in the past even compared the pursuit for an efficient non-transparent structure to the search for the holy grail.
Remember, in passive-structures the disclosure of the holdings is essential, not only for transparency reasons, but more importantly so that market-makers can keep the creation/redemption mechanism going. To do that they need to know which securities to compare ETF share prices with.
Thus, having pondered the issue long and hard most of the fund universe interested in launching active ETFs has resorted to the quickest route to market: the transparent route.
But that didn’t stop the likes of Eaton Vance.
The fund began the regulatory process to approve five non-transparent actively managed bond ETFs in March 2010, based on highly technical patented processes. In April this year, the Securities and Exchange Commission finally granted the fund manager’s request.
So how did they do the impossible?
In a nutshell, their success lies in the intellectual property they came up with, their patented processes for non-transparent trading.
As the FT wrote in November:
At the core of the acquired technology is a business method patent that would allow for so-called net asset value-based trading of ETFs. Rather than allowing the ETFs to be traded intraday based on bids and offers controlled by market makers and arbitrageurs, NAV-based trading would allow investors and advisers to trade at a price relative to the NAV of the underlying portfolio, Gastineau says.
“In order to do intraday trading that’s even remotely close to intraday asset values you have to have a transparent portfolio, and the transparency is a very bad idea in an actively managed portfolio,” he says. With an NAV-based system, which uses limit orders to keep the trades within a band of the NAV, “you can still trade at or relative to net asset value but you don’t have to worry about the value of the intraday portfolio.”
Now, while the FT says that much of the details of how such a trading mechanism would operate have not been disclosed in the patents, the patents themselves are still worth trawling through.
That’s largely because they read like a manual to Skynet.
Indeed, if you thought normal black box trading was scary, this will take you aback one step further — for, as far as we can work out, the entire model relies on nothing more than a bunch of computers talking to each other within highly computerised Chinese walls. The aim, meanwhile, is to protect investors from funding the liquidity provided to entering or leaving shareholders.
Note the schematics:
There’s at least 20 pages more, which we won’t bore you with. But you get point. Simple it is not.
As to the scale of computerisation:
The preferred embodiment consists of major and several subsidiary components implemented through a variety of separate and related computer systems for the fund. These components may be used either individually or in a variety of combinations to achieve the join objectives of protecting fund investors from the costs of providing liuqidity to fund share traders, increasing the effectiveness of the portfolio management process and providing a new and improved way to trade exchange-traded fund shares on a secondary market.
And for fun, we’ll leave you with the following schematic from a patent of yet another actively managed fund process, this time filed by a group called D12 Ventures, which describes as:
Providing computer systems and automated methods for an authorized participant (AP) to create exchange traded fund (ETF) shares without the AP directly delivering the portfolio securities to the ETF and to redeem the ETF shares without learning the identity of the underlying portfolio securities.
We like it because it looks like it can be run by an Amstrad PCW 8256. Nice.
Related links:
Active ETFs come out of hibernation – FT
Low-cost active funds on the way – FT
If we build it, they will come – FT Alphaville
Cost-effective phone calls from ET(Fs)? - BoingBoing