A New Paradigm - Flexible Transparency in an Actively Managed ETF

What Can We Learn from Star Trek?

The classic science fiction television series Star Trek demonstrated a fascinating technology called the cloaking device.Cloaking renders a spaceship temporarily invisible – what is fully visible in one instant is completely obscured and opaque in another. Numerous episodes see Star Trek’s hero characters aboard the spaceship USS Enterprise flounder when they enact futile countermeasures to defend against cloaked spaceships hurled at them by the evil Klingon Empire. To the crafty Klingons, full visibility when attacking the USS Enterprise was seen as a disadvantage; instead, the Klingons desired the flexibility to select on their own terms when they wanted their attacking spaceships to be visible or invisible. When a Klingon spaceship became invisible, the USS Enterprise could not discern its parameters and composition with precision, so it became impossible to exploit and take advantage of any weakness in the Klingon vessel and/or strategy.

Something New…Flexible Transparency in an ETF

Although Star Trek-type cloaking devices able to obscure attacking spaceships exist only in science fiction, readers should know that the United States Securities and Exchange Commission (“the SEC”) has approved an exchange traded fund (“ETF”) structure developed by Blue Tractor Group that confers to the active equity portfolio manager the desirable attributes of the Klingon cloaking device. Specifically, the Blue Tractor structure (or ETF wrapper) allows a portfolio manager to adjust the desired level of portfolio transparency so that the ETF can (a) be essentially transparent or (b) can be significantly less transparent. [1] 

Moreover, portfolio managers can make an adjustment in transparency daily, if desired, with just a few clicks of their computer mouse. The powerful optionality of increasing or decreasing the level of portfolio transparency is termed flexible transparency and underpins the wholly unique attributes of the Blue Tractor ETF wrapper, more fully described below and at bluetractorgroup.com. The Blue Tractor ETF wrapper currently powers actively managed equity ETFs on both the NYSE and Nasdaq exchanges.

The Emergence of Actively Managed ETFs

Since 2020 the funds market has seen a significant increase in the numbers and types of actively managed ETFs. While actively managed ETFs remain a small proportion of the overall U.S. ETF market their popularity is increasing rapidly; 2022 saw inflows of $86 billion and total AUM in the U.S. now stands at $340 billion (source: Yahoo Finance).

Increasingly more and more active managers see the lower cost, greater tax efficiency and intra-day liquidity attributes of the ETF wrapper as highly compelling versus the more traditional mutual fund or SMA vehicles.

Traditional Wrapper Choices for an Actively Managed ETF

What wrapper options does an active manager have when considering launching an actively managed ETF? In general, the ETF can be either transparent or semi-transparent (sometimes also referred to as non-transparent). 

A transparent ETF is required to publicly disclose its exact portfolio composition daily on the fund website and typically it will disseminate a creation basket (for use by authorized participants to create and redeem ETF shares) that is a pro rata representation of the actual portfolio contents as well. So, an investor, RIA or any capital markets participant observing the publicly available fund information will know exactly what the portfolio manager holds and what they are doing, especially when they enter or exit positions. Transparent ETFs fall under the auspices of SEC ETF Rule 6c-11 under the Investment Company Act of 1940 and are effectively a plain vanilla, non-proprietary wrapper structure. By far they are the largest category of actively managed ETFs and enjoy widespread adoption and uptake by all the distribution platforms, wire houses and RIA allocators. Transparency is also a hallmark of ETFs in general (both passive and active) and is one key reason for the success of ETFs to date – many investors and investment advisors clearly prefer portfolio transparency as it’s an unobstructed window into the actual composition of the ETF.

Conversely, active managers concerned that their proprietary stock selection strategy and trading can be compromised by portfolio transparency can instead select a semi-transparent ETF wrapper option. These are relatively new flavors of actively managed ETFs developed by 6 firms (including Blue Tractor) and approved by the SEC in 2019 and 2020.[2] Each firm’s structure is proprietary and requires a license before use by another fund manager. Semi-transparent ETFs do not have to disclose their exact portfolio contents daily on the fund website, thereby shielding from the market their specific trading activity. But in lieu of portfolio transparency the SEC requires these ETFs to disseminate either current portfolio pricing information or a reference basket that correlates closely with the performance of the undisclosed actual portfolio, in order to provide authorized participants, market makers and other capital markets participants with sufficient information to conduct efficient and accurate markets. The semi-transparent space is an emerging segment in the growing actively managed ETF market and the industry is beginning to see adoption by a host of distribution platforms, including the wire houses.

The Flexible Transparency Paradigm

As described earlier, the Blue Tractor structure is a unique semi-transparent wrapper construct that permits an active portfolio manager, at their own discretion, to manage their ETF with varying levels of transparency, including a level where the ETF is essentially transparent. [3] The Blue Tractor wrapper confers optionality to the portfolio manager to decide on any given day whether the ETF portfolio is essentially transparent or not. Termed flexible transparency, this feature resides only with the SEC-approved Blue Tractor structure and not with any other semi-transparent ETF wrapper. 

And because the Blue Tractor ETF wrapper is a cloud-hosted solution, all operational workflow is efficient and secure. A portfolio manager can implement different levels of transparency on a daily basis simply with a click of their mouse.

What are the benefits of flexible transparency for an actively managed ETF? At its core, when the ETF runs as essentially transparent the fund can be presented and socialized to RIA allocators and investors as just that; that this ETF is comparable with a fully transparent ETF. [4] As mentioned, many RIAs and even investors prefer transparency in their ETFs; they wish to know the portfolio composition.

But on the other side of the coin, having an ability to cloak the portfolio and be less transparent whenever desired means that the portfolio manager can be confident when undertaking rebalance trading that their trading strategy and activity is fully protected from predatory actors who may front-run the fund and/or copy the portfolio manager. Front-running unfortunately could reduce a portfolio manager’s edge and ultimately portfolio returns.

Blue Tractor’s cloud-hosted workflow provides the portfolio manager with a choice about the level of portfolio transparency. They could, for example, manage the ETF as essentially transparent 240 trading days of the year but make it less transparent on the one day per month they wish to rebalance the fund (assuming the typical 252 trading days per year). And if they rebalance quarterly, they could operate in a less transparent manner for just 4 trading days of the year. The point being that the ratio of days for the ETF portfolio to be essentially transparent or less transparent is always at the portfolio manager’s discretion.

So, flexible transparency is a win-win for an actively managed ETF. Investment advisors and their investor clients could use ETFs where the portfolio manager elects to operate an essentially transparent ETF on most days but seeks to protect the ETF from predatory third parties by electing less transparency on important trading days for the ETF portfolio.

Contrast this with launching a fully transparent ETF under Rule 6c-11. This ETF can only ever be transparent; this rigidity precludes any option of running the ETF as semi-transparent, even for a day. Although an active portfolio manager may initially view transparency in an ETF as being acceptable, over time and as markets and trading strategies change, they may wish to alter their approach to portfolio transparency, but under Rule 6c-11 they will not be able to. By contrast, the Blue Tractor structure can allow an ETF to transition from being essentially transparent to being less transparent (and vice versa), allowing the portfolio manager to retain complete control on how to manage their ETF through all market cycles and conditions.

Operational Considerations

SEC approval for launching an ETF with flexible transparency follows a simplified pathway based upon Blue Tractor’s regulatory relief; the regulatory application is just over 10 pages long and approval typically is obtained in 3 to 4 months. In addition, the operational workflow is in the cloud so it’s simple, rapid and efficient to implement.

In order to implement flexible transparency in the ETF the portfolio manager need only to instruct the Blue Tractor cloud software to generate the next day’s reference basket to essentially mimic the actual portfolio (i.e., targeting 99.9% weightings overlap with the actual portfolio weightings) and then update this information on the fund website. This is a quick and simple exercise with the click of their computer mouse. The capital markets will therefore know that the reference basket they see is essentially transparent. As a result, the ETF would be comparable to a conventional transparent ETF. [5]

When the portfolio manager wishes to cloak the ETF portfolio visibility, they use the exact same workflow to adjust the transparency level for the day and let the Blue Tractor software randomly generate a less transparent reference basket.[6] 

Why Blue Tractor is the Only Semi-Transparent Wrapper with Flexible Transparency

The inner workings of the 5 other semi-transparent wrappers preclude them from offering active portfolio managers flexible transparency in an ETF. Under their structures an ETF will always operate as conventionally semi-transparent.

The Precidian structure does not publish a daily portfolio or reference basket and is by design a wrapper meant to confer continual invisibility.

The proxy portfolio structures (Fidelity, Invesco, NYSE and T. Rowe Price) do utilize a reference basket. However, these baskets may be composed of substitute securities and/or may omit actual portfolio securities and may have lag periods before incorporating portfolio changes into the reference basket. Baskets may even be required to have more securities than in the actual portfolio. Therefore, they cannot publish a reference basket that can essentially mimic the actual portfolio like the Blue Tractor wrapper can.

[1] When essentially transparent the ETF’s published reference basket would be extremely close to the actual portfolio (see footnote 3). When the ETF is operating significantly less transparent, as per Blue Tractor’s exemptive Order from the SEC, the weightings of the securities in the published reference basket can deviate from the actual portfolio down to a minimum overlap of 90% at the beginning of the trading day.

[2] Precidian, Fidelity, NYSE, T. Rowe Price, Invesco & Blue Tractor.

[3] Blue Tractor defines the term “essentially transparent” as an ETF with a daily published reference basket composed (1) only of the exact security names in the actual portfolio and (2) that the aggregate weightings of these securities in the reference basket will have a target 99.9% overlap with these securities’ correct weightings in the actual portfolio. 

[4] As discussed, an active ETF utilizing the Blue Tractor structure would not operate under Rule 6c-11, which requires the ETF to disclose its full portfolio on a daily basis. Instead, an active ETF operating under the Blue Tractor structure would need to describe in its prospectus, marketing materials and website how the reference basket is designed to differ from the ETF’s actual portfolio and to include certain risk disclosures required by the SEC approval order.

[5] Although not fully transparent as per Rule 6c-11.

[6] Note that under Blue Tractor’s SEC approval, the weightings for the portfolio names in the reference basket will always have in aggregate a minimum 90% overlap with the actual portfolio weightings at the beginning of each trading day; the Blue Tractor algorithm will randomly vary the overlap daily from 90% to 100%. 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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