Semi-Transparent ETFs – Time for a Peek Under the Hood?

Nowadays there can be no doubt whatsoever that not only have semi-transparent ETFs (“STETFs”) offered investors greater choice, they have been a success story regarding accumulated Assets Under Management; as at 3/31/2022 total AUM had risen to over 5 billion dollars and trading spreads were recently reported, by Nathan Tipping in Risk.net, as being tighter than their fully transparent counterparts, a truly remarkable fact given the turmoil the markets have experienced since the start of COVID.

But tight trading spreads and an ability to protect the funds’ intellectual property (“IP”) and trading strategy aside, unlike their fully transparent ETF cousins, not all STETFs are made equal. So, is it time that investors, financial advisors, portfolio managers and regulators now begin to concern themselves with the nuances of each wrapper?

As background, even prior to the SEC granting exemptive relief for STETFs there was a widespread consensus amongst market participants that any differences between the competing STETF wrappers weren’t significant enough to warrant portfolio managers, financial advisors and even investors familiarising themselves with the nuances of the competing ETF wrappers. After all, all these completing structures ‘did what they said on the tin’ i.e. protect the portfolio manager’s IP and trading strategy. However, that was then and today, with (i) the SEC granting Custom Basket (“CB”) relief to some STETFs and not others, (ii) an ever-increasing interest in ESG investing, and (iii) a market-wide desire to expand the currently highly restrictive investable universe¹ for STETFs, I pose the question:

“Is it now time for market participants and regulators to start taking more interest in the differences between the competing structures?”

Below I detail two specific reasons as to why the differences between the competing structures should be recognized and communicated.

1) Custom Basket Relief

It is a commonly held fallacy that an ETF is a naturally tax efficient vehicle. An ETF’s tax efficiency requires constant redemption activity, i.e. for the portfolio manager to be able to take advantage of the Creation/Redemption mechanism, and thereby benefit from the tax efficiencies the ETF, as an investment vehicle, offers. To date, STETFs have witnessed one-way flows i.e. regular Creations, but very few Redemptions, which significantly reduces the tax benefits an STETF can offer. In recognition of this potential flaw numerous STETF providers applied to the SEC for CB relief and many received approval, but, significantly, not all structures received the said approval. 

For investors, the importance of CB relief cannot be underestimated, as with the said relief, their portfolio manager can utilise the tax efficiency an ETF offers despite little redemption activity. So quite simply those STETFs without CB relief are far less tax efficient than those that have such relief and this will directly impact upon investor returns.

In a recent LinkedIn poll, I conducted a survey, asking the question: “Should Investment advisors inform their clients which ETFs have ‘Custom Basket’ relief as opposed to those that do not?” 

A resounding 261 respondents voted “Yes they should”, whereas just 8 respondents voted “No, they shouldn’t”. In follow up commentary, posts such as the following were commonplace 

“I’d like to know the reasoning behind the ‘No’ responses. I’d expect any investment advisor I engage to be fully informed and be transparent as to which ETFs have ‘Custom Basket’ relief otherwise they are falling short of my expectations of their service.”

“Absolutely no question about it, what motivation could there be not to act in a clients’ best interests?”

The results of my poll and associated follow up comments² are overwhelmingly in favor of full disclosure to the investing public regarding which STETFs have CB relief as opposed to those that do not. This information can only be imparted if advisors take it upon themselves to understand the important differences between the competing STETF structures. 

With the aforementioned in mind, advisor education on this matter becomes even more important now that the wirehouses have opened the door to listing STETFs on their platforms.

2) Expanding the current highly restrictive Investable Universe

To date, STETFs are only available to actively managed investment strategies that use US domestically listed securities i.e. actively managed strategies that make use of foreign equities, fixed income, options etc cannot take advantage of an STETF wrapper. Many, but not all, STETF wrappers can also incorporate actively managed strategies that use Brazilian, Canadian and Mexican equities. 

My belief is that all STETF providers have submitted applications to the Investment Management (“IM”) division of the SEC to expand this highly restrictive universe, but to date these applications appear to have stalled. 

The SECs cautious policy of ‘wait and see’ was wholly sensible because, although in theory STETFs would not be detrimental to the market or the ‘client experience’, IM rightly wanted to witness theory translating itself into in practice. That concern has now surely been put to bed.

Without any inside knowledge I suspect one aspect IM are concerned with, when considering expanding the current investable universe, is time differences, so let me address this.

Market participants have always been able to determine fair prices for foreign securities, outside US trading hours, but what is not proven is whether they can obtain a fair price for a foreign security that they have no knowledge about, by using a substitute security³ as a proxy. This is the dilemma IM face with all STETFs structures except one. Only the Blue Tractor ‘Shielded Alpha’ ETF discloses a full list of the underlying portfolio security names on a daily basis, thereby allowing market participants to determine a fair price for every security in the underlying ETF portfolio, in the exact same manner as they currently do for fully transparent ETFs.

In Conclusion

Whether it’s investment advisors or regulators, it is clearly time for the differences between competing STETF structures to be both recognized and communicated. Without such recognition and disclosure, investors cannot make informed decisions and their choice of actively managed strategies, within which they may wish to invest, will remain severely restricted. 

Finally, I would also make the point that these STETF differences are not restricted solely to investor returns, or expanding investor choice, but they can also impact upon the morals and responsibilities of the ever-growing group of socially aware investors e.g. ESG investing.

¹The ‘Investable Universe’ defines what type of actively managed strategies and securities can be used and contained within a STETF wrapper. At present the ‘investable universe’ comprises ‘Long Only’ strategies that invest in US listed equities.

²Readers can review my poll and follow up comments by connecting with ‘Terence Norman’ on Linkedin.

³Rather than reveal the actual name of a security in the underlying portfolio, e.g. if Shell is in the underlying portfolio, rather than reveal that information, a substitute security (proxy) e.g. BP is disclosed in lieu.

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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