The Tokenization of Actively Managed Funds

The tokenization of actively managed funds presents a dilemma for portfolio managers, who must balance the need for transparency with the protection of their investment strategies. Blue Tractor offers a solution by allowing managers to disclose a Proxy Basket (PB) instead of full portfolios, providing enough information for accurate pricing while maintaining confidentiality. Despite the potential benefits, regulatory hurdles and security concerns remain significant challenges for the future of tokenization in asset management.

Tokenization is growing in popularity by the day as we see more and more asset management firms tokenizing their funds and technical issues are consistently being overcome. However, there is one particular group i.e. Active Portfolio Manager’s, a group which can come in many forms e.g. Exchange Traded Funds (“ETFs”), Hedge Funds etc who may be more reluctant than most to have their funds tokenized. After all, what discerning active portfolio manager wants to reveal their Intellectual Property i.e. their investment and trading strategy, and expose their shareholders to the vagaries of predatory ‘front running’ and ‘copycat’ funds? These vagaries only being possible because it was thought that the exact composition of a portfolio was required, on a daily basis, for accurate pricing and hedging by the market making community. However, the idea that having to know the exact underlying portfolio composition, for accurate pricing and hedging, is clearly nothing more than ‘lazy market making.’ 

To begin let us examine the financial consequences of full portfolio disclosure in the world of ‘passive investing.’ The financial costs to funds from predatory ‘front running’ are both well-known and well documented in the world of indexed based ETFs. In the United States it is estimated that these costs to indexed based ETFs range anywhere from between;

• 7.6 basis points per annum, which for a passive fund management size of 15 trillion USD equates to around 11 billion USD per annum.
   
• Roughly 3.9 billion USD worth of returns due to rebalancing and front running.
  These figures being reported by  University of Illinois study by Sida Li titled 
  “Should Passive Investors Actively Manage Their Trades?”.

Furthermore, is there any doubt that almost every major financial house has a desk specifically working to forecast and ultimately ‘front run’ the next set of index constituent changes? And when the tokenization of index-based ETFs becomes readily available these figures can only worsen as global investors and cybercriminal’s jump on the ‘index rebalancing’ gravy train. So, the financial risks are real but the good news for portfolio managers running active funds is that there is a solution to this transparency/opacity dichotomy. By creating in effect a trusted Proxy Basket (“PB”), that offers market makers enough information to be able to hedge their exposure a market maker is able to create a price without the fund manager revealing the entire holdings in a fund.

However, despite the compelling evidence that ‘front running’ exists, some manager’s may claim that the ‘front running’ of their fund is not an issue. As such, let us consider the following;

• The fund only invests in highly liquid large cap stocks e.g. the FAANG’s (Facebook, Apple, Amazon, Netflix Google). 
  ‘Front Running’ may not be a problem for these type funds and they can confidently Tokenize will full transparency of the underlying portfolio. However, are these type managers really ‘active managers’ or simply closet indexers charging active management fees and ultimately doomed to failure?
   
• We are already witnessing the increasing use of robo-advisors, utilizing AI algorithms to provide automated and personalized investment advice. There is little doubt that the very same technology and methodologies can be used to give insight into the rebalancing of active funds i.e. once the underlying investment and trading strategy have been discovered i.e. reverse engineered. Following discovery, by way of example, investors in the Far East can buy securities ahead of a US fund making a swift return at the expense of the fund’s shareholders and thereby negatively impacting their returns.

The establishment of a PB resolves these types of issues for active managers as their funds’ underlying investment and trading strategy will always remain elusive to predatory traders. Prior to Tokenization and working with the portfolio manager and their lead market maker, one needs to  determine an optimal level of transparency/opacity for a particular actively managed fund in the form of what is commonly termed a PB. The PB can take one of almost an infinite number of forms, unfortunately it’s not a one size fits all, and will be dependent upon (1) the type of financial instruments that are contained within the underlying portfolio e.g. domestic equities, global equities, fixed income securities, commodities, cryptocurrencies, real estate, ETFs, options etc etc etc (2) regulatory restrictions and (3) time zones to name but a few such variables that will influence the PB construction process and its ultimate make up.

By way of example;

1. A domestic Australian equity fund may simply require listing the names of the top 10 holdings and matching sector weights. 
   Whereas an Australian global equity fund may simply require insight into global sector exposures along with the disclosure of the Top 5 domestic holdings.
   
    
2. For a fixed income portfolio, the PB may be constructed in order that it has matching risk characteristics e.g. Duration, Convexity and Credit Rating.
   
    
3. A market maker may insist upon knowing if the underlying portfolio contains particularly volatile assets e.g. Bitcoin, and a Blue Tractor solution can accommodate any such request.
   It is important to recognise that, knowing the fund contains Bitcoin is simply information, it is not the knowledge predatory traders require for ‘front running.’ 
   
    
4. Some active portfolio managers may not want any of their underlying portfolio securities contained within the PB.
   In this instance Blue Tractor will construct a PB with the same underlying risk characteristics as the underlying portfolio e.g. Duration, market betas, sector beta’s etc etc using financial instruments absent the underlying portfolio.

In lay terms, it is the knowledge that predatory traders require that a PB will protect, while giving market makers the necessary information that they need for accurate pricing and hedging. No matter what form the PB takes, pre-Tokenization work and discussions will be required to determine the tracking error, between the underlying portfolio and the PB, to finely tune the PB once the basic template has been agreed upon. This is a vitally important aspect of the pre-launch process as;

1. It is an opportunity to install further confidence in the reliability of the PB e.g. within times of high volatility the PB can still be relied upon, and it isn’t simply a ‘fair weather’ utility function. 
   
    
2. An optimal transparency/opacity mix can also be quantified e.g. would it be better to move to top 10 holding disclosure as opposed to a top 5 and what benefits would that bring e.g. greater insight into the idiosyncratic risk, significant lower tracking error etc etc?

An additional benefit of using a PB is that fund managers, administrators, investors, regulators etc all know that the price of the Token is being accurately and independently calculated by market makers using information provided to them via a further independent third party i.e. a PB can help reduce any accusations of ‘insider trading’.

So to recap, in stark contrast to a passive Tokenized portfolio, utilization of a constructed PB means that the actual underlying fund composition remains confidential while enough information is provided to market makers for accurate pricing and hedging their risk. With the PB solution in hand, active portfolio managers can protect their Intellectual Property and confidently Tokenize their funds while potential investors can confidently trade those tokens in the knowledge that they are trading at both an accurate and fair price.

PB are already being used by actively managed ETFs. Blue Tractor is the power behind PB’s and its knowhow is already being used by two ETFs one being;

Ticker DYTA which is listed on the Nasdaq and has around 60 million USD AUM

Kyle Balkissoon, Portfolio Manager at US based Stance Capital and former Head of Cognitive Forecasting at IBM, believes that the Tokenization of Actively Managed Funds will face the same front running and copy cat issues, regarding the protection of the funds Intellectual Property and order execution as they themselves faced when they first considered launching their own Actively Managed ESG ETF (NYSE : STNC).  

It was important for us to engage with Terry Norman and his team at Blue Tractor as they provided us with the technology and know-how required to keep both our Intellectual Property and the funds integrity safe. I’m certain that the same dialogue and technology will assist in bringing Actively Managed funds to the Tokenization table.

The future for the tokenization of all types of financial instruments presents the financial industry with a highly welcome and attractive proposition.  However, like anything some financial instruments will take to tokenization better than others as will the basic concept to different demographic groups. For tokenization to really fulfil its true potential a few issues need to be resolved, particularly those around confidentially which will be of concern to actively traded funds.

Finally, I would conclude with three final points;

1. Although some industry observers and regulators maintain that shareholders want to know the exact composition of the ETF portfolio, this is nothing more than pure speculation. The fact is that there is no quantitative evidence to support such a claim and it therefore remains unsubstantiated.
   
    
2. Current expectations surrounding the tokenization of funds e.g. ETFs, needs to be moderated as the concept remains somewhat in its infancy and regulatory hurdles still need to be overcome. 
   
    
3. Tokenization is undoubtedly the future and regulators from around the world should embrace it with a more collegiate mindset, as opposed to many’s current adversarial stance.