Active Semi-Transparent ETFs: What's Under the Hood?

Everyone wants a safe and reliable vehicle. For example, if you're buying a car, it's a good idea to take a look under the hood. What you see may tell you a lot about the vehicle's performance, cost, and reliability for years to come. The same is true for active semi-transparent exchange-traded funds (ETFs), a type of ETF built differently compared to traditional versions. That makes knowing what's "under the hood" of these instruments more important than ever.

Most ETFs on the road today are based on the '40 Act fund chassis (referring to the Investment Company Act of 1940). This means these ETFs are basically structured the same way traditional mutual funds are, but their sponsors have received permission from the U.S. Securities and Exchange Commission (SEC) to do things a little differently. For example, traditional '40 Act mutual funds buy and sell shares at the end of each trading day, with investors of all sizes, at the fund's net asset value (NAV). ETFs, on the other hand, have received permission from the SEC to transact only with large, authorized participants (APs) in big bundles of shares (typically 50,000). Another difference between ETFs and mutual funds is the frequency of portfolio disclosure. While mutual funds typically disclose their holdings either monthly or quarterly with a significant lag (up to 60 days), most ETFs disclose complete holdings information every day the markets are open.¹

Historically, most ETFs have operated with similar exemptions from the Investment Company Act of 1940, but newer types of ETF structures began receiving approval from the SEC in 2019. These ETF models are frequently referred to as "active semi-transparent," and the first ETFs based on these models were launched in 2020.

Although the details vary, the purpose behind these new models is to make ETFs friendlier to active managers by removing the requirement that holdings be disclosed daily. For years, active managers have largely avoided ETFs,² amid concern that providing daily full disclosure would allow traders to front-run their trades and for competitors to steal their "secret sauce." However, daily disclosure has been a very important component of ETF mechanics. Knowing exactly what's inside an ETF allows market makers and APs to efficiently value the portfolio, and (for most large, liquid ETFs) the market makers and APs tend to conduct trades that keep the ETF's price generally in line with its underlying value. With active semi-transparent ETFs, daily disclosure of holdings isn't the standard.

As a result, these funds rely on other features to keep the fund trading smoothly. For example, one semi-transparent model uses an additional intermediary to facilitate creations and redemptions. Sort of like APs for the APs, authorized participant representatives (APRs) are the only entities other than the fund sponsor to know precisely what's inside the portfolio.³ 

The SEC has also approved other active semi-transparent ETF models, which don't employ additional intermediaries, but instead rely on creation/redemption baskets that are slightly different from a fund's actual holdings. These proxy portfolios may include decoy securities and/or alternative weighting schemes, and they are frequently generated with the assistance of computer programs (typically described as "algorithms" or "mathematical optimizations").

In some cases, the bid-ask spreads of active semi-transparent ETFs are higher than for traditional ETFs. This may be due to the fact that APs must employ new types of tools to efficiently value active semi-transparent ETFs, and many of the new active semi-transparent models appear to depend on a level of trust developing between the entities involved (APs, APRs, fund sponsors, etc.)

Furthermore, tax efficiency could be a concern for models that rely on proxy portfolios, since the ETF's manager will have to buy and sell securities to better align the securities they receive through creation/redemption baskets with the securities they actually want to own. This could potentially reduce the tax efficiency of active semi-transparent ETFs compared to traditional ETFs and possibly create a drag on performance. However, for 2022, capital gains distributions (which result from sales made by the fund) were limited, with only seven semi-transparent ETFs distributing capital gains. Moreover, the Morningstar Tax Cost Ratio, which measures how much of a fund's annualized return is reduced by the taxes investors pay on distributions, shows little difference between the median Tax Cost Ratios of active semi-transparent ETFs and the traditional ETFs in the same Morningstar Categories.

Nevertheless, the range of investment strategies employed by active semi-transparent ETFs is limited, as the securities eligible for inclusion must be U.S. exchange-listed and trade during U.S. market hours.

While active semi-transparent ETFs may provide advantages compared to traditional mutual funds, it's important to remember that these ETFs have structural differences vs. traditional ETFs, and investors should proceed with caution.