ETFs are constantly evolving. They first started as a simple wrapper for pure index strategies. Then the array of products under the common name “smart-beta” were introduced to provide investors with a cost and tax-efficient solution to gain a risk exposure to a particular factor or investment style. Yet, the underlying indexing mechanism with full transparency remained intact. With passive fees declining, many asset managers are looking for ways to fulfil the demand of a broader range of clients. They recognise that the current product offering does not cover the large segment of investors that are looking to beat the benchmark and are willing to pay higher fees for it. The next step for ETF evolution is the introduction of active ETFs.
Active Product Milestones in US. Source: Ryedale
US Disclosure Regulation
Until recently, most of ETF sponsors in the US had to rely on exemptive relief from Investment Company Act of 1940 when launching new funds. In effect, ETFs were regulated under the venerable 40-act but each one required exemptions from certain aspects of the 1940 regulation. In October 2019, the Securities and Exchange Commission (SEC) adopted the new Rule 6c-11 that greatly simplified the process and abandoned the reliance on exemptive orders. However, the rule requires daily website disclosure of portfolio holdings to improve the transparency and promote the efficiency of the arbitrage mechanism.
Full transparency has been the obstacle for active managers that were looking to move from traditional mutual funds to ETFs. Disclosing portfolio composition daily means revealing their “secret sauce” and exposing the actively managed fund to front-running. As a result, many active ETFs with non-transparent disclosure (less frequent or partial basket disclosure) are not covered by the SEC’s ETF rule and therefore still have to rely on the complicated and lengthy exemptive relief mechanism.