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The ETF industry reached a new milestone on November 14, 2019, when the SEC issued notices to Blue Tractor, Fidelity, Natixis and T. Rowe Price approving four “proxy basket” active semi-transparent ETFs. In our <a href="https://www.thompsonhine.com/publications/sec-poised-to-permit-activeshares-etf-first-non-transparent-actively-managed-etf" target="_blank" rel="noopener">April 2019 ETF Reg Insights</a>, we reviewed the SEC’s approval of the first active semi-transparent ETF, Precidian’s ActiveShares. It is important to recognize that to date, no exchange has received an order from the SEC’s Division of Trading and Markets to list an active semi-transparent ETF. While expectations are high, the ETF industry must wait for final regulatory approval to see how the investment community reacts to this next wave of products.

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AP Representative Versus Proxy Basket Models

At the advent of technological advances, competing formats often exist for the same product or service, e.g., AC (Tesla) versus DC (Edison) or Betamax (Sony) versus VHS (JVC). The “inventors” of the recently approved active semi-transparent ETFs have had to overcome significant regulatory and technological challenges. They set out to devise products that protect the intellectual property behind an actively managed investment strategy while at the same time not diluting the arbitrage process, the lynchpin regulatory requirement of the very first ETF and every ETF since SEC approval in 1990. At the heart of prior SEC ETF exemptive orders and the new ETF rule (effective December 23, 2019) is the requirement that an ETF publicly disclose its entire investment portfolio and the relative weightings of its portfolio securities prior to the start of each trading day. Armed with this knowledge, authorized participants and other market participants have the economic incentive to make trades in the shares of a given ETF to exploit any difference between the share’s current trading price and the ETF’s net asset value per share. Such arbitraging, if working properly, drives the ETF’s share price toward the ETF’s net asset value per share, narrowing the ETF’s shares’ premium or discount. One nagging catch for actively managed fund advisers is that competitors and savvy investors could backtest an ETF’s daily portfolio holdings to determine the adviser’s investment strategy (sometimes called the “secret sauce”). As a result, index ETFs and their sponsors, which do not have to protect any secret sauce, have thrived while advisers with actively managed strategies have largely stayed away from the ETF industry for fear of others uncovering their alpha generating processes. Several years ago, a handful of financial firms set out to overcome this conundrum.

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The first SEC-approved active semi-transparent ETF with an approach other than full disclosure of the ETF’s portfolio is Precidian’s ActiveShares ETF. Instead of disclosing its portfolio before the start of each trading day, ActiveShares only makes such disclosure to a single authorized participant called the “AP Representative,” through whom all other authorized participants place creation and redemption orders. The adviser’s secret sauce is protected because the AP Representative is the only one privy to the investment portfolio and is contractually required to maintain the confidentiality of the portfolio’s contents.

Precidian disseminates a verified intraday indicative value (VIIV) of the ActiveShares ETF’s portfolio throughout the trading day. The VIIV is calculated every second throughout the trading day on a per-share basis based on the value of the securities in the portfolio. Using a current VIIV, along with certain other disclosures made by the ActiveShares ETF, authorized participants and other market participants can do a regression analysis and construct dynamic hedge portfolios to hold shares and arbitrage the difference in the market price/NAV of shares when the opportunity arises.

The four new active semi-transparent ETFs utilize an arbitrage mechanism known as the proxy portfolio approach (Proxy Portfolio ETFs). Instead of using the ActiveShares ETF’s approach of hiding the entire investment portfolio, the Proxy Portfolio ETF approach strikes the balance of offering enough portfolio details to all authorized participants and market participants to effectively arbitrage without jeopardizing the secret sauce of the investment strategy though full disclosure of the true portfolio securities and their weightings.

A Proxy Portfolio ETF publishes a daily “proxy” portfolio comprising securities from the potential universe of portfolio securities the ETF may hold, but not the exact list of each portfolio security and its weighting. The proxy portfolio is designed to achieve a minimum end-of-day tracking error compared to the performance of the Proxy Portfolio ETF’s actual portfolio.

Following are general descriptions of the Proxy Portfolio ETFs. While similar in approach, each has important differences. The SEC is expected to issue exemptive orders allowing these ETFs on or about December 10, 2019.

Blue Tractor ETF Trust and Blue Tractor Group

After the close of trading (T), an ETF (or its custodian) will access a secure cloud software platform called the Blue Tractor Shielded Alpha? Service, which generates a portfolio (the Dynamic SSR? portfolio) that will be the in-kind creation basket for trading on T+1. The actual portfolio will not be disclosed daily, only the generated Dynamic SSR portfolio. This basket will be published by the NSCC as the ETF’s portfolio creation file (PCF) and used by market participants and authorized Participants on T+1 for high-frequency intra-day pricing, hedging, to effect bona fide arbitrage and for in-kind creations and redemptions with the ETF. The basket will hold 100% of the actual portfolio securities (and no others), but the portfolio weightings in the basket will differ from the actual portfolio weightings. The basket will have a minimum 90% asset value overlap with the actual portfolio. At the close of each day’s trading a new basket is generated that will have randomly generated portfolio weightings that always differ from the actual portfolio; it is the daily change in basket weightings that obfuscates the ETF’s alpha generation strategy.

Creations and redemptions are effected directly with the ETF by authorized participants through the in-kind transfer of securities in the Dynamic SSR portfolio. Because of the minimum 90% in asset value overlap between the ETF’s portfolio and the Dynamic SSR portfolio, Blue Tractor anticipates that the in-kind exchange will be relatively tax-efficient and low-cost. A cash amount may be required or paid in lieu of certain positions (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).

Fidelity Beach Street Trust, Fidelity Management &amp; Research Company, FMR Co., Inc. and Fidelity Distributors Corporation

Fidelity utilizes a tracking basket (Tracking Basket) to disclose a representative portfolio that can be used to construct a reliable hedge against the securities in the ETF’s portfolio. The Tracking Basket includes the ETF’s most recently disclosed portfolio holdings, representative ETFs and cash. The ETFs included in the Tracking Basket are limited to 50% of the Tracking Basket’s assets. Fidelity developed a proprietary mathematical process to minimize the deviation between the Tracking Basket and the ETF’s actual portfolio as well as to minimize turnover and basket creation costs. The Tracking Basket is reconstituted at least as often as the ETF’s portfolio holdings are publicly disclosed but may be rebalanced more frequently at Fidelity’s discretion. Fidelity monitors the deviation between the Tracking Basket’s performance and the actual portfolio using a 5% threshold, which Fidelity states “will be calculated as the annualized standard deviation of the daily difference between the actual NAV of the Fund and the calculated closing NAV of the Tracking Basket measured over a trailing 90 calendar days.” The indicative NAV of the Tracking Basket is disseminated every 15 seconds throughout the trading day, and the Tracking Basket is published daily on the fund’s website prior to commencement of trading.

Creations and redemptions are effected primarily through the in-kind transfer of securities in the Tracking Basket. A cash amount may be required or paid in lieu of certain positions according to certain circumstances (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the creation basket exchanged for the creation unit).

NYSE/Natixis Advisors, L.P. and Natixis ETF Trust

This ETF discloses a proxy portfolio (Proxy Portfolio) instead of its actual portfolio, which comprises securities in the ETF’s potential universe of portfolio securities and is designed to achieve an end-of-day tracking error of no more than 5% compared to the performance of the ETF’s actual portfolio. The Proxy Portfolio is constructed using the NYSE’s proprietary process, which uses a factor analysis of the ETF’s actual portfolio. The Proxy Portfolio is designed to be overinclusive and contains more components than the ETF’s actual portfolio. In addition, purchases and sales occurring in the ETF’s actual portfolio will not be reflected in the Proxy Portfolio until after a 5- to 15-day lag, and the Proxy Portfolio’s aggregate value on any given trading day will equal the aggregate NAV of the ETF’s actual portfolio. Each day before the exchange opens, the ETF’s Proxy Portfolio is disclosed on its website, along with the historical tracking error between the ETF’s last published NAV per share and the Proxy Portfolio’s value on a per-share basis.

Creations and redemptions are effected primarily through the in-kind transfer of securities in the Proxy Portfolio. A cash amount may be required or paid in lieu of certain positions, according to certain circumstances (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).

T. Rowe Price Associates, Inc. and T. Rowe Price Equity Series, Inc.

A hedged portfolio (Hedge Portfolio) is disclosed daily for the ETF. There is an 80% overlap of the securities in the Hedge Portfolio and the ETF. In addition, an indicative NAV based on the ETF’s actual portfolio is disclosed at 15-second intervals throughout the trading day. T. Rowe provides daily information about the deviation between the Hedge Portfolio and the ETF’s actual portfolio and about the deviation between the performance of the ETF’s NAV and its Hedge Portfolio for the most recent rolling one-year period, which is calculated using prices as of the end of each relevant trading day (Daily Deviation). T. Rowe also provides metrics on annual “tracking error” (i.e., the standard deviation of the Daily Deviation between the ETF’s NAV performance and that of its Hedge Portfolio) and the percentage of Daily Deviations that exceeded a certain number of basis points over the past year.

Creations and redemptions are effected primarily through the in-kind transfer of securities in the Hedge Portfolio. A cash amount may be required or paid in lieu of certain positions according to certain circumstances (e.g., if there is a difference between the NAV attributable to a creation unit and the aggregate market value of the basket exchanged for the creation unit).

Finishing This Chapter of the ETF Evolution

The actively managed semi-transparent ETF chapter is not finished. None of the exchanges that would list these products have received the necessary relief under Rule 19b-4 under the Securities Exchange Act of 1934 to list them. Once the SEC’s Division of Trading and Markets issues the orders, it will take a reasonable period of time to implement the plumbing (e.g., NSCC protocol for creating portfolio composition files of the various types of active semi-transparent ETFs) that supports the ETF product. Advisory firms electing to use one of the approved models discussed above will have to enter a licensing agreement with the product’s sponsor. In addition to the four new approved platforms and the ActiveShares platform, other semi-transparent ETF exemptive applications will be filed. This chapter ends with the story of how well these products will be received by financial advisers and the investing public.

Additional chapters in the ETF evolution are being drafted. Active semi-transparent structures initially will be limited to equity ETFs, so work is be done before they extend to other asset classes such as fixed income securities and investment techniques such as hedging with derivatives. Preliminary discussions about how to convert actively managed mutual funds into active semi-transparent ETFs have begun. Financial engineers undoubtedly are devising new variations of ETF products, both in the actively managed and passive spaces.

Other ETF Reg Insights Addressing Active Semi-Transparent ETFs

Bibb Strench 202.973.2727 <a href="mailto:Bibb.Strench@ThompsonHine.com">Bibb.Strench@ThompsonHine.com</a>

Andrew J. Davalla 614.469.3353 <a href="mailto:Andrew.Davalla@ThompsonHine.com">Andrew.Davalla@ThompsonHine.com</a>

Joshua J. Hinderliter 614.469.3345 <a href="mailto:Joshua.Hinderliter@ThompsonHine.com">Joshua.Hinderliter@ThompsonHine.com</a>

JoAnn M. Strasser 614.469.3265 <a href="mailto:JoAnn.Strasser@ThompsonHine.com">JoAnn.Strasser@ThompsonHine.com</a>

This advisory bulletin may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgment of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel. This document may be considered attorney advertising in some jurisdictions.

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The ETF Evolution Continues: SEC Approves Four New “Proxy Basket” Active Semi-Transparent ETFs

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