If Europe Allows Semi-Transparent ETFs, Which Cloaking Technologies Should be Approved?

Theo Andrew?wrote about whether?Europe Regulatory?bodies will find any compelling reasons to allow actively managed?ETFs in Europe?to use non-transparent holdings reporting and trading baskets. Here is a link to the article:

https://lnkd.in/g8guWEZb

The article does a fairly good job of representing the non-#transparent?#fintech?methods used to protect the trades and positons of the ETFs' actively managed portfolios.?#activemanagement

Mr. Andrew interviewed Andrew Jamieson, global head of ETF product at?Citi, said: “Active managers are making a deliberate choice and saying, ‘we do not want to compete with traditional passive products and the more established ETF players. They want to do something different and embrace that difference, as opposed to getting swept up with more generic passive ETFs.”

The ETF.com article provides a quick synopsis on SEC approval of non-transparent strucutres.

"Added to this, non-transparent ETFs – of which there are five?Securities and Exchange Commission?(SEC) approved structures – offer cost and tax efficiencies for investors which do not exist when investing in mutual funds.

There is no doubt this technology is used within these non-transparent ETF structures. To date, there are five ETF structures, all of which vary in the level of transparency of their portfolio disclosure and the level of algorithm and mathematic processes used to hide their holdings.

The five structures comprise the Precidian model, the Blue Tractor model and three proxy models run by the New York Stock Exchange (NYSE), Fidelity and T. Rowe Price. Jamieson categorises these five models into three levels of transparency starting with the least transparent, the Precidian model, which utilises a new function the ‘APR’ or Authorised Participant Representative. Instead of using a traditional authorised participant – which always knows what is in the portfolio – the APR uses a confidential account to create and redeem shares. "

Jamieson continues to explain that the proxy model takes the middle road in transparency. This is the model provided by Fidelity and two others. The proxy model uses a close approximation of the actual stocks within the portfolio but includes decoy stocks that are similar in industry and risk characteristics to the actual stocks in the portfolio. Jamieson's example is an issuer's basket that contains a similar stock to the AP such as one car manufacturer such as General Motors, when in fact the fund might hold another car manufacturer such as Ford. The proxy fintech product is the one most used currently in the US by mutual fund providers entering the active ETF space.

The article than goes on to say that the most transparent by far is the Blue Tractor model, Shielded Alpha. This model discloses every single stock but with a different weighting to the actual portfolio in a bid to throw other active managers off the scent of their strategy.?

However, I believe the article missed an important point: what is best for the fund companies' end investors?

I first published an article in the?Dow Jones?Jounal of Indexes in 2001 pointing out how using the ETF structure would allow active managers to produce better returns and have greater control over their decision-making. I've updated this article on?ResearchGate?addressing the new FinTech ETF portfolio protection methods along with?U.S. Securities and Exchange Commission?rules changes and DTCC accommodations further facilitates the ETF conversion process. The bottom line averages an additional 200+ basis points for non-taxable investors - in US, the after-tax and after-fee difference is more than 300 bp.

https://lnkd.in/dXGtM9

So, everyone benefits by junking the redeem-for-cash at distributor model. The question here is whether active managers need shelter from full transparency to serve the needs of investors. Focusing on the cloaking preferences of active managers protecting their "IP" misses the entire raison d'etre of the entire ETF revolution: best practices in serving fund shareholders.

Bottom line; does cloaking help shield portfolio returns for investors? If so, which fintech? My report shows that only?Blue Tractor Group's Shielded Alpha can assure investors that no holdings violate their mandates and personal preferences while simultaneously protecting the ETF from potentially deleterious trading impact costs by front-running hedge funds, a nascent but growing source of trading alpha.

Moreover, actively managed ETFs may not be the only funds with trading basket and holdings files that need protection. It turns out that index funds with transparent methodologies and scheduled rebalacing dates may be even more vulnerable to front-running. The research paper "Should Passive Investors Actively Manage Their Trades?"can be accessed by this link: https://lnkd.in/eZsjivmt

In extending his thesis paper into a published article, Sida Li, Ph.d candidate from the University of Illinois Urbana Champaign documents how passive index funds including ETFs are sacrificing as much as 9.6 basis points annually to front-running be professional traders. In terms of dollars and cents, the author concludes that ETF Front-Running costs a whopping $4 Billion a year!

The study analyzed index-tracking ETF rebalancing activity, finding that the price of the stocks the funds buy on average rises by 67 basis points in the five trading days prior to their pre-announced rebalancing, then falls 20 bps over the next 20 days. This study bolsters evidence that the front-running of funds' trading activity is a frequent hedge fund trading strategy and with much more volume than previously thought. Mr. Li's suggested solution is for funds not to do all rebalancing at an announced date and time but to gradually integrate trades throughout the period. This is exactly what can be done with semi-transparent ETF baskets. It would be interesting to produce a study similar to Mr. Li's to measure the impact costs of the larger value, growth and smart beta ETFs, most of which follow announced-date quarterly rebalancing. If the results are similar, the benefits of semi-transparent holdings and basket-trading files staggering the trading over as many as four weeks could help investor returns by saving on trading impact costs. Since all holdings are already known and what needs to be cloaked is which may have zero-weights after rebalancing, the most cost-effective and tax-efficient method is Shielded Alpha by Blue Tractor.

There may or may not be one barrier to protecting investor returns in this way. I checked out an expressed belief that index funds covered by the ETF rule must display their trding baskets every day. Well-respected attorneys at two separate 40-Act law firms I spoke with in informal discussions (and off-the-record) disagreed. They said that nothing in the ETF rule prevents indexed ETF fund providers from using semi-transparent trading baskets. Time will tell but with growing billions of dollars in such funds at stake, it seems to me that a study is warranted. The ETF Evolution is an evolving process. From a regulatory perspective, the main engine of that evolution must be innovations that are in the ETF shareholders' best interests.

Next, I posit an major ancillary question?

It's been alleged in print that Millennium has a program taking arbitrage off the table trading ahead of ETFs with?#transparent?trading baskets. Others may be running similar programs for their desk arbitrage operations.

The question: To what extent has trading technology become sophisticated enough to make?#frontrunning?such ETF?#baskets?, active and passive, a source of trading?#alpha? If so, Europe regulatory authorities need to realize that semi-transparent baskets do more than attempting to shield the IP of active managers. It helps shield ETF shareholders from absorbing portfolio impacts costs which would be in the investors' best interests.