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Standard & Poor's


10/23/14 05:10:28 PM


Over the past year, numerous asset management companies have sought regulatory approval to launch actively managed exchange traded funds (ETFs) without providing daily disclosure of their underlying holdings. Those efforts just received a body blow according to S&P Capital IQ, as the SEC preliminarily denied Precidian Funds LLC's request to deploy such ETFs. Precidian's structure is one that many large asset managers, including American Funds and BlackRock, were hoping to adopt.

The U.S. ETF industry has experienced strong growth in recent years, with $1.9 trillion in assets under management as of September 2014, up 10% since the end of 2013. Much of that growth has come, in our opinion, by taking share from actively managed mutual funds. Indeed in the first nine months of 2014, developed equity mutual funds added $53 billion in new assets -- much less than the $127 billion of fresh money that went to developed equity ETFs from iShares, Vanguard and others that typically incur a lower expense ratio and can be traded intraday.

Amid such pressure, active asset management companies have largely taken one of three paths. The first path, followed in part this year by Fidelity and Calamos, was to launch active ETFs that followed a similar approach to existing mutual funds, with full disclosure of their under holdings on a daily basis. Calamos Focus Growth ETF (CFGE 10 NR) and Fidelity Corporate Bond (FCOR 51 NR) are two such examples; both ETFs are too new for S&P Capital IQ to rank based on our holdings-based research.

A second path was to stand their ground and hope that loyal shareholders value the existing mutual fund offerings enough to not leave for cheaper alternatives. This approach is now mostly followed by smaller asset management companies.

However, recently a number of asset managers have sought to jump into the ETF market and leverage their existing mutual fund strategies without having to reveal their holdings on a daily basis. The appeal to them of this "have their cake and eat it too" approach, in our view, includes offering clients the benefits of an ETF wrapper such as a lower expense ratio and a process that limits tax implications when unexpected inflows/outflows occurred. However, by not disclosing holdings on a daily basis, the asset manager would protect itself from other investors from fully understanding the strategy and front-running the trades. Though we see much of equity and fixed income markets are relatively liquid, managers wanting to build or exit a position benefit when others do not see what is happening on a daily basis, but rather monthly or quarterly. Besides American Funds and BlackRock, T Rowe Price and Eaton Vance are among some of the more prominent firms that have sought SEC approval to launch such ETFs.

In its review this week, the SEC noted that when looking at actively managed ETFs it "has required a mechanism that would keep the market prices of ETF shares at or close to the NAV (net asset value) per share of the ETF. To date, this mechanism has been dependent on daily portfolio transparency". According to the SEC, "this transparency provides market makers and other market participants with an important tool to value the ETF portfolio on an intraday basis, which, in turn, enables them to assess whether an arbitrage opportunity exists."

This close tie between market price and NAV per share of the ETF is, according to the SEC, the foundation for why the prices at which retail investors buy and sell ETF shares are similar to the prices at which Authorized Participants are able to buy and redeem shares directly from the ETF at NAV.

The Commission therefore has granted approval to date only to those actively managed ETFs that have provided daily transparency of their portfolio holdings The SEC said it preliminarily believes that non-transparent ETFs are not in the public interest.

ETFs can and do trade at premiums and discounts to NAV, and we at S&P Capital IQ use this as an cost factor in our ranking process along with expense ratio and bid/ask spread. However, the differential tends to be quite small. For example, S&P Capital IQ ranks 213 fixed income ETFs and all but four of them have traded on average over the past five days with between a 1% premium and a 1% discount. Fidelity's FCOR for example, was at a 0.45% premium to NAV, while iShares Core Aggregate Bond (AGG 110 Overweight) was at just a 0.09% premium.

Though the SEC denied Precidian's request, it will entertain public comments on its preliminary ruling through mid-November. Assuming the ruling stands, as we would expect, this will make it harder for mutual fund focused asset managers to compete against ETFs. We eThe SEC's initial denial of non-transparent ETF launches should help transparent ETFs and those companies that offer them will continue to gain market share over mutual funds as investors seek out lower cost alternatives to gain exposure to the equity and fixed income markets.


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