Non-transparent ETFs may pose heightened oversight challenges for directors, experts say

Mutual fund conversions require expense, distribution scrutiny; boards could face pressure to rush

As the fund industry awaits the arrival of the first non-transparent, actively managed exchange-traded funds, some governance experts believe the products pose heightened oversight challenges for ETF boards, even though their responsibilities are largely similar to transparent ETFs.

Precidian Investments—the first complex to receive regulatory approval for the product—said it has signed approximately 23% of the active management industry, including firms such as JP Morgan Asset Management, BlackRock, American Century Investments and Gamco Investors, to licensing contracts for its ActiveShares product, since it got the green light from the Securities and Exchange Commission in May. The first offerings are expected to reach the market later this year.

A non-transparent active ETF as defined by the exemptive order Precidian received would not disclose its portfolio holdings or net asset value in real time like a transparent ETF, but instead would deploy a verified intraday indicative value (VIIV) calculated every second throughout a trading day based on the value of the fund’s holdings from the previous day.

While the spread between an ETF’s net asset value and market price is always a focus for ETF boards, the use of the untested VIIV mechanism as a stand-in for NAV means that fund directors will have an obligation to monitor even more closely how their fund trades, according to Brian McCabe, a partner at Ropes & Gray.

“[Boards should want to make sure] that the prices individual investors pay are at least close to the then-prevailing value, which is the VIIV,” he says.

In a departure from traditional ETF oversight, directors overseeing any ActiveShares fund will be required to meet whenever the fund’s trading price varies more than 1% from its NAV for 30 or more days in any quarter or for 15 consecutive days. The board must then discuss whether to act to narrow the spread if shareholders are being harmed.

Such a measure reflects the intense regulatory focus that has accompanied the non-transparent products, according to Jay Baris, a partner at Shearman & Sterling. He says that ETF directors ought to give extra care when overseeing non-transparent ETFs, if only because they will draw greater scrutiny because they are new.

“It’s a novel product, so I think that more attention will be focused on them,” Baris says. “Board oversight is always important, but I think that will be heightened here. The less upfront disclosure, the more oversight, arguably, is needed.”

Aside from the notable addition of the VIIV and its implications for fund price arbitrage, experts speculate that the oversight responsibilities for a nontransparent ETF, while higher, will be largely familiar to ETF directors.

“The vast majority of what a board member of a nontransparent ETF will be asked to do would be the same kinds of things that that board member would be doing with respect to a transparent ETF,” says McCabe.

“It’s not going to be a huge jump,” says one independent director who oversees an ETF complex with around $25bn in assets.

Open-end Fund Conversions

As advisers around the industry consider adopting the ActiveShares structure, another question arises that may involve board approval: Should the adviser convert one of its open-end funds into a nontransparent ETF?

There is no precedent for such a conversion, but the non-transparent nature of the ActiveShares structure has made it a viable option in the eyes of many. A nontransparent ETF would allow portfolio managers to protect their investment strategies from copycats or front runners while also benefiting from potentially lower operating costs and tax advantages for investors.

Precidian CEO Daniel McCabe, who is not related to McCabe at Ropes & Gray, told sister product Fund Intelligence last month that he expected converted open-end funds to comprise a significant portion of ActiveShares products.

Before any potential conversion could be executed, however, a fund board would need to review how it would affect shareholders.

“The board would want to understand how the expenses … in the ETF chassis are going to vary from the expenses in the traditional open-end fund form,” says Ropes & Gray’s McCabe, who co-authored a paper in May about the process of converting an open-end fund into an ETF.

Directors should ask how the costs of the conversion would affect shareholders, as well as whether the adviser has a distribution plan, as the products don’t carry the 12(b)-1 fees distribution platforms typically earn, to ensure the fund could maintain inflows in its ETF form.

“It’s hard to imagine that it would be in the best interests of shareholders of a traditional open-end fund that’s been selling just fine to turn into an ETF and then wither,” McCabe adds.

The ETF director says her board is educating itself about non-transparent ETFs while taking a wait-and-see approach. That’s a view many in the industry have taken, in part, because it’s such a new product and they want to see how well ActiveShares products catch on with investors before committing their own complexes’ resources to them.

Eaton Vance, which is also seeking approval for a non-transparent ETF product called Clearhedge, has struggled for three years to garner interest in its NextShares exchanged-traded managed funds, which were intended to offer investors a nontransparent, actively managed exchange-traded product.

Eaton Vance CEO said last year the company planned to cut budgeting to the product to $6m a year from $8m.

Some see that as a cautionary tale. The hype surrounding ActiveShares echoes the excitement that accompanied NextShares, says one independent director who oversees both mutual funds and ETFs.

“There was all this hustle to jump in line and sign on with Eaton Vance, and … it never went anywhere,” he says. “Now Precidian’s out there, with a newer, better mousetrap.”

He adds that he believes the ActiveShares model shows promise, but he would expect his board’s adviser to watch how initial non-transparent ETFs fare before taking the plunge.

“Until there’s a product, until there’s an appetite, until the bugs are worked out, is there a need to rush into that space? That’s a question for the distributor and the adviser,” the director says. “If they want to go that path, we’ll be here to ask questions and provide our oversight responsibilities and look after the interests of shareholders.”

One former fund director says he is aware of directors who have disagreed with their advisers over how to proceed on non-transparent ETFs, with board members wanting to move slowly while advisers were eager to push forward.

“Our board is asking management, what are they doing? Have they aligned themselves with any current providers?” says the independent director who oversees both open-end funds and ETFs.

So far, he says, his fund complex is waiting to see what will happen when the first nontransparent ETFs reach the market.

“It’s a curiosity more than anything else, right now,” he says.

Still, some are plunging ahead. Mario Gabelli’s Gamco, a $37.3bn Rye, New York-based asset manager, plans to launch 11 non-transparent ETFs in the ActiveShares structure.

The firm recently shuttered its NextShares offerings, converting two of the exchange-traded managed funds to mutual funds amid slow asset uptake. Now, the firm is focused on building out an ActiveShares lineup made of strategies it converted, not cloned, from existing mutual funds, Gabelli previously told Fund Intelligence.