Source : www.currency.com
Note: This is a 5-part series that covers the following areas
- Part 1: An overview of the ETFs market globally
- Part 2: Evolution of ETFs -1st -4th generation ETFs
- Part 3: The Future of ETFs (post 2030)
- Part 4: The Risks & Rewards associated with exotic ETFs
- Part 5: An overview of African ETF Market-Challenges faced
Part 3: The Future of ETFs Market post 2030
Around the globe, specifically US, ETFs and mutual funds come under the purview of the 1940 Act. Going back to the era of Nate Most, ETFs have needed to obtain exemptions from certain stipulations in the law that require mutual funds to be purchased and sold only at net asset value at the end of the business day. Since 1993, however, the SEC has issued more than 300 exemptive orders for ETFs, allowing them to be traded throughout the day on super large secondary markets like the New York Stock Exchange (NYSE).
When ETFs redeem shares through authorized participants, they provide the basket of underlying securities in kind, without selling in the open market and redeeming in cash. There is further tax efficiency because the ETFs can choose to redeem securities that have a lower cost basis, increasing the average cost basis of the shares held by the ETF and thus reducing future capital gains
When the basket of securities used in the creation or redemption process is in the same proportion as the overall ETF portfolio, it is called a “pro rata slice” basket. Older ETF firms have had the ability to create and redeem shares using non–pro rata slice, or “custom,” baskets, which don’t exactly match the full ETF portfolio in composition. This has several benefits for the ETF provider, including improved fund efficiency and reduced internal trading costs, as well as increased efficiency for APs, leading to tighter spreads. Younger ETF firms, however, did not have this flexibility, creating an uneven competitive landscape with their older rivals.
On September 26, 2019, the SEC approved a rule designed to modernize ETF regulation “by establishing a clear and consistent framework for the vast majority of ETFs.” The rule allows opened ETFs to operate without obtaining an exemption from the 1940 Act as long as they provide daily portfolio transparency on their websites. ETFs are permitted to use custom baskets of securities that “do not reflect a pro-rata representation of the fund’s portfolio” or do not exactly match the full ETF portfolio in composition. The website disclosure is intended to inform investors about the cost of investing in an ETF and the efficiency of its arbitrage process. According to the SEC, the new rule is meant “to level the playing field” by allowing all ETFs that rely on it to create and redeem shares using custom baskets, as well as to “protect ETF investors.”
The European Central Bank together with SEC have also approved various systems that can be used to introduce actively managed ETFs that are not fully transparent. In May 2019, the agencies granted exemptions from the 1940 Act to Precidian Investments’ nontransparent ETF structure, ActiveShares. The Precidian structure adds a new participant, the authorized participant representative (APR), to the creation and redemption process. The ETF sponsor hires the APR, which contracts with the AP to trade the basket of securities on its behalf. The sponsor also hires a trusted agent to provide real-time pricing data every second to the consolidated tape that exchanges use to report trades and quotes. Precidian worked with State Street and other ETF providers to develop the ActiveShares model.
In December 2019, the SEC approved exemptive relief for Blue Tractor Group’s Shielded Alpha ETF wrapper, which allows actively managed portfolio strategies to operate within an ETF structure without the risk of front-running or free-riding. The Shielded Alpha wrapper uses “proprietary math to generate daily a creation basket” while ensuring that “an advisor’s alpha generation and portfolio trading execution remain fully opaque,” according to Blue Tractor. The company insists that a Shielded Alpha wrapper is highly transparent and will promote “highly efficient primary and secondary market pricing and trading.”
Structures such as ActiveShares and Shielded Alpha — as well as systems employed by Fidelity Investments, Natixis Investment Managers and T. Rowe Price that use proxy portfolios in creation and redemption baskets — enable firms to construct actively managed funds that protect managers’ intellectual property while retaining such ETF benefits as tax efficiency and tradability in secondary markets using real-time pricing data.
AlphaClone Alternative Alpha ETF alpha performance
At the same time, the use of artificial intelligence and machine learning is helping to launch a new class of exchange-traded products. Smart beta initiatives have expanded beyond the basic factors they first covered, and more exotic bond ETFs are being launched. Some of these exotic ETFs are very different from normal index-tracking funds: the AlphaClone Alternative Alpha ETF (which tracks U.S. equities with large exposure among top-performing hedge funds, based on publicly disclosed positions), Credit Suisse X-Links Gold Shares Covered Call ETN (which invests in the SPDR Gold Shares ETF, which trades under the symbol GLD, a physical gold ETF and one-month call options on GLD) and the Invesco S&P Spin-Off ETF (which tracks an index of U.S. equities that have spun off from their parent companies).