Hiding in Plain Sight: Inside the Non-Transparent Active ETF Race

time from trading platforms. So Schwab came out and announced that it was going to cut to zero commissions that it used to charge on trading stocks E t f s and options. This prompted Schwab's share price to fall almost ten percent, but it didn't just take itself down there. It also took E trade t D a merry trade. And I think there's a lot of questions being asked about what this really means for commissions in trading platforms. So kind of a blood bath, but this is good

for me as a consumer writer. Yeah, I think for the small investor is obviously saving what five six bucks on the trade helps you. If you're bigger, that means a lot less that that dollar amount. But per the company's falling, you know, Um, we had some numbers here that Schwab probably felt felt the least because they only get seven percent of their revenue from these commissions, but t D and E Trade are thirty sev so it's

more heavy on them. But really, to me, this is just all part of the Vanguard effect because one year ago Vanguard announced all E t F s could be traded for free, and so I think that just people

you know, dealt with that for a while. And then you saw interactive brokers come out like a week ago, and then you had Um Schwab and then t D amor Trade and now the two left standing our Fidelity and E Trade, and everybody's wondering, you know, how quickly they will follow suit, and when they do, you're basically all the dominoes have fallen. Um. But I look, I think it's good news. I think there's one concern is

there anything really free? I think if they're going to sell, your order flow could have been a slightly wider spread, and if to one bib extra in your spread that could be three to six bucks anyway, so it might be a wash. And also would this encourage bad behavior if you trade um, you know, out of your mind. Um, you're probably gonna lose money. So there's some car you know, concerns and dangerous here, but arguably probably a win for investors.

So this wasn't the only news this week though, because the SEC had a lot of bit of other news. Rachel, what was that? Yeah, So the SEC finally approved more than decade in the making rule about exchange trade of funds. This basically allows e t F s to come to market without going through an onerus and sometimes expensive process of getting what used to be called exemptive relief. They can now come to market under the e t F rule,

which should kind of streamline that process. They also made a few kind of tweaks around the edges, allowing fixed income to kind of have more of a hope because it now is allowed to use custom baskets. Custom baskets, very very technical term, basically means you don't necessarily have to do a pro rata slice of the fun that's coming in or out of the e t F. Gives a bit more flexibility, allows the managers of these products to actually and make a few more kind of decisions

and relating to their fund rather than just to the investor. Eric. How many more ets do you think we'll see because of this rule? So this is interesting. If this rule would come out five ten years ago, I think it would have immediately you see to pop in new launches. I don't think we'll see that. I think that the market has matured and everybody wants you know of the flows this year are going to products that are twenty

basis points or less. That is, I think that's UM made a lot of people who have products in the pipeline more conservative and cautious about launching. I don't think saving whatever UM looks like it might save you a little money on the launch. Probably it probably helps some people who are outsiders who might have been waiting, But UM, I don't know if it's going to help it. I maybe I'll be wrong, we'll say, but I'm I don't. I just think the market's brutality is what's gonna trump

the fact that it's now easier. And what do you think of this does for fixed income ETFs? Like Racil mentioned, I think it's good for them. I think the big winner here is active ETF though because previously only passive and only some of them could do these flexible baskets. UM Here's the stat that um my colleague in London, Tom came out with, which is that only six percent of all e t f s pay capital gains um.

But if you look, active ETF pay capital gains. So this is probably going to help them lower that number. And especially a lot of them are small, and I think this is a big advantage for them. You know, again, active has its own issues, but this certainly should help them, so to me, I think that the bigger takeaway here from this rule is that it probably helps little areas on the fringe, you know, certain little and it probably is democratic because it seems like the winners overall are

the smaller firms. So that's not all that we're gonna talk about on this week's episode, Rachel. You also recently wrote an article for Bloomberg Markets magazine about Dan McCabe, CEO of Presidian Investments. Who's Dan. He's actually right here next to us, but we'll hear from it in a second. Yeah, but as you said, it has been a busy way. Yeah, this was the other thing that we were kind of

working on this week. Basically, there's been a whole kind of structure that's been in the making for for more than a decade or you thought the e t F rull took a long time, Well, so has this. This is something that the SEC has been considering since I believe about two thousand and nine when Dan set up his company Presidian, And basically this structure is designed to allow active funds to come to market in an e t F wrapper without necessarily disclosing their holdings every day.

That's something that's obviously, you know, something that's very common for um, you know, active managers, this kind of concern that they're going to have to disclose their holdings and they don't necessarily exactly, Yeah, you've got your intellectual property, you want to keep that hidden. But for the e t F structure, that is typically been the way you

do it. You put your holdings out every night. So this is kind of a structure that that has gone through the SEC process and seeks to give active managers away to get into the market without necessarily giving away those goods. I want to job out the SEC. It seems like everything take takes a decade there. The financial crisis happened in the middle to this is probably the biggest issue, especially for people in the E t F bubble.

I think it's something we debate constantly because you have twelve trillion dollars in active mutual funds and a good portion of it is wondering how can I take part in this quote new world of e t f s and index funds where all the money is going, which for context is four trillion dollars, which well, no, seven seven and a half. Yeah, so you have twelve over here, seven and a half here, But the seven and a

half has come out of nowhere over the past ten years. Um, And I thought of it actually came out of the active side. Yeah, exactly, Yeah, that this is stolen from the active side. All the active side is grown because of the market returns, but long story short, the organic growth is going towards passive. This to me, I always picture this is like a bridge. Is this the bridge that will get us from one side to the other?

And I think There's been a couple attempts, but I'm excited to go into them here on this episode of Joints making Sense of non Transparent actives. Dan, welcome to trillions. Hey, thank you very much. So, Dan, where did this idea come from? This idea generated actually from meeting I had with the company out in California back in two thousand

and seven. They had asked us to see if we could figure out a way to work embedded capital gains out of the fund that had a small cap fund that frankly got to a point where they were not able to rebalance it because they were triggering so many capital gains. I went to a whiteboard with my partners. We spent in that it was actually on a weekend, so we actually took time away on the weekend, went

to a whiteboard and drew this up. Um Interestingly enough, once we saw, you know, what we had created, we knew what it was useful for. But to Rachel's point, it took us a decade uh in order to be able to get the necessary approvals from the SEC to bring this. So this sounds like a big deal because the thing that an ETF is known for is its transparency. Right like, at any moment in time, I can see what's happening here and what's inside of ye about what

I would disagree with that. I think that what e t f s are really known for primarily very few people know what to do with the transparency other than the professional audience E t F to know for real time pricing and access, and I think that's what we've

we've allowed here. So we're giving actual pricing of the value of the securities in real time per second, updated on the midpoint of their worth, and then we're giving access through what entity we call an AP representative to create a redeem shares the actual shares on a pro roded basis. So very similar to how the spider operates today. But what's inside? How do I know what I've got? Well? What you what you know is you have the corpus of the trust right. You know exactly who the manager is,

you know what he's trying to accomplish for you. And just like a mutual fund, you're going to get the same disclosures on a quarterly basis of what the actual holdings are um. But most importantly, you have full price transparency every day. How was it dealing with the SEC for a decade? Uh? You know, to be fair to

the SEC, there was a lot of turnover. We'd start, we we'd have great, what we thought were really good meetings, We get things moving along and then uh, people may leave or you know, the shoe may drop on on a flash crash or something like that, and everything goes in a drawer for a number of years. So it

was it was a little difficult. So before we get to some of the headwinds that I think this structure is going to face that are bigger, just real quick, let's go into the price and the NAV which I think it's some of the technical issues without getting two technical actions. But the reason et F S works so well is the price you pay for it on the exchange usually is very close to the navy So it's almost like the you know, that blue book value of

a car being close to what you pay. It's a great thing, right, Nobody wants to pay something more than what it's don't know, net asset value. It's basically the value of the stocks or bonds in the e t F So it's like the fair value, right, so you

want to pay something close to the fair value. How can we ensure that in when something's hidden, because how can you arbitrage it if you don't If the people who are arbitraging don't know the underlying components every day, and that's what arbitrage essentially is a dirty sounding wall street where but it's actually very effective in keeping the price in the navy clothes. I would agree with exactly what you're saying. And what we've done is to update what you're calling the nav or in an E t

F terms, an indicative value. We've created a methodologies it's called a verified indicative value. So we're actually updating what I think is UM. Something that is you know, ancient developed in nineteen has not updated so that today's ETFs rely on a fifteen second indicative value based on last cell. You know that's not enough information to your point, So

what we've done is taken next next generation. We've taken it to a per second indicative value on the actual holdings of the component securities priced at midpoints, So you are eliminating stale stale prices in that in that process. UM. The other thing that is critical again and to your point, you need to have access to the underlying component securities in order to be able to to execute that arbitrage um.

Through the ap representative role that we've created here, you have the ability not only to know the value of the component securities, but to access the component's securities, not a proxy, not something that may correlate, but the actual fund itself. Rachel, what do you think this means for the industry. I think it means that there's a lot of mutual fund managers out there that are looking at this very closely and wondering whether this is the kind

of salvation that they've been waiting for. The thing. Yeah, I mean, like you've been seeing, to to Eric's point earlier, this huge amount of money coming out of active mutual funds and going into predominantly passive e t f s. But there's nothing really about the et F structure per se that stops it from being used by active managers. It's just at that point about kind of not wanting

to give up their secret source. So I think there's a lot of kind of like interest in how these structures kind of like do when they hit the market. I think the challenge is going to be sort of standing out because DAN is sort of the only active, non transparent et F to to get approval at the moment, but there are a number of others that are seeking approval and that the SEC is kind of currently evaluating. Let's just go over those real quick, just for anyone curious.

So who is sides PRESIDI and what are the structures are in the running. Yeah, So at the SEC at the moment, there are I think about six proposals that are currently seeking approval. So you've got one from tro Price Fidelity Investments, nice Ease in their company called Blue Tractor Investco. Just filed, and there's a bunch of me I'm missing one there, but there's a bunch of people out there that are kind of looking to to get into the the market. They are primarily proposing something a

little bit different to what Dan's looking at. He mentioned they're the ap representative kind of having sort of this kind of blind trust element kind of standing in the middle that helps facilitate money going into the fund and

coming out from the fund. These are other structures are primarily looking at what we call a proxy basket, which is basically kind of putting out some kind of maybe representative maybe substitute, some kind of version of the holdings within that fund and allowing kind of market makers to see that and use that to make markets. So there

is a slightly different approach going on. What's your pattern for though, Dan, Well, we have about sevenary issued patterns are around this around the ap representative role, uh, which we call trusted agent. Given our conversations with the sec A, UH, the the and then on the indicative value processes as well, we have a bunch of issued intellectual property. Let's let's go into the real I think what I have the real motivation here is the tax efficiency of ets which

was honestly a happy accident. They did not really mean for that to be such a big benefit. But if you're in a taxable count and et F will it defers the taxes, let's say, but it it doesn't spit out capital gains. As the number I mentioned earlier, six percent of e t f s paid taxes last year.

I think for mutual funds is more like and that's got to be very frustrating for the fund itself because et f s get this quote maybe unfair treatment or different treatment, and for the investors in the mutual fund who did nothing but sit there and they got to gain on their hands. So how confident are you that this structure will really um minimize those capital gain distributions? Well, I think yea. To your point, I would agree with you that this is going to be a lot more

efficient than any mutual fund out there. Mutual funds do have the ability to deliver our securities and cond It's just that the structure itself doesn't avail it self to that UM DTF structure. The t F rapper and this what we've created here with active shares is an e t F UM will will function again very similar to

how the spider functions. We're going to hand out a provider slice of the basket to the trusted agent of the ap who have the ability to UH sell those securities and and therefore make that deliver out the low cost basis shares out of the fund to make it more tax efficient than today's mutual funds are. I would take umbradge with with one point. I don't think it's just taxes. I think taxes are very important component. I

think that today's UM investors, younger investors, want access. They want to access from real time, and they want to know evaluations in real time. You know, we all have our phone sitting here. We're all what customed to we're on computers. You know, we don't want to weigh until four o'clock to find out what what our securities are worth. So I think E t F s are are do your point of bridge between you know the traditional fund today and the exchange based model and just to riff

off that. Like on the on the cost side, it is interesting Corlo, when you look at sort of some of the costs inherent with an e t F and mutual funds. You do have that taxation issue, but also you have kind of issues about transfer agency. The e t F isn't necessarily kind of paying the same amount to kind of record that the holders of the fund that a mutual fund would be, so that gets rid of one cost by by doing an e t F structure.

Then you also have what's technically called twelve B one fees, which which kind of like are the marketing fees that most mutual funds do charge and most ETFs do not. Now there's kind of a question mark about how much of that gets incorporated into an overall expense ratio on these e t F s. They are not likely to be as cheap as some of the cheapest passive funds

because somebody is still out there picking stocks. But by removing some of those kind of inherent costs, you potentially have a way in which you know a mutual fund is able to run more efficiently, efficiently and cheaper and that should get posted onto the amvestor. Okay, this brings up a great point and one that I've yet to

get an answer on what will these costs? Because you know, how do you price this thing so it's cheap enough to attract some of the cost obsessed advisors who are E t F users, but not too cheap where it upsets the existing mutual fund shareholders in the company's own fund. PIMCO did this thing where they priced it rate in between the EYE class and the A class, which is, you know, maybe five six bits away from each and

that seemed to do the trick. But they were also doing a fund that was slightly different than the mothership mutual fund. But largely speaking, what's your plan of attack there? You have to step back and understand what we are Prosidian are right, We're we're we're really not going to be the sponsor of the product, right, We're the guys behind the scenes. They have developed a structure, so we have license and you're talking about the other competitors. The

other compartiers are all one off models. We have licensed fourteen of the largest active active managers on the planet who are all coming to market with their own plans. So I think in first quarter of this coming year, you're gonna see a lot of new products come to market. And and from what I see from from these guys, and I'm not gonna put it any any names to this, is that if there are savings, they're gonna want to pass some of those savings along to the client to

make it more efficient for that client. And that's away from just a taxation to to the point removing the twelve B one fees and removing transfer agency costs that automatically and yours to the benefit of the client. And then you're gonna pick up also the the efficiency and taxation that you don't have in the mutual fund. I'm not trying to side scept that I think that they're gonna be guys that are waiting for it, because I'm not.

I'm not the guy who's gonna tell JP Morgan how they should charge, right, So, so you're gonna want these guys look this, we're in a competitive world here, and I think they know. But that said, this is a better mouse trap than anything they've ever had to avail themselves up before to compete with the passive industry. That's had an advantage for twenty five years. So now we're gonna be able to put them on a level playing field and and they'll be able to go head to

head with the past. So here's a question for you, though, there are about Kirk if I'm wrong, two d and fifty transparent active e t f s the account for less than two percent of the assets. They've been on the market for ten years, and if you take fixed income out of there, you get two really more bleaku numbers, maybe like point four percent of the market. The equity side is pretty much unloved. What would make you think

someone would pay for non trant that's acting. So you're saying, if transparent active equity doesn't sell currently, what would non transparent active equity do differently? Again, to be to be fair, if you look at the growth in active even transparent index ETFs over the last cup four years, it's so so it's not like they're not growing the but specifically numbers are small. Numbers are right, right, yeah, very small

for a good reason. Because if I actually have intellectual property, I'm not going to bring my intellectual property to someplace that it can be copied and then mimicked by somebody else a lot cheaper than it cost me the out of it. Yeah, exactly. So. So so if you have your best fund managers out there, you're you were never going to come to market in a vehicle that where

you were forced to give away your intellectual property. So so I think now that they have that vehicle, to your point, we're gonna see what happens well the next decade. Is it possible though, that the fund managers are overestimating how much people actually care what they hold, Like if they just put their holdings out there. I mean Bill Gross did it with bond he put you know, and PIMCO continues to do it. Sure, Um, you know, is

it really doesn't really matters? Besides maybe a big gigantic fiddility contra frind Okay, that's so big you can front run it probably makes some money, But what about like the anything lower than that, Does it really matter? It does? You're talking not only front running, free riding, right, because I have the ability to free ride you now, Bond portfolios are unique because nobody's sitting at this table has the ability to trade baskets and bonds in real time. Right,

It's about access. Equity is actually very easy to access on exchange. So if I show you what I'm going in my equity portfolio, I can mimic that. I can go home on a spreadsheet and mimic that in fifteen minutes. So I would say that again, it is there are other things that can happen in an e t F that do not happen in a mutual fund. E t F are two sided vehicles because you have the ability

to both buy or sell these. If I can go out in an e t F and as your example, you're fully transparent, I have the ability to go out and borrow those securities, and you're charging fifty basis points for that fund and actually redeem the shares in your force to give me the underlying component securities. I'm now long the under underlying component securities short the e t

F and I become the fund manager. So so there are a lot of things that you need as to protect when you're trying to protect that intellectual property for that manager. How does the mutual fund industry feel about you now? Frankly, most of the people were talking to uh, we have we're not really making my partners and I

aren't making outgoing phone calls to people. The traffic is incoming, so I can tell you yesterday we just signed up another fifty billion dollar asset manager and right now, but I guess that can I list some that are that you have, go ahead, just let me know if any of these are wrong. There's some big boys on here, uh, JP Morgan, black Rock, Nationwide, Gamco, American Century, Good Belly, Columbia, Thread Needle, Movin, Goldman Sachs as Wellman Sachs. I've heard

of them. Yeah, there's a comple there's names that aren't on there. But yes, uh, you know, those are all people that have license and and that should be telling to you. And these are incoming phone calls. These are not us going out and actively pushing this. They understand the value of exactly what we've created here. I would point out though, that there is a difference between licensing and launching, so I think that's kind of like worth

bearing a mind. And there was kind of like an interesting sort of development on that last week where Investco, which I believe had licensed the model a long time ago, they kind of came out with their own model um that they're now filing with the sec to to try and get approval. So think it'll be very interesting to kind of see how many of these kind of like put their money where their mouth is. Like if they all want to sit back and see how these work,

then no one's going to be the first mover. So American Century has some filings out there, Gamco has some filings out there. Be interesting to see kind of like when those come to market, whether others sort of follow and like let's let's just just quickly, uh, we never license to Invesco. So so did the point. Yes, there are comparative structures out there, but um, you know, we think that we have the right mouse trap, and I think it's pretty telling, you know, the people have chosen

this structure. Here's the bigger, gigantic issue you're facing, in my opinion, which is that you know, if you look at the numbers right past couple of years, a trillion

out of discretionary equity bond managers doing okay. But let's just look at stock pickers, A trillion out, a trillion has gone into et F and index funds passive and then maybe that smart data right which is we'll sell rules based index fund I guess my question is a lot of that is because they look at the reports of index versus active and they see that like two thirds of managers can't beat their benchmark on the equity side, and then if the ones that do can't persist, and

that's really some rough sentiment that seems to be spreading. Can you overcome that or is that not a concern because you think there's enough fans out there are of active despite all that that really just wanted in a better structure. I think that your again to your point, there are certain managers out there performed very very well, and there are the other managers who do not perform very well. I think that the UM this vehicle is going to enhance all the managers, so they're going to

pick up efficiency. So when you're trying to compare a guy to a benchmark and you say, hey, he's missing his benchmark, but he's gotten embedded. He's starting fifty basis points behind the behind the curve. So if I can move him up and let them start at the same point, let's see what happens going forward. UM. I personally think that there are a lot of managers out there, active managers that I would like to have access to UM.

You know, we're mentioning some of these people today that the major already of UM the United States do not have access to a Goldman UH you know account right. So so if you have that on exchange, and you have UM their expertise UM offered an active shares et f rapper, it may be very interesting. And again I'm not buying you, Dan McCabe. I get to buy the Goldman and the Goldman product, that's what the would be.

Let's unpack Goldman for a minute, because I think this gets to another question, which is that Goldman has you say, active active shares, right, they have something called active Beta, which is their Smart Beta line. G SLC is one of the best selling multi factory ETFs. It's nine basis points of a cost, it's UM looks like an active mutual fund, and that it's pretty close to the benchmark, doesn't take huge risks. It's the Goldman name, it's rules based,

which is more popular. UM. Is it possible that smart Beta has just sucked up all the oxygen that discretionary thinks is there? I don't think so. I think that you're gonna find it. To your point to me, Smart Beta is just active indexing, right, They're going to be guys and it's rule based. You know, in an active shares product, you can actually make determinations in rule time

and you're not constrained by any rules. So I think that there are going to be guys out there that have the ability to add value in real time because of news events or whatever else may be happening. Yeah, I mean, I think the the interesting thing when we do see a sort of some products start to launch, and particularly we see some of the structures that are currently with the SEC also get approved. It's kind of how that sort of dynamic a competition then kind of

plays out. And when I talk to investors, they point out that what they're really interested in is not active shares per se, no offense, It's it's the strategies that could come through on on the active shares intellectual property. So I think it's gonna be interesting, you know, if we do have some of these other structures approved and if they are also licensed, some of them we believe are going to be more proprietary, some of them will be looking to license exactly kind of like what which

kind of asset managers choose to go with? Which structure, because I think that more than that, the underlying structure will the term then uh, you know who is buying what and could ultimately determine the success of these structures. And you know, we had Ropes and Gray on E T F i Q every Wednesday at one pm, UM, and they had a report out saying that you could convert a mutual fund to this new structure. I knew you were gonna ask that question once you said Ropes

and Gray. Um, you know, do you think we'll see some of that? Do you think because this idea of putting out something that's a little cheaper than your mutual fund? I can see it getting messy with your current base, Whereas if you just switch them all over to this better vehicle, Yeah, you're gonna have to self cannibalize a little bit, but you're probably gonna do that anyway. Um, I could see that being a logical move for them. It's happening in Canada, uh more consistently, and it's happened

in the US. First trusted that a couple of times with the Clothes and Fund, so apparently it's legal. Do you think we'll see this? I absolutely do think we'll see this. UM. I don't know the time frame of that, but I can tell you that we've spoken to at least five or six clients that are looking at it, and I know of five or six different law firms other than Ropes and Gray they are also looking at at days on behalf of clients. UM. You know, to

your point, it makes perfect sense. I mean, if I have a mutual fund that uh, you know, potentially um, it's been maybe even a little bit stale. UM, I can actually convert it over to an et F model, pick up more efficiencies, UM, you remove the transfer agency costs and other things, uh, and get to scale immediately on the platforms. So I think that there are a lot of reasons guys are looking to do that. To that point, I do think that's that's probably a great

idea for them. I do wonder how many have the stomach. If you're not in the E T F Terror dome dealing with Vanguard every day, it's it's a rough place, and I'm not sure if you're used to just having this nice life, if you can do those kind of like it's like cutting off your own hand. UM. I don't know how many have the stomach to do that. I guess we'll see. So I want to go back to seven out of whiteboard, drawing a mouse trap, the better mouse trap? What changed from then to like actually

what you've been able to get through at the SEC? Well, to be fair, I think the SEC wanted additional bells and whistles than we originally have put on it, and they also constrained the universe of securities that we could um use out of the gate um. But frankly, it was really very very similar to what we drew up over a decade ago. Um, frank if it works. You know, what we always try to do when when we're designing products is to make them as clean and simple as possible.

But we're talking about here the all the proxy structures proxy is you know you um, I'm laughing because you know we recognize that just means it's not actually what the fund is. And if you're telling me I'm not going to have the right pricing, my pricing is gonna be incorrect. And I'm gonna tell you something that isn't the fund. But I want you to make an efficient market. You're you're gonna have a little bit of difficulty. We're giving you the actual price, and we're giving you access

to the underlying fund for creation of redemption purposes. So um again, create something simple like we did with g LD or currency shares over the years, and it will work, and it'll work through every market environment. Again, McCabe Proceeding Investments, Thanks so much for joinings on Trillians. Thank you very much, Michel, Thank you as always, thanks for listening to Trilliance until

next time. You can find us on the Bloomberg terminal, Bloomberg dot com, Apple podcast, Spotify, or wherever else you'd like to listen. We'd love to hear from you. We're on Twitter, I'm at Joel Webber Show, He's at Eric faul Tunis, and you can find Rachel at Rachel Evans. Underscore in y Trillions is produced by Magnus Hendrickson. Francesca Leedy is the head of Bloomberg podcast Fight