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Written by: Pictured Rocks Investment Advisors At Pictured Rocks Investment Advisors (PRIA), we have previously said that we like to layer on active strategies around our passive ETF (exchange traded fund) strategies. Most active strategies are currently found in the open-end, mutual fund structure, but that's about to change. Soon, we will have the option of finding active strategies within U.S. equities wrapped into an ANT ETF - an Active NonTransparent ETF structure. Ironically, the market is about to become infested with ANTs over the next five years and the analogy to the actual infestation of ants, in our opinion, couldn't be more apropos. Does life need ants to survive or are they just annoying creatures that invade our homes and gardens? Ants are undoubtedly helpful to the soil we use to grow crops, but so are earthworms and they don't tend to destroy many crops like ants do. Ants also disperse certain seeds to spread vegetation across the soil, but so do earthworms, rain, and wind. The point here, and the analogy to the ANT ETF, is that we're not sure these fund structures are really needed by investors.An ANT ETF, or sometimes called a semi-transparent active ETF, will be an exchange-traded fund that, unlike the current ETF structure, will hide its underlying holdings, except on a quarterly-basis. Similar to the current ETF structure, an ANT ETF will trade real-time and, most importantly, offer tax efficiency relative to an open-end, mutual fund. There are quite a few ANT ETF structures that have been approved by the SEC. For a better understanding of those structures, this is a good summary piece, but we want to present our own thinking as an investor that will ultimately buy these ANT ETFs, or not. Fund Strategy :The initial push of ANT ETFs on the marketplace will be within U.S. equities - large, mid, and small cap strategies. At PRIA, we don't see the value of active management within large cap equities, since most active managers underperform the S&P 500 over longer periods of time and we can buy the S&P 500 ETF (SPY) for 9.45bps (basis points) versus a large cap active mutual fund for 86.5bps. So maybe we'll look at an ANT ETF for small-mid (SMid) cap strategies, where we believe an active manager can add more value. Fund Fees :This is where we're hearing conflicting things. Will the ANT ETF be cheaper than the same strategy within an open-end, mutual fund within the same firm? If it is cheaper, of course, we'll consider the ANT ETF. But when we take the perspective of the issuing firm, why would they want to cannibalize their existing open-end, mutual fund assets and firm's margins to launch a still unproven, cheaper ANT ETF structure on that same strategy? This is why we're hearing that an ANT ETF will have to be priced the same as its corresponding open-end, mutual fund strategy to align with Requlation BI.Under Reg BI, we believe ANT ETF issuing firms will run into all sorts of compliance issues if their sales folks are selling the same strategy across two different fund structures at two different expense ratios, and therefore different sales commission rates. Sales folks are generally paid higher commissions on open-end, mutual funds, so they will naturally try to sell that higher fee structure, rather than the cheaper ANT ETF alternative. This is why we believe ANT ETFs on existing open-end, mutual fund strategies, which is what the larger issuing firms are planning, will have to be priced the same. That is a deal-killer for us. Fund Tax Efficiency : Tax efficiency is the biggest benefit of the ETF structure, and for the ANT ETF structure versus the traditional open-end, mutual fund structure. When an open-end, mutual fund pays out a capital gains distribution at year-end, that is taxed and leads to the investor paying a portion of those gains to Uncle Sam. Alternatively, an ETF won't typically have to pay out a capital gains distribution at year-end, if managed correctly, which saves the investor that tax bill and ensuing future returns that can be generated off that theoretical tax bill.For an open-end, mutual fund, meaningful capital gains distributions will occur when the fund is seeing significant client redemptions (outflows), and when the active manager heavily turns over the portfolio (rebalances). These two portfolio events can lead to significant realized, taxable gains on the disposed securities that may require a capital gains distribution. In both situations, we're not exactly sure how the ANT ETF will be significantly "better" for investors.In the case of significant client redemptions, presumably, the strategy has likely underperformed so creating an ANT ETF will not solve that client problem. For active strategies that have a high portfolio turnover, the active manager will likely want to trade on the same day, based on the given market or stock-specific news. To effect a custom in-kind transaction in an ETF, which allows the ETF to deliver out any securities to be sold at a gain and therefore avoid a required capital gains distribution, it typically takes 2 or 3 days to orchestrate that tax-efficient trade. We're not sure active managers have that sort of patience when effecting their trades, as active managers typically think portfolio returns first, and client tax efficiency second. Therefore, we're not that optimistic that an ANT ETF will have significantly less capital gains distributions (or significantly more tax efficiency) at year-end than its open-end, mutual fund brethren. Fund Transparency :At PRIA, we like to use transparent (passive) ETFs so that we can run an overlap and correlation analysis on the fund's real-time underlying holdings - to ensure we are not too "heavy" in any single security or sector across our collective portfolio. With the ANT ETF structure only providing a look at some or none of the daily holdings until each quarter-end, similar to open-end, mutual funds, the structure doesn't provide us the necessary tools and analysis we need to build a properly diversified and collective portfolio. For this reason, we don't see a benefit of an ANT ETF over the open-end, mutual fund structure in terms of positioning the fund. Fund Tradability :ETFs trade real-time in the open market, while open-end, mutual funds only "trade" once a day at the end of the day NAV (Net Asset Value). The intraday liquidity allowed by ETFs is nice for actionable trades, but it is also more costly to trade an ETF as you typically have to pay a cost (spread) above the NAV to buy or sell an ETF. For an ANT ETF structure, the spread may be even wider than traditional passive ETFs, since market makers won't have a look into the underlying ANT basket and/or the potential changes the active manager may be effecting during that particular day. This presents more risk for the market maker that quotes the ANT ETF, and that risk needs to be priced accordingly. For this reason, we don't see a benefit of an ANT ETF over the open-end, mutual fund structure as its added costs outweigh its intraday tradability.The most resounding hesitation on the ANT ETF structure is that the active management industry has created the structure to try to solve its own (outflow) problems, and not the end clients' problems. We agree, per the above rationalizations. While we will certainly consider an ANT ETF relative to its corresponding open-end, mutual fund strategy in our fund analysis, the ANT ETF has quite the uphill battle to prove itself as an effective structure within active management, in our opinion. The believers can't just be the industry; they have to be the end-client buyers, and they tend to justifiably hesitate these days on any new "Wall Street" innovation.
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