Q&A: The Argument for Active Semitransparent ETFs

Typically, transparency is considered a good thing in investing and financial advising. But sometimes, there may be an argument for a less transparency when using exchange traded funds, or ETFs, particularly when active managers want to protect their proprietary investment strategies.

We spoke with J. Womack, managing director of investment products and services for Independent Advisor Solutions by SEI, about how financial advisors can incorporate semitransparent ETFs — which do not fully disclose their underlying holdings — into client portfolios. Here are edited excerpts from that interview.

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What are active semitransparent ETFs?

In a semitransparent ETF, an asset manager may disclose some portion of the underlying holdings along with other securities that broadly represent the remaining “hidden” holdings.

This approach was designed to address concerns from active managers who were averse to things like front-running or potential leakage of their best ideas through the daily disclosures required for traditional transparent ETFs.

Shifting to a semitransparent structure allows for better protection of their proprietary investment strategies.

[READ: Q&A: Why This Asset Manager Is Converting Mutual Funds to ETFs.]

What shifts in investment trends are you seeing today? How do active semitransparent ETFs address these shifts?

While a lot of the emphasis on personalization for investors across wealth management has been in the context of environmental, sustainable and governance, or ESG, factors, which we believe are very important, taxes are another area that aligns with personalization.

Managing the tax profile of the taxable portion of an investment portfolio over time can translate into significantly improved wealth preservation depending on an investor’s time horizon. Fundamentally, the ability to achieve financial goals can be influenced — positively or negatively — by asset allocation and the consistency of that allocation over time. The combined use of portfolio models and robust technology to manage hundreds of portfolios at scale is key.

Active semitransparent ETFs, which are more tax-efficient than active mutual funds, can be used to replace active mutual funds in portfolio models that are used in the marketplace. This will improve their tax profile, specifically as it relates to taxable accounts, and that can lead to meaningful improvements in outcomes for clients.

Why would financial advisors want to use active semitransparent ETFs in client portfolios?

For advisors that are managing the taxable portion of a client’s portfolio, an active semitransparent ETF can be a better choice than a mutual fund, all else being equal. If advisors believe in the value of active management as more asset managers launch semitransparent alternatives to their mutual funds, we expect that advisors will increase their adoption because there are tangible benefits for their clients by doing so.

We believe that the availability of active investment strategies using the ETF structure will expand as a result of the development of semitransparent ETFs.

An advisor’s motivation for including a semitransparent ETF over a transparent one would be related to an investment decision — for example, is this the right strategy for my client? — not an implementation decision — for example, do I prefer a semitransparent ETF to a transparent one?

An advisor might choose an active U.S. small-cap equity strategy delivered using a semitransparent ETF for his client’s portfolio over a passive alternative that might use a transparent ETF structure. That’s much more of an investment decision, and one that might not have been available for consideration absent the creation of a semitransparent ETF vehicle.

How can financial advisors use active semitransparent ETFs?

Our internal research shows that advisors who use a goals-based approach leveraging models tend to grow more quickly than those who don’t.

These advisors, in particular, are the ones who have a preference for active management in certain asset classes. For taxable accounts, these advisors will probably start using models that incorporate these more tax-efficient vehicles.

There are real financial benefits for clients to doing so, and it is a meaningful way in which advisors can demonstrate the value of their advice. Secondarily, for advisors whose value proposition to clients is based, in part, on their investment acumen, active semitransparent ETFs will likely become their vehicle of choice for certain exposures in taxable accounts.

[See: 10 Best ETFs to Buy for 2021.]

What are the drawbacks of active semitransparent ETFs?

At the highest level, active semitransparent ETFs are just another vehicle or wrapper that managers can use to distribute their strategies to clients.

They do have nuances, and their usage in certain contexts is limited given the regulatory environment. But the underlying technology will continue to evolve as both managers and regulators focus on delivering better outcomes to investors.

In that context, the drawback to the semitransparent ETF structure is that it cannot be more broadly applied. But that’s more of an opportunity for the industry than it is a reason not to use these ETFs in a client account.

The rationale for using an active semitransparent ETF in client accounts can be complicated. For example, there may be the same strategy available in a mutual fund or an active semitransparent ETF.

In a qualified account, there is no tax benefit, so the advantage of the ETF is nullified. That said, ETFs are free to trade on most platforms while mutual funds may have a transaction fee or higher relative expense ratio if there is no transaction fee.

Considering the discipline of rebalancing to maintain a consistent asset allocation, advisors have to evaluate the potential transaction costs over time. They might therefore find that it makes sense to use active semitransparent ETFs regardless of the tax classification of an account.

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Q&A: The Argument for Active Semitransparent ETFs originally appeared on usnews.com

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