Semi-transparent active exchange traded funds (ETFs) have evolved from an early concept 10 years  ago to a pair of products now live in the market. Despite launching in the midst of COVID-19 market disruption, their trading experience so far has been highly encouraging.

Ever since the introduction of the first US ETF in 1993, one of the vehicle’s core attributes has been full transparency into the basket or portfolio holdings.

This requirement has kept most active equity and many fixed-income strategies from the marketplace, based on concerns that the portfolios would be subject to front-running or free-riding. A major milestone for the industry occurred on March 31, 2020, when American Century Investments launched a pair of active ETFs that were the first of their kind. Trading under the ticker symbols FDG and FLV, these ETFs leverage intellectual property developed by Precidian Investments known as ActiveShares®. This strategy enables an asset manager to disclose its ETF holdings with the same frequency as its mutual funds.

The key to the Precidian ActiveShares  structure is the creation of a new participant in the ecosystem, the authorized participant representative (APR). The APR(s) are hired by the ETF sponsor and contracted by the authorized participant (AP) to trade the basket on its behalf. The only entities that could serve in this capacity would be “agency-only” trading firms. The ETF issuer would also hire a Verified Indicative Intraday Value (VIIV) agent to stream the value of the underlying holding every second to the consolidated tape. With this information and other publicly disclosed information such as the prospectus, statement of additional information (SAI) and Fund Fact Sheets, industry participants would have the data needed to “make markets,” as they do for daily disclosed ETFs.

State Street has been involved with the creators and licensees of the ActiveShares structure for several years, helping to conceptualize and develop the operating model and workflows to service the product. This has included engagement with the Securities and Exchange Commission (SEC) staff and commissioners to help educate them on the structure and our automated servicing capabilities. We were the first and only ETF service provider asked to participate in the ActiveShares ETF Working Group that ultimately designed the operating model and shared those insights with the broader ETF ecosystem.

We discussed with Frank Koudelka and  Jeff Sardinha, our ETF specialists and Chris Scharver, responsible for the APR role at State Street, to know how the launch went, how the products are trading and what they are hearing from the marketplace.

“There are always lessons learned with every new innovation and launch.”

“The key is to educate, plan for and test the operational nuances.”
 

How did the launch go? What did you learn?
The successful seeding and listing of the products occurred on March 31 and April 2. The implementation was accomplished with poise and confidence across all market participants that had a hand in the initial launch. The project planning began in earnest prior to the Rule 19B-4 filing in June 2019. This laid the groundwork for all parties to confidently execute amidst the unprecedented market volatility linked to COVID-19, as well as the new operating complexities of alternative working arrangements, school and business closures, and social distancing. The initial seed orders were placed, processed and settled within the expected timeframes, including the introduction of the new entrant to the ecosystem, the APR. Since launch, the funds have had regular primary market activity and have introduced a second APR. There are always lessons learned with every new innovation and launch, and the American Century Investments ActiveShares were no different. Three particular themes stand out.
 

Planning
Take the time and effort to update your project plans for the operational nuances of the ActiveShares wrapper. Yes, this is an ETF and functions as an ETF within an operational ecosystem that exists today. But, there are some operational differences that need to be mapped out and understood by all parties. The key is to educate, plan for and test those nuances. State Street (as back-office administrator, custodian and APR), American Century and the rest of the support firms (distributor, exchange, VIIV agent) for these products set aside ample time for different testing runs, including a full end-to-end model office that took place over a period of several months for baskets, trading, etc.
 

Overcommunication
The ActiveShares process flow required the creation of a new role, APR, in the middle of the primary market clearance. While this change brings a new party to the table, it also slightly changes the expectations of another party already at the table, the AP. Thus, you will want a single entity to coordinate communication and instill the expectation of overcommunication across the entire ecosystem. This helps to make sure that members are not caught off guard or assume this ETF works like others with similar investment profiles, so they know exactly what is expected throughout the lifecycle. “The key is to educate, plan for and test the operational nuances.”
 

Flexibility
Do not underestimate the work required to establish the new APR role. State Street has been involved in the ETF ecosystem, including trading AP restricted names (assisted trading), lending the ETFs and underlying portfolios (securities lending) and exchanging currencies (foreign exchange). Even with all of our experience servicing ETFs, the APR role was new and different. Although we have been involved in the ActiveShares Operating Group for several years, we assembled a strong project management team when Precidian received their SEC notice of approval in April 2019. The working group included compliance, legal, risk, operations, trading, technology, custody servicing, etc., to ensure all parties had input to make the role successful. Receiving the fund’s confidential portfolio information is a monumental undertaking not to be dealt with lightly. To be successful, we knew we needed to be flexible and understanding. There would be unforeseen issues that may require changes to workflow, systems modeling and participants’ expectations.
 

How are the products trading? Has there been activity since the launch?
The products have been trading efficiently, with bid-ask spreads of approximately 20–25 bps. The first trading day was April 2 and we have consistently seen trading of 15,000 to 25,000 average daily volume. Assets grew from US$8 million to over US$23 million during the first month since launch. What are you hearing from the marketplace? This was one of the most-watched and anticipated launches in the last several years. Active managers have been looking for a way to introduce their investment strategies to the market using the ETF wrapper. State Street has been conducting ongoing education sessions with more than 50 of the top asset management firms in the industry, who find the ETF structure appealing based on its advantages of liquidity, ease of trading, and cost and tax efficiency. Many firms wanted to see how the first products performed before making their own leap into the market. American Century launched in a volatile market, with large swings in the Dow Jones, S&P and NASDAQ averages and significant volume. The major areas of industry interest — spreads, volume and flows — have all seen positive trends so far, which has renewed the interest of those on the sidelines.

“You will want to instill the expectation of overcommunication across the entire ecosystem.”

We are anticipating additional activity and launches in the short- and medium-term. It is important to note that the ActiveShares structure was the first to gain approval and adoption in the marketplace. There are two licensees (Legg Mason and Gabelli) that have received their exemptive relief approvals and are in different phases of their Rule 19b-4, prospectus, and registration filings. Other firms have indicated that they will leverage the ActiveShares structure and file soon.
 

What’s next?
We have several other clients that are also developing active ETF capabilities. While these firms may be in various stages of development, there is a level of consistency in the delivery model used to bring ETFs to market. The planned approach is known as the proxy basket structure, where market makers use proxy baskets and other information publicly disclosed to value ETFs and ensure efficient trading. Authorized Participants (APs) can create and redeem shares directly with the issuer, just as they do for disclosed ETFs.

1. Fidelity is using proprietary intellectual property that they will license to additional asset managers. What is interesting about the Fidelity approach is they are the only licensor that has the perspective of both an active manager and ETF issuer. The Fidelity model will come with both platform and distribution benefits.

2. Natixis has licensed its methodology from the New York Stock Exchange. The firm will tap into the investment expertise from affiliate managers — Harris Associates, Loomis Sayles and Vaughan Nelson, to launch both single and multimanager ETFs.

3. T. Rowe Price has received approval for its own structure. Other asset managers have been engaged with T. Rowe Price to replicate the methodology in its filing. T. Rowe Price will not charge a license fee. Additionally, T. Rowe Price is planning to provide other services to assist active ETF providers.

Our ETF servicing team is targeting launches for these and other clients interested in disclosing a basket that is designed to replicate the performance of the underlying portfolio, but is not a pro rata slice of the fund. These vehicles will leverage daily reporting supported by our Performance and Investment Analytics team to assist market makers in understanding how the proxy basket performance compares to the actual fund holdings.

“While firms may be in various stages of product development, there is a level of consistency in the delivery model used to bring ETFs to market.”