ETF Capital Markets Desk: A Transparent Look at the ETF Menu

Traditional, active, strategic beta—the menu of exchange-traded funds (ETFs) available to investors continues to expand. David Mann, head of Capital Markets, Global ETFs, addresses some questions he’s received about active ETFs, including the difference between transparent ETFs and another new type of ETF that may enter the scene, non-transparent active ETFs.

It’s clear that ETFs have evolved since their inception in the 1990s, and since then, have exploded in popularity. Different styles and types of ETFs offer the ability to invest in different asset classes, in different regions and in different ways.

In January, we launched the third active equity ETF within our LibertyShares lineup, Franklin Liberty International Opportunities ETF (FLIO). I expected the majority of my conversations with prospective clients to be around either the strategy of the fund or the best practices for buying it (given that it is a newer fund with lower assets under management and trading volumes). What I found somewhat surprising is that many of the conversations eventually led to questions about different types of ETFs, including the idea of potential “non-transparent” active ETFs.

As a refresher, the first ETFs available, what many call “traditional” ETFs, were constructed as a way for an investor to be able to buy and sell all the securities in an established index (such as the S&P 500 Index) in one vehicle that trades throughout the day. Over time, investors recognized that many of these “traditional” ETFs tracked market-cap weighted indexes, which caused unintended risks due to the market-cap weighting methodology.

This led to the advent of “strategic/smart beta” ETFs, which also track an index but with a different set of rules regarding the construction of the portfolio. Herein lies another misconception about ETFs, which is that they are built to track established indexes. In fact, there are many instances where the order is reversed; the ETF sponsor has an idea for a portfolio and then reaches out to an index provider to create an index specifically for that issuer.

Eventually, there became an appreciation that many of the benefits of an ETF could potentially be appreciated without having an underlying index. “Active” ETFs came onto the scene in an attempt to achieve better investment outcomes versus traditional index products by combining the many benefits of the “traditional” ETF structure with an active investment approach. For example, the Franklin Liberty International Opportunities ETF is able to invest across developed, emerging and frontier markets—independent of a specific benchmark and across the market-capitalization spectrum.

But Wait – What’s This I am Reading Now About Non-Transparent Active ETFs?

Remember, one of the distinguishing qualities of an ETF is the transparency. Every day, you know what holdings are in an ETF and in what weighting. Transparent Active ETFs provide daily transparency of their holdings, just as a traditional ETF does. However, as the name implies, non-transparent Active ETFs would not be required to publish holdings daily. Non-transparent ETFs are still proposed structures awaiting regulatory approval, and thus are not yet available to the public. Because they are not yet available, it is hard to predict how they may be structured and what the benefits could be for an investor, so for this discussion, I will focus on what is available today.

Getting More Granular on the Types of ETFs

One of the unfortunate bi-products of the discussion of the rumored non-transparent ETFs, is that (transparent) active ETFs tend to get lumped in with them, which then causes a (mis)perception that they are harder to trade, structurally flawed or even worse—should be avoided.

The chart below contains some ETF characteristics investors have grown to appreciate in both index-equity ETFs and transparent active-equity ETFs.

From an ETF structure and wrapper perspective, the key difference between a transparent active equity ETF and an index ETF is the fact that the latter follows an index. All other aspects are essentially similar. I think the misperceptions about active ETFs are doing a tremendous disservice to the potential benefits they can bring to an investor’s portfolio.

Another Thing… What Index Am I Tracking?

One misconception surrounding index equity ETFs is that an ETF issuer launches an index ETF product to track a well-established index. There are many instances where the order is reversed—the ETF issuer has an idea for a portfolio and then reaches out to an index provider to create an index specifically for that issuer. This is where strategic beta (smart beta), environmental, social and governance (ESG) and some of the more unique exposures come from. Given the chart above, the differences between transparent active and strategic beta equity-index ETFs have become even more negligible!

No doubt, the future is likely to see more innovations and new products in the ETF space.  It’s important to note that active ETFs can offer certain fundamental potential benefits over traditional, index-tracking ETFs.  I encourage you to continue doing your homework—and keep asking questions!

David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

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