The Securities and Exchange Commission (SEC) issued an order approving the Precidian ETF model—a “novel type of actively managed ETFs” whereby daily disclosure of portfolio composition is not required. Active managers who licensed or intend to license the model should have had a keen interest in the long-awaited regulatory disposition.
The approval places some new responsibilities on fund sponsor operations and service provider partners. In our view, asset managers should also use this occasion to examine the entire lifecycle of their ETF investment operations. The goal would be to help ensure firms do not overlook the chance to embrace emerging industry conventions, adopt new technologies and implement efficiencies.
Until now, the SEC has required disclosure of the portfolio composition to protect investors by triggering the mechanisms (arbitrage, creation and redemption activity) that keep the net asset value (NAV) of the portfolio as close to the market price as possible.
The daily disclosure can, however, be a double-edged sword. On one hand, it protects investors by helping to ensure shares are offered at as close to NAV as possible. On the other hand, daily transparency makes the actively managed ETFs “susceptible to ‘front running’ by other investors and/or managers, which can harm, and result in substantial costs to, the ETFs and their shareholders,” according to the SEC’s order.
The Precidian model preserves the confidentiality of the investment manager’s strategy and creates a new role called an Authorized Participant Representative (APR). The fund sponsor discloses the components of the basket to the APR, and a key responsibility of the APR is to keep the contents of the basket confidential. The APR would then disclose to the Authorized Participants (APs) the cash required to process a creation order. In the case of a redemption, the fund sponsor would deliver a basket of securities to the APR who would then provide the AP with the net cash. Under the model, a verified intraday indicative value (VIIV) calculates the value of the portfolio holdings each second of the trading day and preserves the arbitrage opportunities for the APs.
The approval of the Precidian model not only presents a new distribution channel for a firm’s alpha generation capabilities, but also presents some new responsibilities for a fund sponsor’s product, operations and oversight teams. Most of these are familiar—as many asset managers and most service providers have had scenario plans in place for the eventual approval and licensing of the Precidian model. We’ve outlined a few operational considerations below.
#1 New Agreements – New agreements will be required. An APR will be designated to act as a broker dealer agent for the Authorized Participant. A “Confidential Account” must be opened for each fund at the broker for the AP Representative to use for creation and redemption on behalf of the AP. Fund sponsors that license the model will want to ensure that the APR has a confidential account agreement with the AP(s) that meets their firm’s particular legal requirements.
#2 New Policies and Procedures – Prior to launch, the fund sponsor will need to establish NAV divergence thresholds/spreads and report regularly on these to the board. The fund sponsor that licenses the model will need to establish, maintain and operationalize policies and procedures to monitor the extent to which (1) the market closing price or Bid/Ask price and daily NAV exceeds the established level, or (2) the Bid/Ask spread exceeds the established level. The initial approval was for a 1% difference. This may require additional price monitoring tasks from data vendors.
#3 Required Disclosures and Preventing Unauthorized Disclosures – Fund marketing material, including annual reports as investor relations marketing, will need to disclose in a “legend” the differences between non-transparent and fully transparent active ETFs. In addition, the fund sponsor is required to monitor and disclose any illiquid security on the fund’s website if no market quotation is available.
Operations teams will need to do their part to ensure that there are no unauthorized or unintended disclosures of portfolio composition. The APR will establish and maintain policies and procedures to protect non-public material information. The fund sponsor will need to initially and annually receive representations from the AP Representatives to confirm basket confidentiality procedures. Additional steps may need to be taken to ensure service providers, including accounting agents, pricing agents and auditors understand and protect the confidentiality of the basket contents. Perhaps using a custodian’s global market’s services as the APR will mean one fewer confidential party in the mix. It is considered a best practice to review confidentiality provisions of existing agreements with service providers.
#4 Failure to Function as Anticipated – It is anticipated that the VIIV is sufficient to facilitate effective arbitrage. The proposal requires the fund’s board to act should the funds not function as required. Fund sponsors and service providers will need to collaborate and monitor activity on the fund and alert the board of directors as required. This may require that more data and analytical tools be deployed to ensure that the fund does not operate to the detriment of investors. The approval also requires the fund sponsors to provide the SEC with data proving that the fund operates as designed—placing additional requirements on operations and distribution to gather validation data.
Whether a fund sponsor launches new ETFs using the model or converts existing funds to ETFs, the Precidian approval presents an opportune time to review overall operations support of exchange traded funds. Please contact me at email@example.com if you’re interested in learning more about these reviews.