In a January 2022 law review article, I argued that (1) the actively managed ETF was set to emerge as a significant feature of the investment landscape and (2) this emergence would have important implications for the main parties that play key roles in protecting ETF investors (namely, the SEC and investment intermediaries). Two and a half years later, the first argument has proven correct.[1] Given the extent of the emergence of the actively managed ETF over this period, the second argument should now receive more attention.
To be sure, reports of massive inflows to actively managed ETFs from 2023 and the first half of 2024 appear, in hindsight, to make the first argument seem obvious. But it is worth noting that, back in January 2022, it was unclear whether “authorized participant” arbitrageurs (“APs”) would have an incentive to do their below-described work that is so central to ETF success. In fact, in private discussions about my paper at the time, industry participants and regulators offered doubt on that front. Moreover, the tremendous triumph of the ETF had then been almost completely limited to the world of passive investment. This is because before a 2019 rule change, the SEC had long required transparency into fund holdings for an ETF to come to market, yet few active managers wanted to share their “secret sauce.” And the first non-transparent, actively managed products that began trading in mid-2020 got off to a slow start.
Even so, there was room for optimism at the time. As my article noted, large investment companies had already signed on to issuing nontransparent, actively managed ETF shares. Beyond even their broad marketing reach, these companies could attempt to convert their existing, actively managed mutual fund products into actively managed ETF ones. It was also reasonable to expect investors to, on their own, shift a substantial amount of their capital from actively managed mutual funds to actively managed ETFs given (1) the relative advantages (tax and otherwise) of ETFs over mutual funds and (2) the fact that nontransparent active management was now possible on the ETF side.
The SEC and key investment intermediaries such as investor advisers and brokers should watch that emergence closely. This is because at their core, ETFs are pooled investment vehicles that rely on a specific arbitrage mechanism to tie the price of the ETF shares that trade in the open market to the price of the per-share value of the associated fund. APs are authorized to transact opposite the fund, whereas investors and other market participants conduct their buying and selling of shares exclusively among themselves in the secondary market. When ETF shares are trading at prices that exceed the per-share net asset value (“NAV”) of the underlying fund, the APs are able to buy the underlying “creation basket” of securities in the open market and then use their privileges to exchange that basket of securities in return for new ETF shares from the fund. This increased supply of the overpriced ETFs shares puts downward pressure on their price in the open market as the APs sell them off, thereby helping align those prices with the per-share NAV of the fund. (When ETF shares are underpriced in the market, APs can enter into related transactions with the fund where they buy the underpriced ETFs shares in the market – thereby driving their price up – and redeem them to the fund in return for the more valuable creation basket of securities that they can sell in the open market, thereby accomplishing the same price-aligning ends.)
When it comes to traditional, passive ETFs, this ETF-arbitrage mechanism has allowed investors in the open market to buy and sell ETF shares with a significant degree of confidence that the price of the shares they are buying is closely tethered to the per-share value of the underlying fund. But because the arbitrage mechanism is the key to these two prices remaining sufficiently connected, the extent to which share prices will in fact reflect the per-share underlying value of the funds (including during times of crisis or even just limited liquidity) for nontransparent actively managed ETFs is far from clear. This is because the ETF-arbitrage mechanism relies on APs (and other arbitrageurs who must conduct ETF arbitrage trades through them) spotting deviations between ETF share prices in the open market and the per-share value of fund holdings in the ways described above, yet those holdings remain nontransparent to those market participants for these new ETF products.
To be sure, the clever innovations that the SEC approved in 2019 (namely, those associated with publication of the NAV of the undisclosed underlying funds throughout the trading day) do much to address concerns along these lines. But given the extent of the emergence of actively managed ETFs we are observing, the SEC and investment intermediaries would be wise to pay close attention along the lines I suggest in my 2022 article to the extent to which this version of the ETF-arbitrage mechanism is likely to work as well as its simpler passive-ETF predecessor has worked.
ENDNOTE
[1] See, e.g., Isabelle Lee, State Street Says Active ETFs Set for $260 Billion Annual Haul, Bloomberg News (June 6, 2024) Bloomberg News (reporting that “[a]fter a fresh torrent of inflows, actively run exchange-traded funds look poised for a record-breaking $260 billion haul this year,” which is “almost double [2023’s] record $140 billion tally.”); id. (noting that 32 percent of all ETF flows in 2024 have been to actively managed ETFs, and that active ETFs added net inflows for the 50th straight month in May 2024, with that month seeing “the third-highest inflow ever after March and April [2024].”).
This post comes to use from Professor Kevin S. Haeberle at the University of California, Irvine School of Law. It is based on his 2022 article, “The Emergence of the Actively Traded ETF,” published in the Columbia Business Law Review’s Symposium on the Future of Securities Regulation and available here.