How the Clearhedge Method can improve trading outcomes for ETF investors
Using the Clearhedge Method, AFS expects arbitrageurs to be able to efficiently hedge the market risks of their positions in ETF shares over varying market conditions. AFS believes ETFs utilizing the Clearhedge Method will trade with tighter bid-ask spreads and narrower premiums/discounts than other Portfolio-Protected ETFs that do not afford arbitrageurs a comparable ability to hedge their ETF share positions.
Conventional ETFs disclose to the market each day the identities and quantities of each of their current portfolio holdings. The principal purpose of disclosing an ETF's current holdings is to enable market makers and other arbitrageurs to identify potential arbitrage profit opportunities in trading the ETF's shares and to hedge the market risk of their positions in shares. This arbitrage trading is widely understood to play a critical role in ensuring that an ETF's shares trade with tight bid-ask spreads and at market prices that are close to the current value per share of the ETF's portfolio holdings. When arbitrage trading is easy to manage and low risk, competition among market makers and other arbitrageurs seeking to earn reliable, low risk profits drives down the costs to buy and sell an ETF's shares.
Disclosing an ETF's portfolio holdings on a daily basis may, however, harm ETF shareholders by providing other market participants with information that can enable them to trade in front of the ETF's portfolio transactions ("front running"), thereby raising the ETF's costs to buy and sell. Disclosing an ETF's full holdings each day also enables other market participants to replicate the ETF's portfolio positions and exploit its manager's investment insights ("free riding"). As a result, while disclosing an ETF's current holdings facilitates an arbitrage process that supports trading of the ETF's shares at market prices close to the shares' underlying value, the ETF's investment returns may be adversely affected. For this reason, most managers of proprietary active investment funds have avoided introducing their strategies as conventional ETFs.
The ClearHedge Method is designed to support the efficient secondary market trading of ETF shares while keeping the ETF's proprietary trading activity confidential. AFS believes use of the proposed Clearhedge Method will cause ETF's shares to routinely exhibit better trading performance (i.e., lower bid-ask spreads and less variable premiums/discounts to the shares' underlying value) than other ETFs that do not disclose their full portfolio holdings on a daily basis ("Portfolio-Protected ETFs") AFS also expects ETFs utilizing the Clearhedge Method to provide greater transparency of investor trading costs than offered by existing ETFs.
Key aspects of the Clearhedge Method
ETFs utilizing the Clearhedge Method would not disclose their current portfolio holdings. Instead, they would seek to facilitate efficient share arbitrage and low shareholder trading costs by:
- Disclosing each business day a "NAV Reference Portfolio" that is designed to closely track the daily performance of the ETF's portfolio holdings, while maintaining the confidentiality of the ETF's proprietary trading activity; and
- Providing for market makers and others arbitrageurs active in the ETF shares to exchange payments with the ETF based on the relative performance of the NAV Reference Portfolio and the ETF's actual portfolio holdings ("Clearhedge Swaps")
Using the Clearhedge Method, an arbitrageur could offset the market risk of its positions in ETF shares by: (i) buying/selling the disclosed NAV Reference Portfolio instruments (or a suitable substitute); and (ii) engaging in Clearhedge Swaps to offset the "basis risk" between its exposure to the NAV Reference Portfolio and exposure to the ETF itself arising from the arbitrageur's net position in shares. By varying the size and direction of its NAV Reference Portfolio and Clearhedge Swap positions at times and amounts corresponding to intraday changes in its ETF share positions, an arbitrageur could manage its inventory risk in shares with substantially the same precision as if the arbitrageur knew the composition of the ETF's current holdings.
In support of the Clearhedge Method, each ETF would publicly disclose and "Intraday Indicative Value" at 15-second intervals throughout market trading hours each business day. Arbitrageurs with master swap agreements in place with an ETF could initiate and adjust their Clearhedge Swap positions at one-second intervals throughout market trading hours.
Aspects of the Clearhedge Method are subject to U.S. Patent 10,102,573 and pending patent applications. In February 2019, Eaton Vance and AFS filed an application with the U.S. Securities and Exchange Commission seeking exemptive relief to permit the offering of ETFs that employ the Clearhedge Method.