Active ETFs - Considerations for Fund Managers Entering the Active ETF Space in Ireland

With interest in active ETFs growing particularly from traditional mutual fund managers, James Hodgson (Arthur Cox LLP) examines some of the considerations and challenges for entrants to the active ETF space in Ireland.

Globally, exchange-traded funds (“ETFs”) have amassed assets of almost $11.5 trillion as of the end of 20231. While passive ETFs dominate global ETF assets, the actual and anticipated level of demand for active ETFs in the US and in Europe presents opportunities and challenges for fund managers operating in both the ETF and non-ETF space. Recent surveys point to a significant number of mutual fund managers planning to either launch ETFs or to undertake due diligence in the short term, suggesting that future growth will be in the active ETF space.

In 2023, ETFs in Ireland topped $1 trillion, representing c. 70% of the European ETF market. It is a centre of excellence for European ETFs with unrivalled expertise in ETF servicing, a strong regulatory framework, Government, regulator and industry support and a favourable tax regime particularly as a result of the Ireland-US double tax treaty. 

As the leading domicile for ETFs in Europe, this article looks at some of the considerations for fund managers entering the active ETF space from Ireland.

Portfolio Transparency – A Key Consideration?

A key consideration for fund managers considering active ETFs can be the portfolio transparency requirements.

Any UCITS eligible strategy may be established as a UCITS ETF, and the prospectus for actively managed ETFs needs to set out details on how the portfolio manager intends to meet the investment objective of the actively managed ETF. In addition, however, the Central Bank of Ireland (the “Central Bank”) mandates the publication of daily portfolio holdings. Current Central Bank guidance is that it will “not authorise an ETF, including an active ETF, unless arrangements are put in place to ensure that information is provided on a daily basis regarding the identities and quantities of portfolio holdings”.

The Central Bank’s requirement brings considerations, including the need to protect proprietary information and whether the need for intra-day information impacts on the assessment of the suitability of an actively managed investment strategy for exchange trading, but these need to be balanced against

investor expectations of transparency in an ETF structure.

The Central Bank has previously expressed an openness to considering the case for non-transparent ETFs and IOSCO has recently expressed the view that there are merits to different approaches to portfolio transparency. While the Central Bank considers its position, however, more managers are getting comfortable with the required disclosure and moving ahead with fully transparent products. Some strategies may be held back until a European semi-transparent offering is available but this is not currently stopping the flow of new active managers into ETFs.

ETF Share Classes – An Alternative Route for ETF Managers?

The Central Bank introduced the flexibility for a single fund to have both listed and unlisted shares as part of its Feedback Statement on DP6 – Exchange-Traded Funds in 2018.

While many ETF managers included provision for unlisted shares in their ETF prospectus, the mechanism was not frequently used, generally due to concerns about the impact unlisted shares might have on the ETF’s ability to benefit from the US-Ireland Double Tax Treaty. Another consideration arose from the Central Bank’s requirement that where there are listed shares in a fund, the entire fund must include “UCITS ETF” in its name. For some managers, the rebranding of their existing mutual funds to an “ETF” and engaging with existing mutual fund investors on this rebrand was not appealing.

Adding listed shares to a non-ETF (or vice versa) does bring a number of practical considerations, particularly relating to capital markets and distribution. ETF and non-ETF shares in the same fund are

subject to different dealing mechanics, with the listed shares being dealt with on the primary and secondary markets and unlisted shares being dealt with via the traditional TA and settlement models.

However, the recent high-profile addition of listed shares to a non-ETF umbrella and the rebranding of a number of previously non-ETF funds as UCITS ETF has changed the landscape and adding listed shares to one or more non-ETF funds is again a consideration in producing an alternative access point to the ETF market in Europe.

ESG ETFs – What’s in a Name?

It is difficult to decouple the potential growth of active ETFs in Europe with the exponential growth of ESG ETFs, with the expectation that many of the active ETFs coming to market in the near future will have an ESG element. Since the coming into force of the Sustainable Finance Disclosures Regulation (“SFDR”) in March 2021, there has been a significant growth of ESG ETFs (i.e. those classified as Article 8 or Article 9) due to investor demand and distribution advantages for products with environmental or social features.

A decision on SFDR classification and the potential impact for distribution is a key one at the initial product structuring phase. Active funds will need their own internal processes or ESG consultants to ensure the portfolio management approach delivers the sustainability commitments made in the offering

documents. The decision on SFDR classification will also impact disclosures needed and ongoing reporting, which can be challenging as data difficulties continue.

The Central Bank’s focus is very much on transparency in terms of what the fund is seeking to achieve, how securities are selected, how ESG is integrated into the investment selection process and monitored throughout the lifecycle of the product. As with active funds generally, the ESG disclosure obligations for active ETFs under SFDR are more detailed than the index tracking equivalent by virtue of the independent nature of the active strategy.

Once a fund has settled on an ESG strategy, it will generally want to make that emphasis clear in the name, and funds regularly use “ESG”, “sustainable” or “impact” in the name to convey this. However, in November 2022, ESMA launched a consultation on Guidelines on Funds’ Names using ESG or Sustainability-related Terms which closed on 20 February 2023 (the “Guidelines”). The Guidelines,

which are expected to apply during Q2 2024, set certain criteria around the use of sustainability-related terms in the names of investment funds. Managers considering the active ETF market should be mindful of the Guidelines which, for active managers, will require consideration of the strategy. Managers for whom the UK is an important target market need also consider the impact of the Financial Conduct Authority’s Sustainable Disclosure Regulation which, while similar in some respects, differs in its naming convention from SFDR and the Guidelines.

Other Considerations

There is a myriad of other considerations for fund managers entering the active ETF space. Traditional mutual fund manager, in particular, will need to grapple with operational considerations which do not exist in the mutual fund space, such as the appointment of authorised participants and market makers, the diverse and complex European capital markets and market infrastructure for ETFs, different dealing and settlement models and the need for ETF-specific distribution expertise. But, this has been done multiple times recently and market commentary suggests that mutual fund managers braving these challenges is not a “whether” but a “when” decision.

References

1PwC – ETFs 2028:Shaping the Future (ETFs 2028: Shaping the future | PwC).