When it comes to cars, everyone wants a safe and reliable vehicle. If you're buying a car, it's a good idea to take a look under the hood. What you see there may tell you a lot about the vehicle's performance, cost, and reliability for years to come. When it comes to financial products, it's also true that looking under the hood before you make an investment can be helpful. For example, active semi-transparent exchange-traded funds (ETFs) differ in important ways from traditional ETFs. And those differences make knowing what's "under the hood" more important than ever.

Most ETFs on the road today are based on the '40 Act fund chassis (referring to the Investment Company Act of 1940). This means these ETFs are basically structured the same way traditional mutual funds are, but the U.S. Securities and Exchange Commission (SEC) allows them to do things a little differently. For example, traditional '40 Act mutual funds buy and sell shares at the end of each trading day, with investors of all sizes, at the fund's net asset value (NAV). ETFs, on the other hand, transact only with large, authorized participants (APs) in big bundles of shares (typically 50,000). Another difference between ETFs and mutual funds is the frequency of portfolio disclosure. While mutual funds typically disclose their holdings either monthly or quarterly with a lag (up to 60 days), most ETFs disclose complete holdings information every day the markets are open.

Historically, most ETFs operated with similar exemptions from the Investment Company Act of 1940, but newer types of ETF structures began receiving approval from the SEC in 2019. These ETF models are frequently referred to as "active semi-transparent," and the first ETFs based on these models were launched in 2020.

Although the details vary, the purpose behind these new models was to make ETFs friendlier to active fund managers by removing the requirement that holdings be disclosed daily. Active fund managers initially avoided the ETF structure, amid concern that providing daily full disclosure would allow traders to front-run their trades and for competitors to steal their "secret sauce."

However, daily disclosure has been a very important component of ETF mechanics. Knowing exactly what's inside an ETF allows market makers and APs to efficiently value the portfolio, and these entities tend to conduct trades that keep the ETF's price generally in line with its underlying value. With active semi-transparent ETFs, daily disclosure of holdings isn't the standard. Instead, they are required to report their holdings quarterly, with up to a 60-day delay at the end of each fiscal quarter, although some funds may report holdings more frequently, such as at the end of each month.

As a result, semi-transparent ETFs rely on other features to keep the fund trading smoothly. One type of semi-transparent model uses creation/redemption baskets that are slightly different from a fund's actual holdings. These proxy portfolios may include decoy securities and/or alternative weighting schemes. The ETF's sponsor may provide information on the fund's website about how closely the performance of the fund matches the proxy portfolio (also referred to as the "tracking basket" by some issuers).

These structural differences come with tradeoffs. In some cases, the bid-ask spreads of active semi-transparent ETFs are higher than those of traditional ETFs. This may be due to the fact that APs and market makers must employ different tools to efficiently value active semi-transparent ETFs, and some of the new active semi-transparent models appear to depend on a level of trust developing between the entities involved (APs, fund sponsors, etc.).

Furthermore, tax efficiency could be a concern for semi-transparent ETFs that rely on proxy portfolios, since ETF managers will have to buy and sell securities to better align the securities they receive through creation baskets with the securities they actually want to own. In other words, more selling inside the fund could potentially reduce the tax efficiency of active semi-transparent ETFs compared to traditional ETFs. However, in 2025, just three semi-transparent ETFs made capital gains distributions, according to Morningstar. Moreover, Morningstar's Tax Cost Ratio, which measures how much of a fund's annualized return is reduced by the taxes investors pay on distributions, shows little difference between the median Tax Cost Ratios of active semi-transparent ETFs and traditional, actively managed ETFs in the same Morningstar Categories.

Lastly, the range of investment strategies offered by active semi-transparent ETFs is somewhat limited since the securities eligible for inclusion in these funds' portfolios must be U.S. exchange-listed and trade during U.S. market hours.

While active semi-transparent ETFs offer investors additional choices, it's important to remember that these ETFs have structural differences from traditional ETFs, and investors should proceed with caution.