What’s In Your ETF?

What’s In Your ETF?

Last week the Securities and Exchange Commission (SEC) relaxed the requirement for Exchange Traded Fund (ETF) providers to disclose on a daily basis the underlying holdings in their funds. This change was requested primarily by fund companies T. Rowe Price, Natixis, Fidelity, and Blue Tractor, who would like to develop ETFs that follow what are called non-transparent or semi-transparent strategies. New ETFs will still need approval from the SEC as well as from the exchanges on which they are traded, but this step has opened the door to the development of more actively managed ETFs. Is this a good idea? How will it benefit investors?

Some background first. The main difference between an ETF and an ordinary open-ended mutual fund is that ETF shares are traded on the open market (i.e. between investors) while mutual fund shares must be bought or sold directly through the fund company. In practice, mutual funds buy or sell shares of their underlying holdings at the end of each day based on the number of fund shares purchased or sold by fund investors on that day. This guarantees that the fund’s net asset value (NAV) is always equal to the NAV of its individual holdings. ETFs, on the other hand, require a third party called an Authorized Participant (AP) to work with the fund company to regularly swap shares of the fund’s underlying holdings with shares of the fund itself. The purpose is to keep the ETF’s NAV – which can vary not only based on its holdings but also based on supply and demand – close to purely that of its holdings. 

One additional difference between the two types of funds has been the reporting requirement for holdings. ETFs needed to disclose them on a daily basis while mutual funds were allowed to do it quarterly. So one effect of this change would be to standardize the way both funds report their holdings. While that seems fair, it’s more beneficial to fund companies since it will lead to less clarity on what’s inside an ETF from an investor’s perspective.

An additional argument in favor of this change has to do with a problem known as front running. Passively managed ETFs and mutual funds try to keep their holdings consistent with some index. Since all investors know what comprises the index, and also know when the ETFs will be periodically reconstituting their holdings in order to match changes occurring in the index, they can buy or sell those individual holdings immediately prior to the date the ETF makes its trades. This has the effect of driving up the prices of the securities the ETF buys and lowering the prices of those sold. The net result is reduced returns for the ETF and its investors. By allowing passively managed ETFs to delay reporting, the belief is that they may be able to drift a bit more from their indices and avoid this front running problem. However, since this is a problem that impacts all passively managed funds, not just ETFs, I’m not sure this reporting change will really have much of an effect.

The biggest benefit to the industry is the enablement of more actively managed ETFs. It’s part of a longer-term shift away from mutual funds and towards ETFs that has been slowly building ever since the launch of the first ETF in the U.S. in 1993. In my opinion the jury is still out as to whether ETFs as a diversified investment structure are superior to traditional open-ended mutual funds. But for equity funds, active management means predicting the future, either by timing the market or by selectively picking stocks that are expected to perform better than the market at large. I do not believe either is possible and I have seen no evidence to the contrary. So if the result of this change is a deluge of new actively managed stock ETFs, I would consider that deleterious for investors.

On the other hand, the drivers of returns and of risks are more predictable for fixed income investments as compared to stocks. Actively managed bond funds stand a better chance of performing as well as or better than indices. Right now actively managed bond mutual funds tend to be pretty expensive. If this change results in the creation of lower-cost ETFs in various fixed income asset classes, that should be a positive development.

Only time will tell.

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