Investors Win In SEC Active ETF Ruling

October 27, 2014

It may have been inadvertent, but the SEC’s ruling to block nontransparent active ETFs is a real plus for investors.

Hats off to the Securities and Exchange Commission for last week’s ruling preliminarily denying exemptive relief to Precidian Investment’s bid to market nontransparent active ETFs.

Transparency is valuable to investors, because it allows for timely due diligence. The 21-year-old ETF structure has revolutionized investing, because of low expenses, tax efficiency and, critically, daily portfolio transparency. To allow old-style obfuscation would be a clear step backward for investors.

The SEC isn’t always known for protecting investor interest, but last week’s ruling was a breath of fresh air. By highlighting the problems with price discovery, the SEC has not only preserved the arbitrage mechanism at the heart of ETFs, but also laid bare longer-term due-diligence problems that arise when investors can’t see what they hold.

Put simply, if portfolio disclosure—even supplemented intraday indicative net asset value—is useless for pricing a fund, then it’s useless for due diligence, too.

Ensuring The Price Is Right

The SEC’s principal objection to the nontransparent active structure was around traders’ ability to calculate a fund’s price. Specifically, market makers need to calculate up-to-the-microsecond portfolio values—accurately, of course. This instantaneous price is called the “intraday indicative net asset value”—IIV, or “iNAV” for short. The SEC rightly noted that most market makers and associated persons—the traders who provide shares to the public—use the full portfolio to price ETFs.

In its decision, the SEC explained: “Today, market makers calculate their own NAV per share of the ETF with proprietary algorithms that use an ETF’s daily portfolio disclosure and available pricing information about the assets held in the ETF’s portfolio. They generally use the IIV [intraday indicative net asset value], if at all, as a secondary or tertiary check on the values that their proprietary algorithms generate.”

Market makers I’ve talked to concur. At least one prominent ETF market maker has bypassed the calculation baskets entirely, sourcing portfolios directly from issuers, custodians and other providers, involving a minimum of two dozen daily data feeds.

Investors must be able to trust markets to determine they’ve gotten best execution on their trades. The SEC’s focus on protecting the integrity of ETF pricing was great, but that’s just the beginning. The biggest benefit of portfolio transparency isn’t in trading, it’s in allowing long-term investors to properly evaluate what a fund holds. With this week’s preliminary ruling, the SEC accidentally protected investor due diligence.



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