Butting Heads Over Portfolio Disclosure

August 04, 2009

There are plenty of reasons for Fidelity to avoid the ETF market. But the biggest one is regal denuding.

Star-based fund managers have been fighting increased portfolio disclosure for nearly a decade. They couch it on concerns about front-running and market timing. But the reality of the situation is that active management doesn’t work, and the more transparency there is, the more obvious it is how badly most managers do their jobs.

That’s not a slam against the individuals out there working hard and trying to make the best decisions. It’s simply a fact that alpha-chasing is a zero-sum game, and in aggregate, all those “star managers” are going to lose by the frictional costs of trading and expense ratios. There’s just no way around the math, and transparency makes the math all too clear.

Lest we forget, more than 70% of active managers got killed by their benchmarks in 2008.

As investors, we should want and demand that kind of transparency. We may well see, as Murray observes, more pressure applied on the SEC to ease its transparency requirements for ETFs.

But we should be very careful before we walk down that path.

Remember, before 2001, traditional mutual funds weren’t even held to a decent naming standard—that is, you could call yourself a “bond” fund and invest 35% of your assets in small-cap stocks. It’s a little better now: A modern fund can only get away with a 20% dalliance. In ETFs, thanks to the transparency requirements, investors know exactly what each fund owns every day of the year.

In fact, virtually every mutual fund scandal of the last 20 years would be either impossible or a lot more difficult with ETFs, thanks to the transparency and real-time liquidity they offer.

Investors would do well to remember that just seven years ago, the top 10 (which means all) of the investment banks in Manhattan were found  to be acting against the interests of investors and were fined $1.4 billion. And while that settlement was mostly about the Chinese wall between research and trading, it turned out to be the tip of an iceberg.

Underneath the waterline, what we found was rampant "late trading" and "market timing" going on inside—you guessed it—actively managed mutual funds. Both of these practices exploited the antiquated “trades processed after market close” system that mutual funds have to live with, which created the opportunity to buy into securities at old prices.

While bad actors can always break the rules, ETFs are far too clear a pond to be playing in. There’s no chance to use ETFs as anything but a price discovery mechanism for closed markets. You think Japan’s going to open way up? You can make that bet in an ETF trading in New York while Japan remains closed. But you’re doing it in the open market, trading against the NAV that was locked when Japan closed yesterday. And you’re making that bet with every other market participant, entirely transparently.

The issue of portfolio disclosure is one that just won’t go away. Neither is the fact that ETFs are the best financial innovation since passbook savings. The two butt heads every day, and I’m guessing they’ll continue to do so for a while.

Dave Nadig is director of research at Index Publications. He welcomes comments and suggestions for future blogs at: [email protected].


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