Yes, Transparency Is Still A Good Thing

August 27, 2020

Investors often disregard regulatory proposals as dry, boring stuff. But I implore you to pay attention—because the Securities and Exchange Commission (SEC) has been cranking out some real bangers lately.

For example, in July, the SEC proposed a rule change that would bump up the quarterly Form 13F reporting threshold for investment managers from $100 million to $3.5 billion.

In other words, the SEC wants to make it so that if you manage less than $3.5 billion in assets, you won't have to regularly tell the world what you own.

By the SEC's own estimates, the proposal would eliminate the need to file 13Fs for roughly 90% of all current filers. According to SEC Chairman Jay Clayton, this would reduce "unnecessary burden" on smaller filers, while preventing would-be copycatters and front-runners from being outwitting and outrunning active managers.

What the proposal really does, however, is conceal valuable, non-alpha-generating data from investors, institutions, advisors, academics, fund issuers, individual companies—and yes, even journalists—about what the smartest minds in finance are doing.

That's good for the biggest fish in the sea, I guess. Not so good for us guppies.

What Is A 13F & What's It Good For?

But before we get into the why, let's back up a second and talk about what a 13F filing is and how it's used.

A 13F is a quarterly tax filing on which investment managers must disclose their equity investments, as of the date of filing.

In essence, it's a quarterly inventory of which stocks a manager or fund holds. As such, it's really just a snapshot in time—and an obsolete one at that, given that the form itself goes public on a 45-day lag.

A lot can happen in 45 days. (In these markets, a lot can happen in 45 minutes.) So by the time a 13F filing gets published, it is already hopelessly out of date.

So the SEC's claims of needing to raise the reporting threshold to prevent front-running are ridiculous on their face: Anybody hoping to front-run an active manager using only 13Fs would need a time machine.

Furthermore, 13F forms disclose only certain exchange-traded equity holdings, such as stocks and ETF shares—meaning that individual bonds, most derivatives, even mutual funds won't show up on a 13F. It's an incomplete—often woefully so—picture of what an investment manager holds: less like a snapshot, and more like a daguerreotype with significant blurring around the edges.

Share Ownership

What a 13F form does reveal is equity share ownership, and that's worth its weight in gold for companies, including ETF issuers, who use 13F filings to track who is buying their security shares and why.

You see, trades are anonymous: Flows data is readily available, but individual stock issuers or ETF companies don't really know who is buying or selling their shares on the secondary market at any given time. So the Form 13F gives them a peek—an incomplete and out-of-date peek, yes, but a peek nonetheless.

Using it, they can see which big investors are selling their stakes; which activist investors are amassing significant share positions; and whether their funds have been added or removed from any well-known tactical strategies.

If fewer shareholders file 13Fs, stock and ETF share issuers will have significantly less ownership transparency available to them. One study from IHS Markit found that small cap companies would lose visibility into 15% of their share ownership; micro cap companies would lose visibility into 17% of ownership. And if the proposal passed, the researchers found that, on average, 55% of the investors in any given stock or fund would stop filing 13Fs.

Fewer 13Fs Means Less Crowding Risk Insight

Yet I think reducing the number of 13Fs published is even worse for shareholders. Not only do investors lose a valuable benchmarking tool, they lose critical insight into a security or fund's particular crowding risk.

Crowding—what happens when everybody buys and sells the same securities at once—has two main impacts on investors. The first is that alpha-generating strategies often become less profitable the more popular they become, because arbitrage opportunities are often resolved more quickly and for less profit.

The second—and this is also a risk for passive investors as well as alpha-seekers—is that in times of extreme market volatility or systemic shocks, it can become more difficult or more expensive to exit certain equity positions if everybody else is trying to do it, too.

So it pays to keep an eye on which stocks or ETFs are rapidly gaining (or losing) favor—especially if you tend to hedge your portfolio.

In a note to clients about the proposal, Goldman Sachs specifically pointed out the challenge of crowding risk, stating that the proposed rule change would make it significantly harder for them to track crowding risk by reducing the number of hedge funds the firm tracked from 822 to just 59.

Even SEC Commissioner Thinks Cost Savings Overstated

But surely lifting the 13F filing burden results in some great cost savings for filers, right?

Wrong.

By the SEC's own estimates, its proposal would result in a savings of $68 million to $136 million in legal fees across all filers. In this industry, that's chump change—hardly an adequate trade for investment data.

Even that figure might be inflated. After the proposal was made, SEC Commissioner Allison Herren Lee wrote, "I am concerned that the projected cost savings in today’s proposal are greatly overstated and wholly inconsistent with the Commission’s past analysis—and, importantly, that the actual cost savings do not justify the loss of visibility into portfolios controlling $2.3 trillion in assets." (You can read her full argument at the above link.)

Copycat ETFs Already Exist

What about the SEC's claims of copycatting? Couldn't investors use 13Fs to ride the coattails of more successful active managers?

Yes, they can. In fact, there are a handful of hedge fund-cloning ETFs that use 13F forms as a way of selecting stocks, including the $110 million Goldman Sachs Hedge Industry VIP ETF (GVIP); the $58 million Global X Guru Index ETF (GURU); and the $26 million AlphaClone Alternative Alpha ETF (ALFA), for example. (Read: "Some ETFs Ride 13F Filings To The Bank.")

Here's the thing, though: These ETFs are scraping dozens—sometimes hundreds—of 13F filings to pick their constituents. Rather than trying to copycat any particular individual active manager, they're looking for investing trends across the hedge fund industry as a whole.

Plus, they're kneecapped by the fact that, again, hedge fund holdings are reported on a significant lag—any security selection changes may be happening months after the market stimulus for which they were originally relevant. Imagine finding out that crude oil went negative in April, then deciding to sell an oil producer stock now—because that's essentially the time frame these funds are working on.

That’s hardly a threat to active management.

Make Data Easier To Find, Not Harder

The proposal is now on the Federal Register and in its 60-day comment period. Last I counted, more than 1,900 individual comments had been logged—many from individual investors concerned about how the proposal will constrict transparency, as I described above.

Some commenters have brought up excellent counterproposals that would instead increase 13F transparency, including shortening the reporting lag to just 30 days, or requiring filers to report their short side bets or smaller positions.

That's what the SEC should be doing, in my opinion: making it easier to find data, not harder.

There are few fundamental truths of investing, but one of them is this: Transparency is always a good thing. I really do believe that. Investors don't have to take advantage of the transparency that's available to them—they don't even have to understand it—but the more we make information available, the more we democratize finance and the better all of our investment outcomes will be.

This proposal does the opposite. I hope the SEC reconsiders.

The proposal is open to public comment until Sept. 29.

Contact Lara Crigger at [email protected]

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