Investors Win In SEC Active ETF Ruling

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.

The Value Of Daily Transparency

Before deciding to buy a fund, and for the duration of the fund’s holding period, investors must assess, evaluate and monitor their investments. Daily portfolio transparency can be critical for understanding exposures, and avoiding or managing adverse events.

Mutual fund investors who wanted to avoid Puerto Rico’s general obligations bonds earlier this year were out of luck; ETF investors had daily insight into their muni bond portfolio’s Puerto Rico exposure. Emerging markets investors concerned about Russian equity exposure had complete visibility into their ETF portfolios, but only stale disclosures from their mutual funds.

There’s really only one argument that supports nontransparency from an investor’s point of view: The longer the portfolio manager can conceal holdings, the longer the window to protect alpha-generating ideas.

The Value Of Nontransparency

Researchers Weili Ge and Lu Zheng have indeed found that longer times between disclosure intervals amplify performance: Outperforming managers increase their outperformance, while underperforming managers lag even further. The law of averages still holds, but the dispersion of results increases.

Every active manager believes she can outperform the markets, on a risk-adjusted basis. Naturally, actively managed mutual fund shops believe that not revealing their “secret sauce” helps their performance.

Dan McCabe, chief executive officer of Precidian Investments, the firm behind the nontransparent active fund application, explained, “Nontransparent active ETFs would allow protected intellectual property to fit comfortably in the ETF structure.”

Who Benefits?

But investors have every reason to push back, because risk-adjusted outperformance is both rare and fleeting.

The S&P Indices Versus Active (SPIVA) data show again and again that most active managers fail to outperform appropriate benchmarks. Worse for active managers, the SPIVA data show little or no persistence—the ability to outperform over multiple time periods. There’s precious little alpha arriving to actively managed mutual funds.

The alpha-protection argument is largely a red herring. If there’s no long-term, persistent investor value to the secret sauce, then investors in nontransparent funds will find themselves on the losing end of the nontransparent active deal.

So who wins? Long-time mutual fund companies like American Funds, which have seen their assets decrease in recent years, have been looking to nontransparent ETFs as a way to protect their businesses. Fund sponsors would be well positioned to launch marketing blitzes hyping their shiny new, seemingly investor-friendly, ETF strategies. They would be half right, because ETFs are indeed more efficient than mutual funds.

A Better Mousetrap

Compared to mutual funds, ETFs are a better mousetrap. The freedom from record-keeping reduces management fees, while minimizing capital gains distributions. Better still, ETFs typically don’t support so-called trail fees—kickbacks that fund sponsors pay to advisors who sell their funds.

If American Funds could switch all its current mutual fund shareholders to nontransparent ETFs, investors would win on costs alone. American Funds would also win, simply by preserving its core business.

But current mutual fund investors cannot really switch to the ETF structure. Some are stuck in their existing funds for tax reasons. Many more are stuck with advisors who depend on receiving trail fees, and have no reason to switch their clients to a new structure. And still others are stuck in no-ETF 401(k) accounts.

This game isn’t really about existing fund holders. It’s about new money, and the newest of the new ETF money is coming from retail investors.

Investor Vulnerabilities

Retail investors, the newest group to embrace ETFs, can’t do due diligence the way institutional investors can.

These investors most likely won’t know about the failure of active management or the value of due diligence. They’re ripe for the picking.

It’s not hard to imagine that old-line mutual fund companies would do everything they can to leverage their brands and their huge marketing budgets to attract new clients.

Still, it’s not the SEC’s job to protect clients from flashy ad campaigns.

Investors got lucky this time, because traders’ and investors’ interests are aligned around transparency. The SEC has agreed: ETF portfolios must be transparent to promote price discovery. It’s an inadvertent win for due diligence.

Contact Elisabeth Kashner, CFA, at [email protected].