Milestone For Nontransparent Active ETFs

This week, the NYSE expects to hear from the SEC. What will it mean for ETF investors?

Oct. 24 will supposedly be a big day for the ETF market. On that day, the NYSE is supposed to get a ruling on the proposed changes it submitted to the Securities and Exchange Commission back in February. Those changes, the so-called “19b-4” filing, for the name of the form used, would permit the listing of ETFs that only disclose their portfolios quarterly.

How you get from February to Oct. 24 is a matter of Federal Register date-math and built-in delays that the SEC generally invokes, but because this is a matter of actual trading on exchanges, not product approval, the SEC actually has some requirements to deliver a verdict on whether they like what they see.

The rule change being requested also specifically lists three nontransparent active funds from Precidian—the “ActiveShares”—as the products to be listed.

Good For Investors

I doubt anyone’s looking for me to put a finger on the scale here, but I figured I’d at least make it clear: I think in general this is good for investors.

Now, I can’t say that without reservations: I believe most investors would be better off in low-cost index funds. I also believe most investors probably trade too much. But what I believe isn’t really the issue.

We don’t live in a nanny state where everyone can have any color portfolio they want as long as it’s gray. Investors make choices. And a lot of investors—wielding trillions of dollars—choose to invest in actively managed mutual funds.

Every year, millions of those investors make a smart guess, and pick a manager who not only beats his or her own high expense ratio, but beats the market on a risk-adjusted basis. Every year—if you believe the SPIVA reports, which I do—more investors guess poorly, and take too much risk for too little reward versus a passive approach.

Investors Make The Call

But I don’t get to make that call—investors do.

Similarly, I personally really like what I own. As I said in my comments about Bill Gross going to Janus, I think investors would be better off knowing what Gross is up to with a transparent fund, instead of waiting a few quarters to see how he changed up the game at his new unconstrained bond fund.

But there are a lot of people who remained convinced that the only way to maintain an edge is to keep the Street from knowing what you’re doing.

I don’t get to make that call either—investors do.

Alpha Seekers Benefit From ETFs

And investors will. While I may personally advocate long-term, dirt-boring passive investing, investors will continue to seek out active managers to try and beat the market. And those investors are, nearly without exception, going to be better off in an ETF wrapper like the one the SEC is going to be opining about in a few days.

The reasons are simple:

#1: Cost

The ETF structure removes a slug of shareholder-servicing costs. It also generally removes trading expenses, as those expenses are born by authorized participants (or in this case, an external trust) to deliver or to liquidate underlying securities.

Most ETFs don’t charge a 12(b)1 distribution fee, because ETFs are “bought,” not “sold.” So there’s no need to compensate the distribution channel on assets.

And while we don’t know for sure, evidence suggests the active ETFs backed up in the pipeline will probably come out with the lowest comparable fees—something akin to the institutional share class fees.

That’s what the PIMCO Total Return ETF (BOND | B) did. After all, those higher fees are generally justified by issuers as covering increased marketing and distribution costs, or even to fund things like loads paid back to brokers.

#2: Tax Efficiency

Because of the creation and redemption process, few ETFs pay out meaningful amounts of capital gains. That’s helpful for your S&P 500 index fund, but it’s really critical in an actively managed fund. Most actively managed funds have much higher turnovers, and pay out more in capital gains.

Some popular active equity funds paid out in excess of 10 percent of their net asset value (NAV) in cap gains distributions in 2013. That kind of tax hit can be easily avoided in ETFs, and my hope would be that any nontransparent active ETF would fully leverage this, assuming there’s buy and sell activity to manage the tax lots with.

#3: Transparency And Trading

What? Isn’t this about nontransparent active ETFs? Yes, it is, but here’s the thing: While it’s definitely the case that you won’t know exactly what you’re holding in a nontransparent ETF on a day-to-day basis, you will know what it’s worth.

Each ETF will continue to publish an intraday NAV, and when you have a major market shock, this at least gives investors more information about how they’re doing than they have with traditional mutual funds.

Imagine it’s noon, and the market has collapsed 8 percent since the open. If you’re a mutual fund investor inclined to act on this information, you have no idea what your actual investment is doing. You could be flat, because your manager was a genius and went to cash yesterday. Or you could be down even more.

In an ETF version of the exact same strategy, you’ll have more information with which to make a decision, and better still, you’ll have the ability to act on it—perhaps taking advantage of a downmarket by investing more.

Voting Yes

These three key advantages—cost, tax efficiency and yes, transparency—are why I’m still a supporter of nontransparent active ETFs.

While I won’t be hunting for the next hot manager personally in any structure, putting these strategies into an ETF wrapper will likely yield better investor outcomes, in any case.

And hey, once they discover ETFs, maybe they’ll discover indexing.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.