Time For SEC To Liberate Active ETFs

Matt Hougan is CEO of Inside ETFs.

Sensible proposals for nontransparent active ETFs have languished at the Securities and Exchange Commission for years; it’s time to let them free.

I spent much of last week in New York City visiting with ETF issuers. Amid a number of great meetings and a lot of excitement around things like electronic RFQ trading, socially responsible investing and more, one meeting stood out to me: Davis Advisors.

Earlier this year, Davis took the brave step of launching three fully transparent actively managed equity ETFs: the Davis Select U.S. Equity ETF (DUSA), the Davis Select Worldwide ETF (DWLD) and the Davis Select Financial ETF (DFNL).

There are plenty of transparent actively managed ETFs out there, but the Davis funds are brave because they use the same underlying strategy (and presumably create similar portfolios to) Davis’ existing active mutual funds, including its $12 billion flagship, the Davis New York Venture Fund.

That fund launched in 1969 and has posted a compound annual return of 11.66%. As noted on its website, “a hypothetical $10,000 investment in the Fund on February 17, 1969, compounded to $1,966,380 as of December 31, 2016…” That has far outpaced the S&P 500 during a time when it has been hard to outpace the S&P 500. Impressive.

Not Bothered By Daily Disclosure

To launch the fund, Davis (like other active ETF pioneers before it) agreed to the SEC’s requirement that active ETFs fully disclose their entire portfolios at the end of each trading day. That stands in contrast to mutual funds, which must only disclose their holdings quarterly with a 60-day lag.

In other words, right now, the most recent portfolio disclosure for a mutual fund would be from Halloween. Given that the average mutual fund turns over its portfolio 85% a year, by the time disclosure is required, it’s likely that one-third of the portfolio is no longer held by the fund.

Davis says it’s not bothered by transparency, as it invests in large, liquid securities and holds them for the long term. Investors wanted access to its strategies in the ETF format, so it launched ETFs to meet that demand.

I seriously applaud Davis’ efforts. They’re not only brave, they’re doing the right thing for investors, and particularly for retail investors, for whom every dollar counts. Mutual funds give big price breaks for large accounts because they’re much cheaper to administer than small accounts.

Davis’ flagship fund, for instance, charges investors 0.89% for A shares, which are available to all investors with a minimum investment of $1,000; that number declines to just 0.63% for Y shares, which are available for accounts greater than $5 million.

Its new comparable ETF charges 0.60%.

Offering Remarkable Track Record To The Masses

By sticking its neck out, Davis is making its remarkable track record of success so much easier for mom-and-pop investors—or smaller RIAs—to access at a low price.

The firm isn’t doing this just because it’s nice; it’s already a low-cost shop, and I’m sure that profit margin on the ETF is similar to that on its other share classes. It’s pricing its ETF this way because ETFs are a more efficient vehicle for delivering exposure to the masses.

That’s where the SEC comes in. While Davis was willing to stick its neck out—and while I think concerns about transparency are silly—there are thousands of mutual fund firms that won’t launch ETFs because they’re unwilling to let investors look behind the curtain. We could wait for Davis to prove that the transparency shibboleth is silly (and I think it is!), or the SEC could set these nontransparent ETFs free today.

It’s not like the ETF industry is struggling to figure out how to deliver nontransparent ETFs. Various proposals exist, most of which hinge on the idea of publishing a true real-time estimate of the value of the ETF throughout the day and using what amounts to a blind trust to allow authorized participants (APs) to do their job. (This Financial Times article does a great job of describing one of the most advanced of these proposals, from Precidian.)

SEC Frets More Over Minor Risk Than Greater Good

Regulators worry that a lack of transparency will make it hard for APs to keep the price of an ETF trading in line with its net asset value. Most APs and experts disagree; regardless, by hyperfocusing on this concern, the SEC is trading a small, theoretical, opt-in risk for a large, unavoidable, universal cost.

Like many instances of regulatory status, the SEC seems focused on protecting investors from the negative impact of new ideas, while ignoring the very real costs of the status quo, particularly for retail smaller investors.

That’s a bad trade.

Even if the SEC’s worst nightmare occurs, and ETFs swing 1-2% around their NAV on an intraday basis, what’s so bad about that?

An investor looking at such an ETF will: 

1. Know that the ETF is trading at a premium or discount, because a real-time valuation will be available.
2. Decide if that cost and future premium variability is worth the cost savings of the more efficient ETF structure.

(The ETF will also be more tax efficient, more tax-fair and will externalize trading costs so that those entering and exiting the fund bear the costs of trading [instead of those holding the fund.])

Armed with this information, an investor can either buy the ETF or not.

There are various ways for the SEC to tiptoe into these nontransparent waters. For instance, it could restrict launches to U.S.-listed securities, which would ensure that real-time NAV estimates are accurate and that the underlying portfolios are liquid.

But by sitting on these proposals, it’s costing investors millions.

At the time of writing, the author held no positions in the securities mentioned. Matt Hougan is CEO of Inside ETFs and can be reached at [email protected].