Gary Gastineau Interview: NAV-based trading essential for Active ETFs

In October 2010, ActiveETFs | InFocus spoke with Gary Gastineau, who is the principal of ETF Consultants which provides specialized ETF consulting services. Gary is a recognized expert on ETFs and also author of a book titled The Exchange-Traded Funds Manual. He has also authored other books and written papers on various topics concerning ETFs. Gary chats with us about problems resulting from transparency in Active ETFs, how NAV-based trading will significantly improve the effectiveness of Active ETFs and why he doesn’t see mutual fund conversions into Active ETFs until a better model for actively managed ETFs is developed.

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Shishir Nigam, ActiveETFs | InFocus: What are some of the challenges you see which are confronting actively-managed ETFs?

Gary Gastineau, ETF Consultants:  There are a number of problems; some of them can be resolved fairly easily and some of them are going to be difficult. The biggest problem is that the current actively managed ETFs do not trade in any quantity.  That can be a real problem and it is due to the fact that the degree of transparency in these portfolios is slightly less than the transparency of the index funds. The press has gotten the investing public and advisors overly sensitive to the importance of transparency. As a consequence, no one is particularly comfortable with these funds. Because they don’t trade very much and the liquidity is spread throughout the day, the spreads are very wide.

You had a very interesting piece that you put out today, showing the trading spreads on the actively-managed ETFs. I would say that I thought the spread that you used as your base case, which was a full percentage point from bid to offer was a spread that no ETF user will tolerate. You’re not going to find very many people who will sign on with a product that trades that way. I think the major problem is that there is liquidity at a reasonable level in these funds, but it’s not liquidity that can be spread out through the trading day, if you’re trying to trade at intraday prices. One of the things that’s going to solve this problem is the introduction of NAV-based trading.

Shishir: Do you believe that the daily transparency required by Active ETFs has deterred investors as well as ETF manufacturers from taking advantage of these products?

Gary:  I think any investor who understands how portfolios are managed and any manager of portfolios who understands what he’s doing, is going to be very reluctant to have only one day to trade in the portfolio before the change is disclosed. That model can work if you have a portfolio that consists entirely of large-cap stocks and if the size of the portfolio is somehow constrained; that is, if the fund cannot get very large. If you’re trading in large-cap stocks and you have a portfolio that’s much more than a billion dollars, there are going to be occasions when you’re not going to be able to complete the trades you want to make in a single day. Now, if you get into mid-cap and small-cap stocks, or if you get into other kinds of securities, particularly bonds which have their own special problems; if you’re dealing with this kind of situation you can have a lot of obstacles to getting the portfolio management job done because some of your trading is going to be done in a fishbowl where everyone can see. There will be all kinds of people trying to front-run you, and take advantage of the trading that you’re committed to doing. That’s the problem that benchmark index ETFs have today with the transparency they face, in terms of their index composition changes.

Shishir: You’ve written extensively about “NAV-based trading” as something that could help actively-managed ETFs. Could you briefly explain, in layman terms if possible, what “NAV-based trading” means?

Gary:  Ok, the basic idea is that trading will take place throughout the trading day, around a proxy price. The proxy price will represent the net asset value that will be calculated at 4pm today. That calculation will be the center-point of the trading. So people who are trading any time during the day will trade relative to this proxy. Let’s say the proxy is 100.00. If you have an execution that is at 100.01, that will be at net asset value (NAV) plus a penny. If the trade is executed at 99.99, it will be net asset value minus a penny. In other words, the 100 is not a dollar figure and not a percentage figure, it’s simply the mid-point around which you’re trading and each 1/100^th of a point is a penny, regardless of what the price of the ETF is. Once the NAV is calculated, there’ll be a calculation of what the transaction was in a particular case. Let’s say the NAV is $20, the execution price on a trade at 100.01 will be $20.01 and so forth. I can’t guess what the regulatory process will be but sometime, probably early next year, we’ll probably see net asset value based trading introduced in the U.S.

Shishir: What kind of instruments will we see NAV-based trading introduced for?

Gary:  I think it will be most of the more popular ETFs. It would include equity ETFs, hopefully both domestic and foreign. It will include sovereign debt and investment-grade corporate debt. And it will include exchange-traded notes and grantor trusts that are based on easily discernible commodity prices or commodity future prices or something of that nature. There will be a few things that will not be introduced right away, but eventually I would think that most ETFs will trade this way. I’m not suggesting that for something like the Spider (SPY), that this is going to replace intraday trading. But for something like the actively-managed ETFs that you are looking at today, it should concentrate their liquidity around a price and it would bring down the spreads very sharply.

Shishir: Aside from bringing in spreads, how else would NAV-based trading be beneficial to actively-managed ETFs?

Gary:  Well, for one thing, the reason we developed this is that the SEC, for very understandable reasons, is reluctant to permit a non-transparent fund to trade at an intraday price. If there is no information on the composition of the portfolio out there – there will be no information on intraday values. If you were to give out intraday values on a portfolio that has 100 stocks in it (that’s a little more than the average number of positions that the typical actively-managed fund has) every 15 seconds, in fairly short order a lot of people would figure out exactly what is going on in that portfolio almost hour by hour. That simply doesn’t work. There have been a number of proposals made to deal with the situation; but  the best approach is to step back and think about where ETFs came from and why they trade the way they do today.

ETFs were developed to provide something to trade on the floors of the Toronto and American Stock Exchanges. They were traded and they were popular and they were successful because they provided exposure to a securities basket product that tracked some of the popular market indexes. In each case, there were a lot of other products like futures contracts and options and today you would add swaps, that were also linked to the index. You have kind of an “arbitrage complex”. In a product like this, you can get very tight spreads and it’s no accident that, for example, the SPY which is the oldest and largest of these products, will trade at a spread of a penny and in many parts of the day you’ll have locked and crossed markets because volume is so high. Intraday trading was the natural way to trade these funds as long as they were index funds. The public liked it, the exchanges liked it and the volume took off. I don’t have to tell you about the volume for ETF shares. They have been an enormous product for the exchanges. While people were developing this great index trading product, they also happened to create – and I think the regulators get a certain amount of credit for this – a product that was a much better vehicle for fund investors, whether they’re actively-managed funds or index funds. ETFs provided a much higher degree of shareholder protection from the cost of flow from investors going in and out of the fund. The person who buys a share in an ETF pays the cost of his entry and eventually his exit from the fund. Now, the creation-redemption process with the authorized participant and the in-kind creation/redemption – that cost is borne initially by the authorized participant. But the authorized participant counts on recovering his costs in the secondary market when the shares are bought and sold by investors who are going to hold them for a period of time. That cost is not huge, it’s not even very large in most of these ETFs, although in some of the ones you were looking at in your publication today, it was pretty high. In most of the larger actively-traded funds, the trading cost is really very modest. But if you can protect investors from the cost of everybody else’s trading, what you have is a situation where the product that was designed to be traded is a much better product to hold. A trader, if you let him, would much rather trade an open-end mutual fund because the open-end mutual fund provides him with free liquidity at the 4pm net asset value. Focus back in 1992 and ‘93, when these were introduced in Toronto and on the AMEX and the emphasis was on getting something to trade on the floor. Today’s focus is on getting the best investment product. Sure you can trade it throughout the day, but why focus on intraday values. Why not focus on the net asset value which is a way of concentrating the liquidity throughout the day on a single value.

There are a lot of ways of dealing with the fact that you have to buy and sell whole shares on the market today. There will be an infrastructure developed that will permit people to buy and sell shares of ETFs very much like they trade mutual fund shares. An advisor won’t have to worry about whether he’s a good trader or not, he’ll be able to go to a service provider and he’ll be able to get an execution in dollars or in whole and fractional shares of ETFs. The ETFs on the exchanges will still trade in whole shares, they’ll clear and settle through DTCC in full shares, but you’ll be able to buy and sell fractional shares and you’ll be able to buy and sell dollar amounts.

Shishir: You also wrote a paper on converting actively-managed mutual funds into ETFs. We have already seen a couple of firms announce plans for such conversions into Active ETFs. Do you think this could become a primary avenue through which mutual fund firms enter the Active ETF space?

Gary:   I think I wrote a couple of papers on that. Over the past few years I have changed my mind several times, so I’m not even sure which paper you’re looking at. The way I see it now is that I’m not sure that I would be particularly interested in a mutual fund that was in existence today that decided to convert from a mutual fund structure into an actively-managed ETF given the “1-day to trade” rule that’s in effect at this point. Down the road, you’re going to have a much different structure. There’s a limit to how much I can talk about that, but I’ll give you a general idea. Ultimately, you’ll be able to trade actively-managed ETFs every day, at or relative to a net asset value. In most funds, you’ll probably have adequate liquidity. I can’t predict that with any assurance, but you will be able to trade these and people will be comfortable with the fact that you do not necessarily have any more revelation of the portfolio composition than you have required of all mutual funds today. Today, the requirement is that a fund reveal the contents of its portfolio quarterly with a 60-day lag. Most funds reveal it more frequently. Some funds do it monthly with a 60-day lag, some do it monthly with a 30-day lag. It varies over the industry. The key is that you have to protect your shareholders from traders front-running your transactions. You can’t reveal anything about your portfolio that will enable traders to determine what your ongoing transaction program is. There are ways of dealing with that. You will need to provide some information to market makers so that they can create and redeem in much the same way that they do today. They will have a little bit of additional information but this information will be available to the entire market. This is not something that will be available just to market makers.

Shishir: Given the potential introduction of NAV-based trading, what kind of a timeframe do you see in which Active ETFs could gain more traction and really take off?

Gary:  We’ve had conversations with the SEC in the context of actively-managed ETFs. I think they made it pretty clear to us that in order for them to approve what I call a full function actively-managed ETF they need to see a demonstration of NAV-based trading. I think it will take a little while for that to happen. It’s not going to happen overnight because this trading mechanism is sufficiently different from what people are used to. It’s going to take a little time to get it established. It’s certainly not necessary for trading in the SPDR, but I suspect that the SPDR will be the most actively traded ETF in the NAV-based market simply because it is already the most actively traded ETF, period. I certainly don’t think that NAV-based trading will rival the SPY volume in the intraday market, but I think we’ll have respectable NAV trading volume in the existing ETFs and it will be essential for a lot of the less actively traded ETFs and any useable, actively-managed ETF.

Shishir: That’s fantastic, Gary. Thanks a lot for speaking with us today.

Gary: Ok, it has been a pleasure.