Much has been made of disclosure issues relating to Actively-Managed ETFs. The disclosure related concerns were probably what made the SEC take 2-3 years before finally approving the first Active ETF in 2008, which was brought to market by Bear Stearns. The discussion of this issue usually revolves around Active ETFs being seemingly less transparent than their index counterparts and the possible front running that these ETFs open themselves up to by disclosing their holdings and hence the manager’s portfolio management strategy. Another important point is that disclosure might actually have the potential to harm the returns investors get in some funds.
Some of these arguments have a solid basis but others are based on inaccurate facts and it’s important to bring some clarity to this much debated issue.
Argument: Active ETFs are less transparent than Index ETFs
One of the points made compares Active ETFs to Index ETFs and claims that Actively-Managed ETFs are not as transparent as Index ETFs because portfolio managers are allowed to hold anything they want and can change their portfolio composition whenever they want. First off, I would say that comparing Active ETFs to Index ETFs is not an accurate comparison because the two products bring two completely distinct strategies to investors. If any comparison is necessary, Active ETFs should be compared with other products that provide access to active management (e.g. active mutual funds) and not passively-managed products.
To address the argument though, I bring to your attention to this piece by Matt Hougan of IndexUniverse. It is commonly believed that Index ETFs are the most transparent of instruments and that investors always know what the portfolio manager is holding at any point in time. This belief is not entirely accurate because as Matt points out, Index ETFs are actually not required to disclose their full portfolios on a daily basis. They are only required to publish their “creation baskets” which can at times differ significantly from the actual portfolio holdings, as highlighted by the examples in the article.
In contrast, Active ETFs are required to disclose their full portfolio holdings on a daily basis which imposes a higher standard of transparency on Active ETFs relative to Index ETFs.
Argument: Active ETF disclosure can result in front-running
The logic behind this argument is that if an active manager’s holdings are disclosed regularly, then short-term traders could use that disclosure to front-run the manager’s trades, bidding up prices for securities being bought and doing the opposite for sales, resulting in less than ideal purchase or sale prices for the manager. This issue was a big challenge for issuers who were pioneering Active ETFs, such as PowerShares. PowerShares overcame the hurdle by keeping its portfolio turnover very low and only rebalancing or changing the portfolio composition when necessary. Other funds since then have taken a much more fundamental approach with a higher turnover.
Active ETFs attempt to reduce the possibility of front-running by making disclosures with a 1-day lag. This means that changes an active manager makes in the portfolio today would only be disclosed the day after. This does help alleviate many of the concerns that are associated with front-running and potential losses to investors in the ETF.
Argument: Disclosure can harm return to Active ETF investors
This argument may seem similar to the one made above, but there is a subtle difference. Here, the issue is not really front-running – which is largely a short-term concern, but the issue focuses attention on the consequences of revealing a portfolio manager’s long-term strategy. For example, when a large manager like PIMCO runs an active strategy in an ETF, it is possible for observers to assess the portfolio manager’s moves and their long-term strategy. For instance, if the PM for an active fixed income ETF thinks the yield curve is going to flatten, and then goes on to position his/her portfolio accordingly over time, observers could themselves move into the sectors or durations that the portfolio manager is looking to target. Also, if the PM was trying to take advantage of a particular inefficiency in the market, more players making the same moves would lead to that inefficiency disappearing more quickly and the PM not profiting as much as a result. This is the reason why some active portfolio managers shy away from continuous disclosure.
This issue is a genuine concern. Looking at it from an investor preference perspective though, we might already be at a stage where the need for transparency shown by investors outweighs the discomfort that active managers have with disclosure.