Active ETFs: Last Thing You Want is Full Transparency – Gary Gastineau

In December 2010, ActiveETFs | InFocus had a conversation with Gary Gastineau, Co-Founder of Managed ETFs LLC and Principal at ETF Consultants. Managed ETFs LLC’s assets were acquired by Eaton Vance, including patents for NAV-based trading owned by the company. Eaton Vance has indicated that it intends to utilize the patents to bring forward non-transparent actively-managed ETFs to market. Gary chats with us about Eaton Vance’s plans, how NAV-based will benefit investors and why investors should have transparency in their trading costs, but not in the portfolios.

Shishir Nigam – ActiveETFs | InFocus: Will Eaton Vance’s backing help a lot to push forward your proposition for non-transparent active ETFs with the SEC?

Gary Gastineau – ETF Consultants: Eaton Vance is a large, highly respected money manager and it’s a lot easier for them to bring the necessary resources to the effort than it is for a couple of individuals. So I don’t think there’s any question about that.

Shishir: How could Eaton Vance’s ETFs utilize the NAV-based trading mechanism in the future?

Gary: First, if approved, the NAV-based trading mechanism is going to be available, in one way or another, for most ETFs. In other words, if an issuer wants their ETF shares traded using the NAV-based trading method, that will be possible. There’s nothing that is exclusionary here. Eaton Vance’s ETFs and Joe’s-pizzeria ETFs can trade using the same mechanism. The plan for “commercialization”, as suggested in the Eaton Vance press release, is open licensing.

Shishir: Does Eaton Vance plan to file for non-transparent active ETFs that will utilize NAV-based trading?

Gary: Eaton Vance has already filed for the limited function transparent actively-managed ETFs that now trade.  If they are approved for use by the SEC, Eaton Vance believes that non-transparent ETFs would be an attractive vehicle for some of its investment strategies.

Shishir: What are the major hurdles in the way before the SEC can approve non-transparent active ETFs?

Gary: The mere fact that it requires an approval is, in itself, a hurdle.  Whether it’s a major hurdle or not, only time will tell. My feeling is that the availability of NAV-based trading will help alleviate at least a few of the problems we’ve seen in ETF trading in recent months.  I would not argue that NAV-based trading will solve all possible ETF trading problems; but I think NAV-based trading is beneficial to ETF issuers,  and most importantly, to investors in ETFs because it will almost certainly reduce their transaction costs.

Shishir: What is the path towards commercialization from here and when do you see non-transparent active ETFs coming to market?

Gary: I wouldn’t even want to make a guess at timing. I have my own thoughts, various other people that I’ve talked to have expressed their thoughts and the range is a broad range.  I think that this is an extremely beneficial market and product development.  If you think back to the original launch of ETFs, the first product out of the box was the 500 SPDR in the U. S. and there was a similar index ETF issued in Canada a few years earlier. The products were traded intra-day because they were developed to provide something to trade on the exchanges during trading hours. They were introduced and developed by the exchanges as something to trade. However, the original ETF intraday trading mechanism does not work particularly well for many of today’s ETFs.

Now, we’re talking about products developed by money managers which are being designed to provide better results, better performance for investors. The issue of trading is an issue of how do you find the most efficient trading mechanism.  The trading mechanism that works for an S&P 500 index fund doesn’t necessarily work as well for, let’s say, a small-cap equity fund or a fixed-income fund.  If you can go to NAV-based trading, then you can get a tighter spread by focusing liquidity at a particular price and the liquidity that becomes available all through the day is focused on that price. You should be able to get tighter spreads and, hence, more efficient trading.  In reality, there may well be more total profitability for market makers in trading some of these non-benchmark ETFs simply because the trading volume will be higher. If you take a look at the way the stock market has worked, a little over 40 years ago a very big day on the NYSE, which was most of the U. S. stock market at that point, was 4 million shares. Today, 4 billion shares would be a very poor day on the listed equity markets.  Just because the trading spreads are narrower doesn’t mean that there is going to be less total profit in trading if volume increases. There’s certainly is going to be a lower cost of trading many ETFs for individual investors than they are facing today.

Shishir: So most of the benefits we are talking about here are accruing to the end investor.

Gary: Yes. If these developments were not highly attractive to the average investor, they wouldn’t have a prayer.  This trading mechanism and fund structure are very attractive to the average investor, I believe they will reduce the average investor’s trading costs and they will increase his returns.

Shishir: One of the appeals of the fully transparent actively-managed ETFs was that they are a lot more transparent than mutual funds. So investors have a lot more transparency and clarity as to what the manager is holding. Now, with the new mechanism, most Active ETFs would revert back to the non-transparent form. In a way then, you’d be reducing transparency for the end investor, so how do you see that playing out?

Gary: I certainly agree that transparency in costs is very important and every investor has the right to know what costs are associated with holding his fund shares and trading the fund shares. In the current market, I would submit that most investors in ETFs have no idea of what their transaction costs are. They know what their commission is, but that’s a trivial part of the total transaction cost in most cases and an increasing number of firms are providing commission-free transactions in ETFs (which may or may not be a bargain, but that’s another issue). You don’t know what your ETF trading cost is today, in terms of the bid-asked spread and the market impact of your transaction.  That is a flaw in the current market structure. With NAV-based trading, you will be able to measure very precisely what your transaction cost is relative to each day’s net asset value because that will the basis on which you place your order. If you place a buy order and it’s executed at, say, a penny over NAV, you’ll know that your transaction cost is a penny a share plus any commission.

Now, in terms of transparency in index funds, the greatest cost to an index fund investor is associated with the transparency of index composition change transactions. In Chapter 5 of my book, and in an article that I wrote for The Journal of Portfolio Management in the Fall 2008 issue, I discussed this in great detail. You lose from index transparency because everybody and his brother know what the index fund has to do to change its portfolio composition.  They know what the fund will be buying and selling before the fund trades.  You, as a holder of shares in that fund, are paying the cost of that transparency. So that kind of transparency makes no sense to me. I think it’s important to have transparency in costs, but the last thing you want is full transparency in your portfolio transactions.

Today, every investment company in the U.S. is required to report its portfolio holdings quarterly with a 60-day lag. Many funds report their portfolios monthly with a 30-day lag. It usually doesn’t matter too much which your portfolio manager chooses.  If you hold shares in a small-cap fund where it sometimes takes a long time to make a transaction without too much market impact, you want less transparency (less frequent portfolio disclosure) than would be necessary in a large-cap fund. In a large-cap fund, you can probably reveal your portfolio every 30 days with a 30-day lag with no difficulty. If you’re in small-caps, you and your investor are going to want less transparency. The important point is that the SEC has a rule requiring fund portfolio disclosure at least quarterly with a 60-day lag.  If that makes sense for a mutual fund, it makes sense for an actively managed ETF.  An ETF should use the same disclosure rules as a conventional mutual fund. The ETF is a structure; it’s a fund delivery vehicle. The NAV-based trading mechanism will be an important part of that delivery mechanism. NAV-based ETF trading is a substitute for the way conventional mutual fund shares trade as well as a substitute for conventional intraday ETF trading.

Many of us have argued since the early years of ETFs that the primary virtue of ETFs for investors is that the parties trading the ETF shares pay the cost of their trading. In a conventional mutual fund, all of the shareholders of the fund pay for the cost of investor entry and exit. In my book and in a lot of the other things I’ve written, you’ll see diagrams of this, showing that all the shareholders of a fund pay for the cost of entry and exit in a mutual fund and the traders alone pay the cost of entry and exit in an ETF, but they pay only when they trade.  With the same underlying investment process, an ETF will usually show a better long term return than a mutual fund because the transaction costs of investors getting in and out of the fund is borne by the fund share traders.  If you are long-term investor and you have an ETF share, you’re usually going to earn more and have a higher return than an investor who holds shares in a mutual fund using the same investment process.  If you can deliver that, and I believe you can, the world should be your oyster.

Shishir: With regards to Eaton Vance’s 5 planned active bond ETFs that they have filed for previously, will they still remain fully transparent?

Gary: I can’t speak for Eaton Vance, but that is a question that no one will have to answer for a while.  I personally believe that it will become very difficult to manage most large ETFs that announce portfolio changes every day.