The daily transparency required of actively-managed ETFs in the US has been one of the main selling points of these new products, while at the same time being probably the biggest hurdle discouraging many active managers from embracing this relatively new structure. Since they were approved in 2008 by the SEC, actively-managed ETFs in the US have been required by regulation to disclose all their portfolio holdings publicly, with a 1-day lag. In other words, before markets open every day, every portfolio manager behind an Active ETF has to disclose what his/her holdings were at the end of the previous day.
From a regulatory standpoint, this transparency requirement makes sense. Shares of exchange-traded funds are ultimately a claim on the underlying basket of securities held by the fund. This means that the price of the ETF shares should represent the value of the underlying holdings in the fund. The market makers help maintain that relationship by arbitraging between the ETF shares and the underlying securities if there is a significant deviation between the value of the two. From the SEC’s standpoint, for the market makers to do this job effectively, they need to know what those underlying holdings are, in the absence of other information, so that they can assess whether the value of the ETF shares is indeed in-line with the value of the underlying.
Since actively-managed ETFs represent an actively-managed fund where, unlike index funds, the portfolio manager could make daily holdings changes, this translates into a daily transparency requirements. Gary Gastineau, Principal at ETF Consultants, spoke to us in an interview saying 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”.
The daily transparency results in concerns from active managers of their strategy bring front-run and also of the overall portfolio strategy being copied as a way to avoid the management fee.
Front-running is not a problem if the portfolio managers are able to finish all their desired trades within a day. If they can do that, then any changes to the portfolio will be completed by the time the “new” portfolio is disclosed before market open on the following day.
However, in situations where a portfolio manager is unable to complete his/her trading program within a single day and changes take several days or weeks to implement, front-running becomes a possibility. This is because an observer would be able to see that a manager is building or reducing a position by comparing the disclosed portfolio from two separate days. If the manager still has to continue building or reducing the same position, then that trade could be front-run by the observer. Of course, to the outside observer, there is no guarantee that the manager has not already finished a particular change in holding. So there is some degree of risk involved for people trying to front-run the manager, but with enough traders “guessing” the changes, trading programs that run beyond a day have the potential to be affected.
Completing trades within a single trading day would be harder especially if funds become large, relative to the market they operate in or if they operate in small, less liquid markets like emerging market bonds or equities. Referring to the daily disclosure requirement affecting active managers, Patrick Daugherty, Partner at Foley & Lardner, in a past interview with us said that, “There’s no doubt it discourages some of them because sophisticated and active traders whom I speak to, who have been known to do other things that require capital and human resources, have told me that this is the reason they have not gone into this field”.
Other concerns also revolve around the entire portfolio being copied by investors/traders who can just replicate the portfolio disclosed and avoid paying the management fee all together. This is a much broader concern compared to individual trades being front-run.
How Existing Managers Are Dealing With It
How are some of these funds dealing with the issue?
Utilizing A Fund-of-Funds Approach
One of the ways that managers behind Active ETFs have dealt with this is by utilizing a fund-of-funds approach and investing exclusively through ETFs, instead of individual securities. It is much harder for a trader to benefit from front-running trades in ETFs than in individual securities. This is because the value of the underlying ETF shares, unlike individual stocks and bonds, is not dependent of the supply and demand of the ETF shares, but instead on the underlying securities of that ETF. As such, the price of that underlying ETF will not be affected significantly if someone traded a large block of shares in the ETF just before the portfolio manager. Also, the managers generally utilize high volume ETFs which makes any one market player insignificant relative to the total activity in that ETF.
Utilizing Market-on-Close (MOC) Trading
Another method used by managers to reduce the market impact of completing trades in a day is to utilize the higher liquidity available at market-on-close, instead of trading intraday. This means that the portfolio manager receives whatever the closing price is for their orders and also benefits from the liquidity which is usually much higher at MOC.
ETF Convenience Justifies Expense
When it comes to investors copying the entire portfolio to avoid the management fee, there are those managers who believe that is just not cost effective for investors to replicate the portfolio and “follow along”. Paul Hrabal, President CIO of U.S. One mentioned this in an interview saying that “If you think about it, if you have 5 ETFs and you’re going to rebalance it and you’re going to put in new money maybe 4 times a year, to make those incremental trades for 5 different ETFs, depending on where your brokerage account is, could end up being much more costly than paying us the 35 basis points. Consider a $10,000 investor, they’re going to pay us $35 a year extra to do it for them versus doing it themselves. In most people’s view, that’s not going to be enough of a cost that they’re going to want to do it themselves”.
In fact, Hrabal encourages investors who’d rather implement the portfolio strategy themselves to look at their holdings and read their methodology. His reasoning is that he believes the majority of investors would rather opt for the convenience of holding the entire portfolio through a single fund rather than monitoring disclosures for changes regularly.