Transparency matters. It promotes marketplace competition, supports better investor decision-making and exposes suspect market practices. As Supreme Court Justice Louis Brandeis famously observed, “Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”
Proponents of exchange-traded funds cite transparency as a key benefit of those funds. As the argument goes, they are more transparent than mutual funds because ETF holdings are typically available daily, whereas mutual fund holdings are normally disclosed monthly or quarterly.
This view overlooks two important facts: Mutual funds offer greater cost transparency than ETFs, and real-time holdings disclosure can harm shareholders by facilitating front-running of fund trades.
The cost of investing in a mutual fund or ETF has two main components: the cost to enter and exit positions, and the ongoing cost of ownership.
The annual cost of owning a mutual fund or ETF is its total expense ratio. That is calculated and disclosed in the same manner for both, so there's no advantage there either way.
But entry and exit costs are a different story. Because all mutual fund transactions take place at net asset value, plus or minus a disclosed sales charge when applicable, investors can always measure the cost to enter and exit their mutual fund positions.
Most ETF investors can only guess their trading costs. They can see what they pay in commissions, but that's only one element of ETF trading costs. The difference between trade execution prices and underlying portfolio values is often more significant.
ETF shares trade with no fixed or disclosed relationship to either end-of-day NAV or contemporaneous portfolio values. The intraday indicative values (IIVs) disseminated every 15 seconds throughout the trading day are, at best, crude indicators of current value.
Unlike NAVs, determined at the end of each day, IIVs are frequently based on stale price data, are not subject to uniform calculation standards and may be prone to error because no responsible party stands behind them.
Further, the widespread belief that market forces cause ETFs to always trade close to underlying portfolio values may be misguided.
A recent academic study by Antti Petajisto, “Inefficiencies in the Pricing of Exchange-Traded Funds,” concluded that “the difference between [an ETF's] share price and the value of the underlying portfolio is often economically significant, indicating that the unsophisticated investor may face an unexpected additional cost when trading ETFs.”
Leaving ETF investors in the dark about their true trading costs positions them to make poor investment decisions, including trading too much. Even worse, not knowing the value of what they trade sets up ETF investors to routinely get their pockets picked by more-informed market participants who trade against them.
On the issue of portfolio holdings disclosure, do most investors value the ability to examine their funds' holdings daily, versus monthly or quarterly?
A recent investor survey conducted by the consulting firm Naissance suggests not. In the Naissance survey, only 13% of investors said it's important for full holdings to be disclosed every day.
One audience is keenly interested in real-time disclosure of a fund's holdings: front-running traders. Armed with daily holdings and a history of fund trading patterns, a front-running trader can learn to anticipate a fund's future trading. By trading ahead of the fund, the front-runner can profit at the fund's expense, driving up fund trading costs and undercutting shareholder returns.
To avoid front-running risk, most active managers have not introduced their leading strategies as ETFs, thus depriving their investors of the performance and tax advantages an exchange-traded product structure can provide.
NEW FUND TYPE
In December 2014, the SEC granted Eaton Vance Corp. and related parties exemptive relief to permit the offering of a new type of actively managed ETP called exchange-traded managed funds.
Exchange-traded managed funds will be the first active ETPs to provide trading cost transparency, by using a new trading approach that directly links all trading prices to NAV, and protection from front-runners, by disclosing portfolio holdings monthly or quarterly like mutual funds.
Because exchange-traded managed funds will not disclose their holdings daily, they are sometimes described as “less transparent” than ETFs. This ignores the fact that they offer greater cost transparency than ETFs and avoid the potential downside of too much holdings disclosure. That's not less transparency, it's better transparency.
How can existing exchange-traded products improve their transparency? Here are three ideas:
• Establish standard protocols for the calculation and dissemination of IIVs. To the greatest extent possible, IIVs should be determined in the same way and be subject to the same standards as NAVs.
• Improve reporting of investor trading costs by including on sponsors' websites data comparing intraday trading prices to contemporaneous IIVs and end-of-day trading prices to NAV.
• Increase prospectus disclosures of front-running risks. The myth needs to be debunked that transparency in real-time portfolio holdings is unambiguously good for investors.
Over the past 20-plus years, ETPs have provided tremendous benefit to fund investors. Following these recommendations for better transparency will bring even greater investor benefit in the years ahead.
Tom Faust is chairman and chief executive officer of Eaton Vance Corp., developer of NextShares exchange-traded managed funds.