The Securities and Exchange Commission appears to be on the cusp of deciding whether or not to allow investment management firms to offer nontransparent, actively managed exchange-traded funds.
Money managers argue that having to disclose their portfolio holdings each day keeps them from offering their best active strategies in ETF form, because other firms could find and copy those strategies.
That news that the SEC is ready to approve these ETFs stirs conflicting emotions: On one hand, we welcome the development of products that provide investors with more choices in constructing portfolios to meet their investing needs. Eventually, the market decides which succeed and which fail.
A CONFLICT
However, building less transparency into new products appears to be a step backward, seemingly in conflict with the SEC's reported interest in increased disclosure of mutual fund holdings, on which we commented last week.
On balance, we oppose nontransparent ETFs because the potential losses outweigh the potential gains.
First, let's discuss the possible advantages for investors of nontransparent active exchange-traded funds.
Being able to offer the funds without daily portfolio holding disclosures would let firms offer new, and hopefully more successful, active strategies to investors in ETF form. It might also bring into the ETF market successful active managers who do not currently offer mutual funds or ETFs, giving investors more selection.
In theory, that would provide inv-estors the tradability and tax efficiency of ETFs with a greater variety of active equity strategies. Also theoretically, because ETFs don't have to keep cash on hand to meet redemptions — as mutual funds do — and don't require transfer agents, these ETFs could offer the strategies at lower cost than the equivalent mutual funds or
separately managed accounts.
THE DOWNSIDE
What are the possible disadvantages for investors?
First, the obvious loss of transparency. Both the SEC and investors should favor more transparency, not less, especially in products that will be offered to individuals who for the most part aren't wealthy or sophisticated. Lack of transparency in hedge funds is one of the reasons the SEC instituted strict standards of sophistication for those seeking to invest in those vehicles.
Second, how likely is it that the managers of these ETFs will offer them at lower cost than normal active or indexed ETFs? Why should they offer them with reduced fees? They are promising higher returns — a superior product — because of their opaqueness. More likely, the nontransparent ETFs will be marketed as offering greater alpha and so will command higher fees.
In fact, it's possible that nontransparent ETFs' greatest benefit will accrue to money managers, who will gain a sexy-sounding investment product to market, and in the process boost active ETFs and get higher fees.
Third, individual investors are likely to be overwhelmed by additional choices. Research has shown that people tend to invest in one of each fund or vehicle when offered more choices — ending up with inefficient, high-cost, accidental index funds. That might not be a problem for investors guided by financial or investment advisers, but the overwhelming majority don't have such help.
POSITIVE ALPHA
The disadvantages seem to us to outweigh any possible gains to investors from nontransparent active ETFs, especially given the statistics showing how few active managers have positive alpha over more than a few years.
If the SEC does approve nontransparent active ETFs, investment advisers will have to step up to determine which of the new funds are worthwhile for their clients, and that will be a more difficult task than selecting from among the current menu of mutual funds and active ETFs.
