The case for non-transparent ETFs

headlights_edited-1Clear, simple and cheap. Those are three main elements exchange-traded funds (ETFs) have been sold on for years, right? Well, now there’s a push within the industry to roll back on at least one of those factors. Some of the biggest asset managers in the U.S. are looking to make ETFs a little less clear by asking the U.S. Securities and Exchange Commission to relax the disclosure requirements for actively managed ETFs. And while any push to reduce transparency should probably be looked at with a good deal of suspicion, this one actually makes a lot of sense.

The goal is to put actively managed ETFs on a more level playing field with mutual funds. The problem is that, now, ETFs are required to disclose their holdings daily—for an active manager, it lay all his or her secrets bare for the world to see. And this is one of the biggest barriers to growth in the active ETF space, which has been looking to replace traditional mutual funds in the eyes of investors.

If asset managers such as BlackRock, State Street and Eaton Vance have their way, this could change—and relatively soon according to this article by Reuters. By putting reporting requirements of active ETFs on par with mutual funds, an entirely new chapter could open up for the industry.

Lighter transparency requirements would allow more ETFs to use sophisticated investment strategies—and bring them to a broader set of investors. It would also reduce the risk of front-running due to that daily transparency requirement, as other investors in the marketplace try to replicate a particularly interesting or successful investment strategy.

According to one source quoted by Reuters, “You don’t want everyone and his brother knowing what changes you made in your portfolio so they can front-run you,” said Gary Gastineau, who developed several patents for proposed ways to enable non-transparent ETFs.

So what would the new requirements look like in the ETF space? One proposal would see market makers base buy and sell decisions on the fund’s set asset value at the end of the day, even though individual investors would still be able to trade the ETF throughout the day on the open market. Since a fund’s NAV is based on the closing prices of its holdings, it can help those market makers understand the value of the portfolio without having to know what exactly is being used in it.

Another model proposed would see blind trusts created through which market makers or authorized participants can execute orders, without a manager disclosing fund holdings on a daily basis.

Interesting ideas—and they might even help ETFs make some headway further into the retail space (where low-cost options are desperately needed, especially here in Canada).

At the same time, in today’s transparency-obsessed regulatory environment (think the Volker Rule and the pending Client Relationship Model), loosening up transparency even in this area could be something regulators balk at.

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