Review & Outlook

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Nontransparent Actively Managed ETFs: Another Wall Street Solution in Search of a Problem?

7 November, 2014 by Matthew O'Brien, Ph.D. in Commentary

The Wall Street Journal reports that the SEC has approved a proposal from fund company Eaton Vance to offer actively managed exchange-traded funds (ETFs) that don’t automatically track an index and don’t disclose their holdings day-to-day.  Apart from a few actively managed bond ETFs, fund companies have avoided offering actively managed strategies through ETFs because their disclosure requirements would allow other market participants to front-run the trades of active ETF managers.  This problem doesn’t arise for mutual funds, because they are only required to disclose their holdings quarterly.

It should be noted that the problem of front-running ETFs isn’t really unique to an actively managed strategy.  Last year Bloomberg reported that some managers were worried about big banks taking advantage of the predictable rebalancing needs of passively managed ETFs (like SPY, the oldest and biggest ETF that tracks the S&P 500 Index) by offering unfavorable currency exchanges (“Traders Said to Rig Currency Rates to Profit Off Clients,” Bloomberg, June 12, 2013).

In any case, the Journal’s “Total Return” blog summarizes the import of the SEC’s new ruling with a rather laconic understatement:

The SEC ruling may initially be more exciting for asset-management companies than for individual investors.

Maybe I’m missing something, but why would any investor want to own an actively managed ETF?  I know why Wall Street would want to sell them; novel investment products generate new revenue.  (An acquaintance who used to work at a big Wall Street bank told me how bemused he was by the constant calls he got from brokers — er, excuse me, “wealth managers” and “financial advisors” — who wanted to know “what have you got that’s new”.)  Here’s a dated but still accurate chart from the Journal that shows why fund companies are eager to find new kinds of ETFs to replace lost mutual fund revenue.

etf vs mutual

Its true that generally ETFs are more tax-efficient than mutual funds and that many mutual funds are too expensive.  But there are plenty of reasonably priced, quality mutual funds out there.  The instant liquidity promised by ETFs, as opposed to the daily liquidity offered by mutual funds, might be an argument against owning an ETF in some cases.  The ease of trading an ETF can lead to excessive price volatility.

The larger point, I think, is to be skeptical about new products from Wall Street.  We buy ETFs for our clients at O’Brien Greene, but only in limited and targeted cases where their benefits are clear and demonstrable.  Generally speaking, for investors who have sufficient assets to diversify across the market, they are better off owning individual securities directly, through their own separate account held in their name.