Business & Real Estate

So, what’s in your exchange-traded funds?

In 2020, the Securities and Exchange Commission gave its blessing to the creation of so-called nontransparent exchange-traded funds. These are ETFs that are not required to disclose the underlying holdings and weightings in their funds on a daily basis, which had been the rule up until then.

Is this a good idea? How will it benefit investors?

Some background first. The main difference between an ETF and an ordinary open-ended mutual fund is that ETF shares are traded on the open market (that is, among investors), while mutual fund shares must be bought or sold directly through the fund company.

In practice, mutual funds buy or sell shares of their underlying holdings at the end of each day based on the number of fund shares purchased or sold by fund investors on that day. This guarantees that the fund’s net asset value (NAV) is always equal to the NAV of its individual holdings.

ETFs, on the other hand, use a third party called an Authorized Participant to work with the fund company to regularly swap shares of the fund’s underlying holdings with shares of the fund itself.

The purpose is to keep the ETF’s NAV – which can vary not only based on its holdings, but also based on supply and demand – close to purely that of its holdings.

An additional difference between the two types of funds has been the reporting requirement for holdings. ETFs needed to disclose them on a daily basis, while mutual funds were allowed to do it quarterly. So, one effect of this change would be to standardize the way both funds report their holdings – at least for new ETFs requesting this capability. While that seems fair, it will lead to less clarity on what’s inside an ETF from an investor’s perspective.

One argument in favor of this change involves a problem known as “front running.” The vast majority of ETFs are passively managed, which means they try to keep their holdings consistent with some index.

Because all investors know in advance what comprises the index – as well as the date when the ETF will reconstitute its holdings to match changes that had occurred in the index since the fund’s previous reconstitution – they can buy or sell the securities the ETF is planning to buy or sell before the fund does. This has the effect of driving up the purchase prices and lowering the sale prices of the securities the fund trades. Depending on trading volume, this can reduce the returns for the ETF and its investors. Delaying reporting should logically make front-running more difficult. However, because this is a problem that even passively managed mutual funds face, I’m not convinced this reporting change will really have much of an effect.

Who benefits?

The biggest benefit to the industry is the enablement of more actively managed ETFs (“active” meaning fund management is attempting to outperform the market). For equity ETFs or mutual funds, the only ways to achieve this are by timing the market or by selectively picking stocks that are expected to perform better than the market at large. There has been extensive research on this topic and no evidence to suggest either is consistently possible. So, if the result of this change is a deluge of new actively managed stock ETFs, I would consider that deleterious for investors.

On the other hand, this change could be beneficial to fixed-income investments because the drivers of returns and of risks are more predictable for bonds compared to stocks. Numerous actively managed bond mutual funds have performed as well as or better than those based passively on indices.

Right now, actively managed bond mutual funds tend to be pretty expensive. If this change results in the creation of lower-cost, actively managed bond ETFs compared to their open-ended mutual fund cousins, that ought to be a positive development.

Only time will tell.

Los Altos resident Artie Green is a Certified Financial Planner and principal at Cognizant Wealth Advisors. For more information, email [email protected] or visit cognizantwealth.com.

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