This is a guest article contributed by Shishir Nigam, editor of Active ETFs in Focus.
The daily transparency required of actively-managed ETFs in the US has been one of the main selling points of these new products, while at the same time being probably the biggest hurdle discouraging many active managers from embracing this relatively new structure. Since they were approved in 2008 by the SEC, actively-managed ETFs in the US have been required by regulation to disclose all their portfolio holdings publicly, with a 1-day lag. In other words, before markets open every day, every portfolio manager behind an Active ETF has to disclose what his/her holdings were at the end of the previous day.
Regulatory Justification
From a regulatory standpoint, this transparency requirement makes sense. Shares of exchange-traded funds are ultimately a claim on the underlying basket of securities held by the fund. This means that the price of the ETF shares should represent the value of the underlying holdings in the fund. The market makers help maintain that relationship by arbitraging between the ETF shares and the underlying securities if there is a significant deviation between the value of the two. From the SEC’s standpoint, for the market makers to do this job effectively, they need to know what those underlying holdings are, in the absence of other information, so that they can assess whether the value of the ETF shares is indeed in-line with the value of the underlying.
Since actively-managed ETFs represent an actively-managed fund where, unlike index funds, the portfolio manager could make daily holdings changes, this translates into a daily transparency requirements. Gary Gastineau, Principal at ETF Consultants, spoke to us in a recent interview with ActiveETFs | InFocus, saying that, “The SEC, for very understandable reasons, is reluctant to permit a non-transparent fund to trade at an intraday price. If there is no information on the composition of the portfolio out there – there will be no information on intraday values”.
Manager Concerns
The daily transparency results in concerns from active managers of their strategy bring front-run and also of the overall portfolio strategy being copied as a way to avoid the management fee.
Front-running is not a problem if the portfolio managers are able to finish all their desired trades within a day. If they can do that, then any changes to the portfolio will be completed by the time the “new” portfolio is disclosed before market open on the following day.
However, in situations where portfolio manager is unable to complete his/her trading program within a single day and changes take several days or weeks to implement, front-running becomes a possibility. This is because an observer would be able to see that a manager is building or reducing a position by comparing the disclosed portfolio from two separate days. If the manager still has to continue building or reducing the same position, then that trade could be front-run by the observer. Of course, to the outside observer, there is no guarantee that the manager has not already finished a particular change in holding. So there is some degree of risk involved for people trying to front-run the manager, but with enough traders “guessing” the changes, trading programs that run beyond a day have the potential to be affected.
Completing trades within a single trading day would be harder especially if funds become large, relative to the market they operate in or if they operate in small, less liquid markets like emerging market bonds or equities. Referring to the daily disclosure requirement affecting active managers, Patrick Daugherty, Partner at Foley & Lardner, in an interview with us said that, “There’s no doubt it discourages some of them because sophisticated and active traders whom I speak to, who have been known to do other things that require capital and human resources, have told me that this is the reason they have not gone into this field”.
Other concerns also revolve around the entire portfolio being copied by investors/traders who can just replicate the portfolio disclosed and avoid paying the management fee all together. This is a much broader concern compared to individual trades being front-run.
How Existing Managers Are Dealing With It