Non-Transparent Active ETFs Finally Win SEC Approval
Precidian Investments filed an application with the SEC back in 2014 for a type of active ETF that does not require transparency. The SEC likes transparency. They finally gave in.
To say that the Securities and Exchange Commission, or SEC, prefers transparency in dealings between fund companies and investors would be an understatement. From the perspective of investors, the levels of disclosure that are required generally for regulatory purposes extends way beyond what would be practically necessary, as anyone who has read a full prospectus can easily attest to.
We do need to be kept informed, and well-informed at that, even though few individual investors read such things and even care about such things very much, beyond the broad protections that we need against fraud and misrepresentation and a general idea of what the fund will be doing.
No one wants to be cheated, and we need to be reasonably protected against this, although you can’t protect against all of it. The second major function of full disclosure is to properly inform people of the strategic and tactical elements of a fund, so that we do have a good idea of what we are buying and what we continue to hold as things change.
The world of exchange-traded funds, or ETFs, have been dominated by index funds, who are operated upon the principle of simply looking to reproduce the results of an index. This is similar to how index mutual funds operate, and both lend themselves to full disclosure and transparency, since there is nothing that the fund operators want or need to keep out of public view.
Actively managed mutual funds do make changes to their portfolios, and when they do, they need to tell the world all about it. This involves additional regulatory costs as well as disclosing to their competition exactly what they are doing and when they are doing it.
This does place a burden upon these actively managed funds, and ends up furthering the advantages of passively-managed funds, who do not engage in such things and do not bear the cost or potentially sacrifice proprietary knowledge. We therefore create an inefficiency here with regulation, and although regulation always does, we need to make sure that we only use what is justifiable and necessary so that we don’t create more inefficiency than we need.
Thus far, the SEC has been very much biased toward transparency, and not really concerned about how much inefficiency it creates in doing it, as they have viewed transparency as an end in itself it seemed. There are some situations where they have been seen to relax this a bit, like the lesser amount of time it takes to get approval for a new ETF, due to their realizing that a long and arduous process that we’ve been accustomed to with everything limits the introduction of new funds.
We Need to Only Regulate What it Makes Sense To
This has resulted in a more streamlined regulatory process, but one that still holds transparency at the forefront. The idea that we would allow a fund like ActiveShares, asking us to set some off this transparency aside, was predictably met with a lot of resistance at the SEC, which is why it took so long to get approved.
When funds have to make a filing every time that they make a change in their holdings, this will naturally limit the number of changes they make. If they want to make a change and end up not doing so because of the trouble and cost involved, that clearly creates real inefficiency. Unitholders would have benefited from it presumably, but these benefits end up being withheld due to what may be over-diligence by our government.
There’s also the matter of a fund not necessarily wanting its competitors to be fully aware of what they are doing, and we do allow proprietary knowledge to be held by companies in general. If Coca-Cola were a fund, they would have to tell us exactly what is in their formula and exactly how they make it, which isn’t something we really need to know to make an informed decision to buy some, but their competitors sure would like to know this so that they can copy them.
The information disclosed by funds revealing all of their moves in the market isn’t quite as proprietary as the formula for Coke, but this is still seen as important enough to matter, and matter enough that Precidian Investments continued their fight to get approval for such a scheme.
Investors in a fund are concerned about performance, especially the potential that an active fund has to outperform index funds, something they haven’t done a very good job of overall thus far. Some funds do beat them, but most do not. If we are placing restrictions on them that impede their ability to do this, and these impediments can be found to be not necessary enough to justify them, then easing up on disclosure can be a clear win for both funds and investors.
If the Minutia Doesn’t Matter, It Does Not Need to be Disclosed
Few investors care about what exactly goes into this recipe, although they do want to know what the strategies are and other broad information about the fund. No one is taking that away, but like our bottle of Coke, we don’t necessarily need to know how these ingredients are mixed up to get it to taste the way it does. How it tastes is what really matters, along with assurances that what it has disclosed to us is true, and nothing that is material to our decision to buy it or drink it has been left out.
Not having to disclose its day to day activities can be a real plus to actively managed ETFs, as it allows them to be more agile and be better engaged in making decisions that will further both their objectives and ours as investors.
We are paying these people essentially to move things around to benefit us, and short of any practice that could even potentially be deceptive or important enough to have us change our own decisions if we were privy to the withheld information, these highly paid fund managers should be free to execute their decisions more efficiently.
This really is a watershed moment for both active funds and the SEC, and while it may only be a small thing, it is one that is expected to provide a boost to the active ETF industry, which has thus far barely gotten off the ground. Index ETFs remain by far the ETF of choice among investors, and index ETFs are a valuable tool in itself for those who wish to play the market so to speak, especially those who wish to play both the long and short side of the market.
Actively managed funds still have their place, and should be able to provide superior results to index funds in theory, although this theory often does not translate to practice. Given that ETFs involve more investor participation and engagement than mutual funds do, and one can exit a position immediately if needed, this has influenced the SEC to do something that would have simply been unthinkable until now.
Times are changing though, and sometimes for the better, and this decision is indeed for the better. We are still mired in what many consider to be an environment of over-regulation, and if we have the opportunity to eliminate excesses such as what was done with this decision, if we are even willing to make an honest appraisal of regulation based upon sensibilities, then that is indeed a change for the better.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
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