The ETF Transparency Issue: Part 2

In my previous post, we discussed the idea of an active ETF which has less than daily disclosure of its fund holdings. That post dealt with much of the background behind the concept.  Here we will attempt to deal with the rationale for the concept.

So, why is disclosure of fund holdings for an active ETF an issue?  Turns out, this is a 2-fold question. On the one hand, as the 2001 SEC Concept Release on active ETFs (http://sec.gov/rules/concept/ic-25258.htm) points out:

“Would frequent disclosure of portfolio holdings lead to "front running" of the ETF portfolio, where other investors would trade ahead of the ETF and the Creation Unit purchasers who must assemble Portfolio Deposits? Would frequent disclosure of portfolio holdings lead to "free riding," where other investors would mirror the investment strategies of an actively managed ETF while the ETF investors pay the advisory fees?”

These are major concerns for many potential issuers of active ETFs.  So much so that many firms would choose to not issue an ETF utilizing one of their active strategies if it meant daily disclosure of holdings and exposing the fund to these risks.

On the other hand, and again from the 2001 SEC Concept Release:

“What level of transparency in portfolio holdings is necessary to allow for effective arbitrage activity in the shares of an actively managed ETF? Should an actively managed ETF be required to disclose the full contents of its portfolio? Is it sufficient for an actively managed ETF to disclose only a sample of its portfolio or the general characteristics of its portfolio? Can effective arbitrage occur without any disclosure of the specific securities in an ETF's portfolio (i.e., arbitrage that is based strictly on the NAV and market price of ETF shares)?”

So there you have the dilemma.  Daily disclosure of fund holdings may subject the active fund and its shareholders to the risks of “front-running” and “free-riding”. The obvious way to deal with those risks is to use something less than daily disclosure of fund holdings. But is it possible that something less than daily disclosure could provide insufficient information to allow the ETF arbitrage mechanism to operate efficiently enough for effective trading? 

Clearly, if an issuer contemplating an active ETF is not concerned about the “front-running” or “free-riding” risks for some or all of their strategies, then daily disclosure of holdings would be a suitable choice for providing information to market participants for those particular strategies. In fact, there are currently a number of active ETFs which provide daily disclosure. 

However, as we’ve pointed out above, many potential issuers consider the risks to the fund and its shareholders too great for daily disclosure to be a viable option. For those entities (and there are a lot of them) they are left with 2 questions:

  1. What is the right type and amount of information regarding the active fund that can be disclosed to the market to allow for the efficient operation of the ETF arbitrage mechanism and thereby promote effective trading, short of daily disclosure?
  2. Will the answer to question 1 provide so much information about the fund that market participants can reverse engineer the holdings of the fund, thereby defeating the entire exercise?

A perplexing problem, indeed. However, there are several “less than daily disclosure” processes that have been proposed as solutions. While they differ in many of their details, they all share the common goal of attempting to disclose enough information to the market to allow the arbitrage mechanism to operate efficiently but not so much information that it would allow market participants to reverse engineer the fund’s holdings. In my next post, we’ll delve more deeply into the general nature of this information disclosure process.