The Trouble with Non-Transparent Active ETFs

Barron’s has an interesting article discussing “The Trouble with Actively Managed ETFs.”

The article should have been titled “The Trouble with Non-Transparent Active ETFs.”

A few quotes from the article:

[Non-transparent ETFs] change the very nature of ETFs. Mutual fund companies—Fidelity,T. Rowe Price (ticker: TROW) and Vanguard among them—have joined ETF providers in laying the groundwork to move into the active ETF space. But most fund companies won’t make a move unless the Securities and Exchange Commission approves so-called nontransparent ETFs.
…
‘If I were a betting man, I’d say something gets approved this year,’ says Matt Hougan, president of ETF.com. ‘There is more pressure on the SEC than there has been in the past, and the exchanges have already filed regulatory papers. Things are moving for the first time in a long while.’

Non-transparent ETFs, really?

The beauty of ETFs is that they are transparent, lower-cost, tax-efficient, and give investors a lot of power to “vote with their feet,” in other words, the ability to fire the manager simply by entering a SELL order.

What does non-transparency get you? Does anyone really still believe that the massive mutual fund companies throwing darts at the wall among a basket of large, liquid, and deep securities can add value?

The aggregate portfolio of U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suggest that few funds produce benchmark adjusted expected returns sufficient to cover their costs. If we add back the costs in expense ratios, there is evidence of inferior and superior performance (non-zero true alpha) in the extreme tails of the cross section of mutual fund alpha estimates. Source: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021

Using new, survivorship bias-free data, we examine the performance and persistence in performance of 4,617 active domestic equity institutional products managed by 1,448 investment management firms between 1991 and 2008. Controlling for the Fama–French (1993) three factors and momentum, aggregate and average estimates of alphas are statistically indistinguishable from zero. Even though there is considerable heterogeneity in performance, there is only modest evidence of persistence in three-factor models and little to none in four-factor models. Source: http://www.hec.unil.ch/agoyal/docs/persistence_jof.pdf

We’ve known that low p/e stocks beat high p/e stocks for over half a century at this point. The strategy is pretty transparent. And this simple strategy has outperformed just about every mutual fund ever launched.

Does a lack of transparency drive alpha? Or is more related to behavioral bias and limits of arbitrage?

Non-transparency drives fees, not performance.

Non-transparency allows managers to charge higher fees and throw terms around the marketplace such as ‘proprietary.’ The sales tactic in play is referred to as “scarcity,” since the implication is that no one else possesses something that is proprietary to one investment manager. This tactic is highly influential and effective for the sales process.

But is there any evidence that a lack of transparency, and the supposed proprietary methodology it enables, actually drives performance? None that I’ve seen. But that won’t keep the large active mutual fund companies from trying to convince the public of their stock picking prowess and all around “awesomeness.”

What SEC Chair would approve lower transparency?

It will take a bold SEC chair to facilitate their request. Does the top dog at the SEC, an organization dedicated to protecting investors, really want to be known as the person that made the marketplace less transparent?

The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

Of course, there are arguments why non-transparent active ETFs might be good for the market. For example, it would make it much easier for less liquid strategies to operate in the ETF wrapper. But there are legal issues with constraining the capacity on an open-end ETF. The reality is that small-cap and niche strategies are not appropriate for the ETF wrapper as the rules currently stand.

The problem with the current crew pushing non-transparent ETFs is they aren’t peddling niche small-cap investment strategies. They are pushing overpriced average performance product through their massive sales distribution pipelines.

They might end up successful, but I’m hopeful the SEC Chair can see through the charade.