Why Transparency Matters and the Merits of Exchange-Traded Funds
By Noah Hamman
I will start by offering that much in the ETF industry can be improved overall including people, process and product. I think we can all agree with that assessment but what is more concerning is when a representative of the $18 trillion dollar mutual fund industry offers a perplexing critique of the exchange-traded fund (ETF) space and its full transparency. After reading Mr. Faust’s Sunday commentary on InvestmentNews.com, it was rather ironic the piece would begin with a quote from former Supreme Court associate justice Louis Brandeis. While we hold differing viewpoints, I will attempt to address the concerns about ETF transparency that were outlined.
First, the key benefit of ETFs is not their transparency, but rather the operational cost and tax efficiency of the ETF structure. While those key benefits may not be itemized on an expense table, they provide real returns to investors and allow a manager to perform better in an ETF structure than in a mutual fund structure. In fact, a white paper by Navigate Fund Solutions, a wholly owned subsidiary of Eaton Vance formed to bring to market the exchange-traded managed fund (ETMF) structure, highlights the real, measurable benefits of that structural difference.
Transparency is a necessary feature to ensure that an ETF trades at or near NAV, instead of trading similarly to the significant premiums and discounts that are traditionally associated with closed-end funds.
Let’s address the assertion that “mutual funds offer greater cost transparency than ETFs” – in support of that Mr. Faust states “most ETF investors can only guess their trading costs” and intraday indicative values (IIVs) “are, at best, crude indicators of current value” and “may be prone to error because no responsible party stands behind them.”
In regards to guessing ETF trading costs, the fact is, investors can make a real-time assessment of an ETF’s underlying holdings thanks to its daily transparency. What is most surprising is that the leader of one of the largest mutual fund companies (whose mutual funds price only once a day, after the market closes) – who has subsequently created the next innovation (ETMFs will also price once a day, after the market closes) in the mutual fund space – thinks that a transparent portfolio valuation updated every 15 seconds is stale. Let’s just let that one sink in for a moment.
Regarding the credibility of the indicative value, those who calculate the indicative value are organizations such as the New York Stock Exchange, Interactive Data Corporation (which is a significant provider of security valuation services for the mutual fund industry), and the NASDAQ. The latter of which will be responsible for listing the aforementioned ETMF. These are organizations that stand behind their services and are worthy of their stellar reputations. It remains imperative to differentiate that indicative value and execution price are not the same— however yes, mistakes can be made on occasion but to be equally fair, mistakes can occur in mutual fund NAVs as well.
To defend his point of view, Mr. Faust references a research paper originally published in 2010 by Dr. Antti Petajisto, also a BlackRock portfolio manager. He cites a conclusion that ETF execution prices can be driven away from the true value of the portfolio. For most ETF investors, this will not be shocking news that ETFs trade at a spread. For the flow of new investors moving from a mutual fund structure to ETFs, then yes, they have this information to learn. All ETF firms provide education on this topic, and as demonstrated from Dr. Petajisto’s paper, your costs can be calculated.
One can only assume the article is referring to market makers when it states that ETF investors “routinely get their pockets picked by more-informed market participants who trade against them.” It’s an interesting statement given these are the same market participants the ETMF structure is counting on to appropriately price the costs for trading that structure. More importantly, there is no evidence supporting the claim.
Like most transparency opponents who believe portfolios should be shielded from the investors who own them, he turns to the front running argument—although no white paper is referenced to support that claim. It remains to be seen if such an assessment becomes fact. What we do know is that an actively managed transparent equity strategy can deliver five-star investment performance. That is a fact. What is disingenuous about the front running argument is that most mutual fund firms, especially the larger companies, offer many of their mutual fund strategies in separate accounts, most often to large institutions with full daily transparency. Small investors in mutual funds don’t receive transparency. However, the largest investors, who actually possess the best capability of front running, can obtain full transparency. It just doesn’t make sense.
It’s frustrating that ETFs are being accused of not being transparent with their fees. In his commentary, Mr. Faust describes, “all mutual fund transactions take place at net asset value, plus or minus a disclosed sales charge when applicable, investors can always means the cost to enter and exit their mutual fund positions.” That is mostly true, however, it doesn’t account for the fact that these transactions into mutual funds have an additional cost of investing the cash for purchases, or selling securities to meet redemptions—which can happen on a daily basis for mutual funds. The good news for the investors conducting such transactions is that those expenses are shared with all the other shareholders within the mutual fund. The bad news is that buy-and-hold investors carry the cost of these transactions by these trades. No transparency is provided to investors to know how much embedded costs exist for these transactions.
This level of cost uncertainty will also be present in the ETMF structure. While it seems clear that investors will know the fee paid to buy or sell an ETMF, they will not know what the cost is for the shares. And more importantly, investors will not know the difference (positive or negative) of the shares’ value after submitting the order versus when they receive an execution price after the market has closed. It’s the equivalent of locking in a realtor’s commission and then not knowing the cost of the home for six months. In today’s volatile global markets, the difference in value between noon and 4:00 pm can be significant.
Transparent ETF investors pay a spread and a commission. A long-term investor in a transparent ETF does not have to share in the transactional expenses generated by the more active, trading investors. In fact, the buy and hold investors in an ETF are benefited by the actions of the frequent traders, which create narrower spreads and better tax efficiency. One of the many reasons why ETFs are a great structure is that the costs on the investors are based on how they want to use an ETF—and not applied to all of an ETF’s investors. Again, what makes Mr. Faust’s InvestmentNews commentary so perplexing is that Navigate Fund Solutions’ white paper explained previously how the ETF structure of a market maker intermediary with in-kind creations and redemptions can save investors significant expenses.
Finally, on the referenced survey that indicates investors don’t consider transparency important – which in my opinion, is completely out of touch with today’s investors and the distrust people have in Wall Street. Do people want to look at their investments daily? Not really, but it’s the investors’ money, and they should be able to lift the hood and see their entire investment portfolios at anytime they want.
The reality is that nothing is perfect. There are always pros and cons and constantly room for improvement. The good news is that criticism can make you better and as advocates of a transparent ETF structure, we will duly note the feedback.