With the SEC seemingly poised to allow investment management firms to offer nontransparent, actively-managed ETFs (Exchange-Traded Funds), retail investors may be asking themselves two questions: what the heck are nontransparent, actively-managed ETFs and how would SEC approval of these fancy-sounding securities possibly affect me?
Question #1. You might have already heard of ETFs, or Exchange-Traded Funds. For the past ten years or so, ETFs have been the “it” security for many money managers, brokers, and sophisticated investors, with US assets growing ten-fold in 2012 alone to around $1.2 trillion, according to research. Basically, an ETF is an investment fund traded on stock exchanges, much like stocks, with the important distinction that ETFs close to their net asset value (NAV) over the course of the trading day. Most ETFs track an index or market benchmark. Fewer of you, especially if you’re a casual retail investor, have probably heard murmurs about non-traditional or leveraged ETFs, which are supercharged ETFs that offer amplified returns for positions taken pro or contra certain benchmarks on a daily basis. With the increased prospect of reward of course comes some high-risks, along with the absolute obligation to close out these investments each day. Now, nontransparent, actively-managed ETFs are related to traditional and non-traditional ETFs in that they are typically composed of these investments; but they are different in that they refer not just to a type of investment or security, but to the way in which those investments are handled by money managers. Actively-managed ETFs are ETFs that are, just like they sound, actively managed by money managers deploying sophisticated trading strategies that, for obvious reasons, they would rather not share with their competitors and the market generally. Here’s where transparency comes in. Until now, as per SEC rules, ETFs have been forced into full-disclosure of their trading activities. Compare that to mutual funds, which are only required to disclose on a quarterly basis. Recently, however, the SEC has been fielding an array of applications by ETF providers and money managers that would exempt them from full-disclosure obligations. They argue that exemption, or some level of secrecy to their holdings, would not only protect their investment strategies, but it would allow tremendous growth in such ETFs, which currently comprise only about 1% of the ETF market. If those lobbying for secrecy get their way, it could usher in the golden age of the nontransparent, actively-managed ETF.
Question #2. SEC approval of nontransparency among actively-managed ETFs could grow their presence in the marketplace such that retail investors may increasingly see these investments showing up in their portfolios. Several of the biggest investment management firms in the land have thrown their considerable weight behind the movement toward greater secrecy in ETFs, and many experts expect the SEC ulimately to give them what they want. There are two potential problems with this. One is that the providers of nontransparent, actively managed ETFs are as likely to bend or break the rules as any other investment entity, and less transparency generally means more bending and breaking. The recent and timely revelation that the largest provider of actively-managed ETFs, F-Squared, will be subject to disciplinary action by the SEC for exaggerating their returns strikes an ominous note for the industry. Two is that as these complex products trickle down into the hands of brokers and into the accounts of retail investors, there’s potential that like any new (and especially, complex) financial product, they may be used inappropriately or unsuitably by brokers who do not fully understand how they work.
So keep a watchful eye out for ETFs in the news and, eventually, in a portfolio near you.
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