Exchange Traded Funds (ETFs): Not Always a Passive Approach

 

The use of exchange traded funds (ETFs) has become widespread in recent years. The early incarnation of the ETF was essentially an index fund which could be traded on an exchange intraday, as opposed to a traditional index fund which was bought and sold directly via the issuing mutual fund company.

In recent years, a number of active managers have begun to launch actively managed versions of ETFs in which there is a traditional manager, no different than a traditional mutual fund. However, they are not without their differences.

A mutual fund at one time had certain structural advantages for an active a manager, in particular, they were not forced to disclose their holdings until the end of each quarter. In theory, a manager may have taken a position in a particular security, then liquidated the position in between quarterly filings, and their competitors would have no public knowledge of that holding. This makes it much more difficult to “front run” the activities of another manager.

Front running is process in which either an individual investor or another manager may steal your ideas by monitoring the purchases or sales you are making. Because many funds are very large, it can take several days to implement a new purchase or sale, making the fund more vulnerable to front running. Investment firms spend vast amounts of money on research, which ultimately defines their strategy. So obviously they don’t want anyone else to utilize those research dollars by implementing their actions before they have a chance to complete their trades. As such, and ETF, which requires more disclosure, was less attractive to active managers.

However, a new Securities & Exchange Commission (SEC) approval in early 2019 now makes it permissible for an ETF to conduct business without having to disclose holdings every day. This ruling was on the basis that the ETF provider uses a “trusted agent” to serve as the middleman who holds the portfolio information and uses a confidential account to create and eliminate ETF shares on behalf of the fund company. This ruling will allow fund companies to create new versions of their products in which transparency concerns will no longer be relevant.

It is important to point out that the mutual fund structure already has this benefit. So why the need to create an ETF version?

The answer is that there are still some other structural advantages to the ETF version over a traditional mutual fund. A mutual fund often had to keep a sizable cash position in order to address redemptions as they receive requests. Simultaneously they need to invest cash as those new dollars come into the portfolio. It is not always possible to get all the cash invested or liquidated quickly, so there is often a lag between what the manager wants to allocate to, and what they are actually invested in at any given point in time. Because the ETF shares are traded on an exchange, much of the buying and selling is transacted from one investor to another, which does not require the manager to maintain a large cash position and enables them to stay fully invested. This also limits the internal trading of the portfolio, which helps limit the funds operating costs, making it more attractive to investors.

Additionally, ETFs can use what are known as in-kind exchanges. Traditional mutual funds redeem shares for cash, which can potentially generate capital gains inside the portfolio of a mutual fund. These gains are ultimately passed onto the shareholders of the fund as a tax liability. In an ETF structure the portfolio can swap out positions that have a higher cost basis and don’t generate high capital gains, if any at all. The higher volume and more liquidity the ETF achieves in the marketplace, the less likely it is that a capital gain will be realized.

Ultimately, there is still no solid evidence that active equity managers outperform their corresponding benchmarks across the entirety of the global stock market with any degree of consistency. However, if an investor wishes to engage in the use of active management, the ETF options are likely to expand in the wake of this new SEC ruling. More importantly, it is important for the individual investor to understand what they are buying, as not all ETFs are passive index funds anymore.

Joe Favorito

Joe Favorito

Joseph Favorito is a Certified Financial Planner™ who began his career in the financial services field in 1997. Over the past two decades Joseph has worked for several New York stock exchange members. In 2011 he founded Landmark Wealth Management, LLC , a Long Island-based Securities Exchange Commission registered investment advisory firm.

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