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What Wall Street Doesn't Want to Tell You

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Wall Street wants to keep some secrets from you. So far, professional money management companies haven't managed to convince regulators to allow them to withhold valuable information from investors. But, with more companies seeking the ability to keep their proprietary trade secrets confidential, it's likely only a matter of time before investors could lose one of the most groundbreaking and transparent investment vehicles ever.

Mutual fund giant Eaton Vance (NYSE: EV  ) recently filed a request with the Securities and Exchange Commission that would allow it to create a new type of exchange-traded fund. Dubbed exchange-traded managed funds, these ETFs would be exchange-traded equivalents of existing actively managed traditional mutual funds that the fund manager already oversees. Eaton Vance is even hoping to earn licensing revenue by extending the practice to active mutual funds managed by other fund companies.

The catch, though, is that Eaton Vance doesn't want to follow the traditional practice of disclosing these new active ETFs' holdings on a daily basis. Given that one of the biggest benefits of ETFs has been their transparency, should the SEC approve Eaton Vance's request?

The strange gulf between mutual funds and ETFs
At first glance, it doesn't make sense why disclosure rules for ETFs would be any different than for traditional mutual funds. With mutual funds being able to disclose their holdings as infrequently as once every quarter, active managers are able to keep their portfolio holdings secret over long periods of time, and manage their exposure at every quarter-end to obscure what may have been their true strategy throughout most of the quarter. Why shouldn't ETFs be allowed to do the same thing?

The reason for disclosure has to do with the mechanics behind ETFs. Large institutional investors routinely create or redeem large blocks of ETF shares, helping to provide liquidity that makes trading in ETFs more efficient, and also taking advantage of occasional arbitrage opportunities that, in turn, keep prices relatively close to the true value of the ETF's underlying assets. ETFs are required to tell those institutional investors what stocks are in the fund's official basket of investments for purposes of creating new ETF shares. Most of the time -- though not always -- those official baskets reflect the broader holdings of the ETF.

Why active ETFs haven't grown faster
Daily disclosure is a problem for active managers, though, because they don't want their every investment move exposed to the general public. With many funds being large enough to have market-moving influence, especially on smaller, less-liquid stocks, it's impossible to build up or sell off a position in a particular stock in a single day. Under daily disclosure, investors who saw a new position accumulating could rush in to buy shares, effectively forcing the manager either to do an about-face on its investing strategy, or accept having to pay higher prices to obtain the shares it wants.

The problem is especially bad with stocks, where the market is relatively simple. The PIMCO Total Return Bond ETF (NYSEMKT: BOND  ) is an actively managed bond ETF, but it's a lot harder for individual and even institutional investors to copy trades in the bond market. That's why Pimco was comfortable opening an active ETF, where managers who focus on stocks, such as T. Rowe Price, have made the business decision not to pursue active ETFs.

Will the active-ETF floodgates open soon?
Eaton Vance might have to wait a long time before it gets a decision from the SEC. BlackRock made a similar request for less frequent ETF disclosure a year and a half ago, and it still hasn't gotten word from the SEC on whether the request will be approved.

Given the willingness for investors to buy mutual funds with infrequent and incomplete disclosure, it seems inevitable that active ETFs will eventually rise in popularity. The real question, though, is whether investors will reap the rewards of Wall Street's secrets -- or whether fund managers will end up keeping much of the profits for themselves in the form of higher management fees.

To learn more about a few ETFs that have great promise for delivering profits to shareholders in a recovering global economy, check out The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery." Just click here to access it now.

Read/Post Comments (1) | Recommend This Article (2)

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  • Report this Comment On April 01, 2013, at 1:47 AM, EricTheRon13 wrote:

    I don't see how Eaton Vance could do this, unless they mean to supply their own agent for the creation and destruction of ETF share blocks. Presumably then only this agent would know the current ETF content on a daily basis. However, this means there is no arbitrage from every quarter to keep the ETF price in line with its NAV. One would have to wonder how well this would work when prices are volatile. Or is there some other mechanism that Eaton Vance has in mind? You aren't very specific as to how they intend to handle this.

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