Opaque ETFs not in the public interest

Score one for the little guy. Last week, the Securities and Exchange Commission bucked the conventional wisdom and denied applications by fund managers BlackRock Inc. and Precidian Investments to offer nontransparent exchange-traded funds to investors, saying such products were not in the public's interest. Just a month ago, many industry pundits expected the agency to approve the measure but, in a sometimes rare moment of clarity, the SEC said no, explaining that approving the proposals in their current form could “inflict substantial costs on investors, disrupt orderly trading and damage market confidence in ... trading of ETFs.” According to the 60-page ruling: “The commission preliminarily believes that it is not in the public interest or consistent with the protection of investors or the purposes fairly intended by the policy and provisions of the [Investment Company Act of 1940] to grant the exemptive relief” that the two fund companies sought. The fund managers — specifically in this case BlackRock and Precidian, but others have similar applications pending — argue that opening up actively managed ETFs to full transparency would lead to front running, or trading ahead of the strategies, by other investors, thereby making the strategies toothless.

TRANSPARENCY NECESSARY

But the SEC said daily transparency is necessary to keep the market prices of ETF shares at or close to the net asset value per share of the ETF. Without getting into the technical details of how ETF shares are priced and issued, daily transparency allows market makers and other market participants to value ETFs intraday to identify arbitrage opportunities. Front running is not a fictitious concern dreamed up by money managers as a smoke screen. Indeed, regulators for decades have been tweaking the market's structure to curb the practice. But several fund companies — well-known fund companies, to be sure — are offering actively managed ETFs that have full, daily transparency. This year, for example, both Fidelity Investments and Calamos Investments launched active ETFs with full disclosure of their holdings. This story isn't over. American Funds, T. Rowe Price Group Inc. and Eaton Vance Corp. all have applications pending at the SEC for similar nontransparent ETFs. Eaton Vance's Navigate Fund Solutions unit has proposed a model it calls an exchange-traded managed fund. The SEC could rule on that proposal early next month. In addition, Precidian's chief executive, Daniel J. McCabe, told InvestmentNews reporter Trevor Hunnicutt he was sanguine about the prospects for nontransparent ETFs.

'IT TAKES LONGER'

“These are things that can be worked though,” he said. “It's not a process that I enjoy, but when you do novel things, it takes longer than if you do standard things.” The SEC, for its part, is accepting public comments through the middle of November, and fund companies seeking approval are likely to rejigger their product offerings and try again. So while the little guy has won the battle, the outcome of the war is far from decided. We only hope the SEC keeps the interests of investors front of mind and avoids being swayed by arguments about how fund companies will manage the product without transparency and no one will be any worse off. (An earlier version of this editorial incorrectly characterized the Eaton Vance's model. It is an exchange-traded managed fund.)