Tuesday, December 10, 2013

Non-Transparent ETFs and Foreign Stock Funds

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Typically, it's better to know more about an investment rather than less. When it comes to mutual funds and exchange-traded funds (ETFs), transparency means knowing what the fund is buying and selling, and therefore the underlying investment strategy.

Some commentators have claimed that fund transparency is a bad thing for investors. If a fund has a predictable investment strategy, then traders can front-run its trades, which may be large enough to move prices. The criticism is even louder when it comes to ETFs, which can be more transparent. The fund industry, including Eaton Vance, Blackrock, and Precidian, has responded by filing applications for so called exchange-traded mutual funds (or, alternatively, 'non-transparent ETFs') that trade intraday (like stocks or ETFs) but provide transparency only daily (like mutual funds).

Brendan Conway at Barrons is reporting that these non-transparent ETFs will likely trade like foreign stock funds. Foreign stocks often do not have current market prices simply because foreign markets are not open at the same time as domestic markets (we covered this effect before as it relates to Chinese stocks). Non-transparent ETFs would similarly not have accurate information about their holdings, yet would trade throughout the day based on an estimate of net asset value. It is likely that the value of a non-transparent ETF would trade at premia or discounts to net asset value.

Regulators have yet to approve non-transparent ETFs, and it is not clear that investors will prefer this format. It is also still controversial whether or not the problem of front-running in ETFs actually occurs with much frequency. It is questionable whether active managers, who are pushing the hardest for less transparency, can deliver consistently better returns than passive investments. What is clear is that ETFs have become more than just passive investments, and that ETF innovation can fundamentally change the nature of the investment.

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