For years, there was little innovation in the investment industry. Stocks, bonds, mutual funds – that was pretty much the range of choices for investors. Exchange-traded funds, introduced to the market in 1993, changed all that. ETFs are touted for their tax efficiency, liquidity and low costs. But asset managers are looking to develop a new ETF spinoff that would remove one core characteristic of these popular investments: transparency.
What are non-transparent ETFs?
Originally designed to mirror the return of an index, such as the S&P 500, a growing number of ETFs being sold today are actively managed funds that seek to beat the market. This would have been heresy just a few years ago, contrary to the core mission that ETFs were created to accomplish: a low-cost indexing investment.
Exchange-traded funds are similar to mutual funds in many ways: both are essentially market machines containing many investments. The moving parts inside can be stocks, corporate bonds, Treasuries – or a combination of all of the above.
Of course, there are differences between the two. One of the primary distinctions is how they are traded. Mutual funds are bought and sold once a day, while ETFs trade throughout market hours, like stocks.
The other contrast is transparency, the extent to which all of those investments “inside the machine” are revealed. Mutual funds disclose their holdings quarterly; ETFs reveal their investment holdings daily.
Big fund managers, like Black Rock, State Street, Eaton Vance and T. Rowe Price among others, have filed applications with the Securities and Exchange Commission (SEC) to develop actively managed “non-transparent” ETFs that will disclose individual holdings every three months, just like mutual funds. These hybrid ETFs are also known as exchange-traded managed funds (ETMFs).
Why asset managers are seeking SEC approval
Money managers are seeking regulatory approval for ETMFs in order to keep from revealing the cards (investments) they are holding. Convinced they have a magic mix of investment ingredients, fund companies have so far resisted creating ETF versions of their most popular mutual funds because of the required daily “reveal” of holdings.
With SEC approval of quarterly disclosure for ETMF holdings, the fund managers would be able to clone their flagship mutual funds as non-transparent ETMFs in an effort to gain additional investor dollars.
ETFs versus ETMFs
In the T. Rowe Price SEC filing, the fund company compares the benefits of traditional ETFs and how they may differ to actively managed non-transparent ETMFs.
- Low cost: The fund company says non-transparent ETMFs will provide investors with a “more cost-efficient investment vehicle than a comparable mutual fund” even though the management fees will be similar. However, annual operating expense ratios are expected to lower, because many of the costs embedded in the expense ratios of mutual funds -- such as transfer agency fees -- are generally much lower for ETFs.
- Tax efficiency: T. Rowe Price says the new ETMFs will offer investors a “relatively tax-efficient investment option as compared to similar traditional mutual funds,” though the company admits that non-transparent ETMFs may not be as tax efficient as index ETFs.
- Liquidity: The new ETMFs will provide investors with the same liquidity as they have come to associate with ETFs.
A good investment?
Will ETMFs render mutual funds obsolete? Eaton Vance, a venerable mutual fund company which can trace its history back some 90 years, says no.
“There's an important role for both mutual funds and ETMFs to play for the investor and in evolving our industry,” Eaton Vance spokeswoman Robyn Tice tells NerdWallet. “We developed a unique, innovative way to deliver the benefits of active management in a way that improves performance, lowers cost, and obtains tax efficiencies. A year from now, we anticipate that the marketplace is going to look very different. This will further demonstrate that active management can be provided in different forms, meet various needs, perform as it’s intended to -- or even better -- yet at a lower cost.”
T. Rowe Price says in their SEC application that “investors and their advisers have not been able to access in the ETF format the full spectrum of active management strategies available in the mutual fund format.” Instead, investors “have been limited to investing in active ETFs whose strategies are amenable to full portfolio disclosure.”
Removing that restriction will allow investors to buy an ETF that resembles, ever more closely, an actively-managed mutual fund.
Whether that is a true innovation or not remains to be seen.
Hal M. Bundrick is a Certified Financial Planner™ and former financial advisor and senior investment specialist for Wall Street firms. He writes about personal finance and investing for NerdWallet. Follow him on Twitter: @HalMBundrick