Hougan Calls Out Vanguard on Transparency

Matt Hougan of IndexUniverse.com recently wrote that ETFs Are Not Really Transparent. He calls out ProShares and Vanguard as the worst offenders, although the accusations against Vanguard are much worse. ProShares lack of transparency is more a matter of degrees, while Vanguard pretty much gives investors a poke in the eye.

In fact, Hougan says ETF firms are lying when they say they’re “fully transparent.” It’s a pretty scandalous statement to make about the ETF industry. Transparency is part of the mantra ETF providers chant when trying to convince investors to abandon mutual funds for their products. For those who haven’t heard the mantra it goes something like this: “ETFs are better than mutual funds because they’re cheaper, more tax-efficient, more flexible and more transparent.”

This famed transparency is a direct result of the creation unit process in which the Authorized Participants receive ETF shares directly from the firm. The creation process is what’s known as an in-kind trade. The AP buys a basket of all the securities in the ETF portfolio and trades them for an equal number of ETF shares, which it then sells on the stock exchange. For instance, trading all 500 stocks in the S&P 500 Index for shares of the SPDR (SPY). In order for the AP to buy the correct basket, the ETF needs to publish its portfolio every night. This compares to the mutual fund, which only needs to publish its portfolio every three months.

Hougan says there’s “actually no rule requiring index-based ETFs to disclose their portfolios any more frequently than traditional mutual funds. And for many ETFs, portfolio disclosure is either incomplete or significantly delayed. And the problem is getting worse.”

ETF firms do say if you can’t find the portfolio listings then look at the index. But many ETFs optimize their portfolios, because some securities are so illiquid or small that if the ETF purchased them it would significantly affect the market. So they don’t hold the exact same holdings as the index. This can create a disparity between the index return and the ETF’s return, a situation called tracking error. He adds that some portfolios and creation units differ too, though I lost him on this part.

Still, it’s a bit of a head fake, because as Hougan admits, almost all ETF families do provide the entire portfolios of their ETFs on a daily basis on their Web sites. He also acknowledges that almost all ETF creation units can be found on Bloomberg or if you directly contact the ETF sponsor. However, that’s not great for retail investors without an expensive Bloomberg machine.

However a few firms are taking advantage of the right to not disclose. Hougan calls ProShares a worse case scenario. For most of its short and leveraged funds, ProShares uses equity swaps to achieve their daily return. The swaps and their amounts are listed, but not the counter parties who hold the swaps. This becomes an issue if the counter party can’t fulfill its obligation, which happened in 2008. Lehman Brothers held some swaps for ProShares on the day it went bankrupt, causing problems with the portfolio. However, transparency is a big issue within the entire swaps market, so this might not necessarily be ProShares fault. Rydex SGI and Direxion (click on direct holdings), which also sell short and leveraged funds, list the swaps but not the counter parties.

Most surprising is Vanguard, which Hougan calls the worst offender even as it promotes transparency of holdings on its sites, but only gives them out every three months, like their mutual funds. The latest being Dec. 31, 2009. I’m surprised by this because Vanguard is definitely the ethical standard by which to measure mutual funds. So I figured they would be on the forefront with ETFs.

Ironically, Hougan points out the actively managed ETFs must be totally transparent every day, sort of beating the index ETFs at their own game.

While the few exceptions are troubling, overall I think the window on transparency remains pretty clear, especially considering the alternatives, mutual and especially hedge funds, where you hardly ever know what you own.

For Those Who Need to Amp Up the BRIC Risk

As if India and the emerging economies known as the BRIC, Brazil, Russia, India and China, didn’t have enough risk, leveraged ETF house Direxion launched on Friday six new Bull and Bear funds to track India, all four BRIC countries, and the U.S. semiconductor industry. Direxion says these are the first leveraged ETFs to track India and the BRIC countries.

The Direxion Daily BRIC Bull 2x Shares (BRIL) and Direxion Daily BRIC Bear 2x Shares (BRIS) track the BNY Mellon BRIC Select ADR Index. This index holds a select group of American depositary receipts from stocks that are listed in Brazil, Russia, India and China. Each fund either returns twice the daily performance of its tracking index, or twice the negative daily return of the index.

The Direxion Daily India Bull 2x Shares (INDL) and the Direxion Daily India Bear 2x Shares (INDZ) track the Indus India Index, which represents the whole Indian equity market. The index holds the 200 largest companies listed on India’s National Stock Exchange and the largest 200 companies listed on the Bombay Stock Exchange. INDL returns twice the daily return of its tracking index, while INDZ twice the negative daily return of the index.

The premier index for tracking the U.S. semiconductor industry is the Philadelphia Exchange Semiconductor Sector Index, which is known by its ticker, and called the SOX. The Direxion Daily Semiconductor Bull 3x Shares (SOXL) gives 300% of the daily move on the index while Direxion Daily Semiconductor Bear 3x Shares (SOXS) gives a negative 300%.

The funds lift the total number of leveraged ETFs offered by Direxion to thirty-four.

J.P. Morgan Plans to Jump Into ETF Biz

J.P. Morgan Chase is jumping into the ETF business.

In two SEC filings dated March 10, J.P. Morgan filed for exemptive relief for its first ETFs ever. The filings ask for relief for both index-based and actively managed ETFs.

The passive funds appear to be two bond-index ETFs. One will track an index of investment grade municipal bonds with 1 to 12 years to maturity and the other will track investment grade corporate bonds with an issuance of at least $300 million.

For actively managed funds, the filing asked for exemptive relief for funds that could hold stocks, bonds, open-end funds, closed-end funds and unit investment trusts. The strategy for J.P. Morgan’s first actively managed ETF would be to invest in about 300 large-cap stocks across many sectors. The actively managed fund would have a fundamental weighting. The fund would “overweight inexpensive stocks with improving fundamental characteristics and underweight expensive stocks with deteriorating fundamental characteristics.”

Currently, the bank runs the J.P. Morgan Alerian MLP Index ETN (AMJ). This exchange-traded note isn’t a true ETF, but rather an unsecured debt sold to investors. However, J.P. Morgan wasn’t the fund’s sponsor, Bear Stearns was. J.P. Morgan acquired the ETN when it bought Bear Stearns in 2008. The AMJ tracks the market of master limited partnerships. MLP are partnerships that sell shares like a public company. Typically they’re involved in the business of transporting oil and natural gas.

The filings were first reported on the news feed at ExchangeTradedFunds.com.

New ETF to Hold Closed-End Shares

Invesco PowerShares launched the first ETF whose portfolio consists of closed-end funds last month. The PowerShares CEF Income Composite Portfolio (PCEF) tracks the S-Network Composite Closed-End Fund Index.

Like mutual funds and ETFs, closed-end funds are diversified portfolios, but they differ in the way they sell and price their shares. Mutual funds and ETFs are open-end funds because they can sell as many shares needed to satisfy investor demand. In addition, they’re priced each night at their net asset value, or NAV. However, a closed-end fund sells a limited number of shares on the stock exchange in an initial public offering. Because closed-end fund shares trade on the stock exchange, demand for the shares determines price not the NAV. Thus, most closed-end funds sell at a discount or premium to the fund’s NAV.

PCEF is a “fund of funds,” as it invests its assets in the common shares of funds included in the underlying index. The index selects constituents from a universe of 350 U.S. closed-end funds with a concentration in one of three sectors: taxable fixed income, which includes corporate bonds, government bonds and mortgage back securities; high-yield emerging market debt and bank loans, and option-income funds. Unique to close-end funds, option-income funds buy high dividend yield equities and sell options to create high current income.

The fund of funds concept is an interesting one. Essentially, the fund sponsor says there are a lot of great funds out there and we’re going to give you one-stop shopping and create a portfolio of the best so you don’t have to do the research. Since the cost of buying many closed-end funds would be huge, you get the ETF benefit of diversification within a minimal investment. But since, each closed-end fund is already a diversified portfolio, how many does one investor really need?

The key advantage to this kind of ETF is dividend yield, which can get pretty sizeable with closed-end funds.

“PowerShares wanted high maximum current yield and to be well diversified,” says Paul Mazzilli, senior advisor to S-Networks Global Indices. “Because ETFs invest in the most liquid high-yield bonds, they don’t have the highest yield, but do have significant tracking error. Since, closed-end funds can hold illiquid securities, high-yield closed-end funds will have a higher yield than high-yield ETFs.”

Dividends and yield have become hot topics as people look for some guaranteed returns in a market full of uncertainty. Yield is the rate of return you receive from the dividend. While the dollar amount of the dividend payment remains the same, yield moves daily in an inverse relationship to price. When the share price of a closed-end fund falls, the yield percentage rises. When prices rise, yield falls. Currently, the index has a composite yield of 8.66%, which is double the 10-year Treasury note.

Up to now investors have had only one choice it they wanted to track closed-end funds in an exchange-traded product. Two years ago, the Claymore CEF GS Connect ETN (GCE) launched. Unlike PCEF, which actually holds closed-end funds, GCE is an exchange-traded note, an unsecured subordinated debt instrument that promises to pay the index’s return without actually holding assets. The GCE currently yields 8.3%, but since it has not funds, it receives no dividend, so their are no payouts. The yield is merely factored into the total return of the index. With only $3 million in assets under management, it hasn’t garnered much enthusiasm.

One especially nice thing about PCEF is that dividends are paid out monthly. This ETF expects to go ex-dividend on March 15, which means you need to buy before then to get this month’s payout.

Currently, the index holds 71 closed-end funds, of which 27 invest primarily in taxable investment-grade fixed-income securities, 15 invest primarily in high-yield fixed-income securities and 29 primarily use an equity option writing (selling) strategy. The index bases its weightings on a value-based rules approach, instead of market-capitalization. Market-cap weightings give additional weight to richly valued funds and underweight the undervalued funds, which is the opposite of what an investor wants.

“During the quarterly index rebalancing, we look at the average discount of all the funds,” says Mazzilli. “The funds with a wider discount get their weighting increased, while the funds with as wider premium get their weight decreased. Like fundamental indexing, the index focuses on value, selling the expensive funds and buying the cheaper funds.”

This approach enhances the fund’s return because it’s focused on securing the highest yield over price appreciation. It addition, you avoid capital gains inside the fund because closed-end funds and ETF’s have more tax efficient structures than mutual funds.

However, there are some serious negatives here. High yields are not just a function of shares being discounted, but typically signify a higher level of risk in the underlying securities, especially high-yield emerging market debt. The multiple layers of diversification within the closed-end funds and the ETF itself should lower that risk. However, closed-end funds have the transparency requirements of mutual funds. They only need to tell you what they own every six months. So, you never really know the level of risk of each fund’s holdings.

Then there’s the cost. While PCEF charges an expense ratio of 0.5%, a reasonable rate, each closed-end fund in the ETF also charges an expense ratio which will be paid out of the underlying funds. And while the ETF won’t hold any funds with an expense ratio higher than 2%, this duplicate level of fees significantly increases the cost of the investment and it’s not specified by how much, but it looks like 1.8%.

Dave Nadig of IndexUniverse calls it “the worst of all possible worlds – zero transparency, high costs, and unreliable pricing.” I’m not sure I would go that far, but I am concerned by the fact that PowerShares hasn’t posted a factsheet yet on the fund.

In the comments section, Mazzilli debates Nadig over the funds transparency, pointing to the white paper detailing the fund’s workings. In addition, on the S-Network Web site you can find the constituent list for the index as of Dec. 31, 2009, which would have been the holdings when the fund launched. You can also find the fund holdings on the PowerShares Web site. You could make the effort to find out what the closed-end funds hold, but that’s a layer of research the ETF tries to help you avoid.

Personally, I like the idea of a high-yielding investment that pays monthly. But I’ve always been bothered by the duplicate level of fees found in every fund of funds product and how it will take a significant bite out of that dividend payment. The big benefit seems to be the ability to invest in closed-end funds with a much lower level of risk than you would have when you put a lot of money in a single fund.

General Franciso Franco Is Still Dead

ETFs are investment companies regulated by the Investment Company Act of 1940, which prohibits the trading of funds. Thus, they need to get exemptive relief from certain regulations in order to trade like a stock. Removing this step of the registration process could cut months out the time between a fund’s initial filing and its launch.

In 2008, the SEC submitted the proposal to eliminate the exemptive relief process for industry comments. The comment period closed a while ago. I just spoke with a spokesman at the SEC about the status of the proposal. The news is no news. The SEC’s staff is currently reviewing the comments and considering the issues. There is no timetable for a decision.