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.