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February 02, 2015 at 07:00 PM
Advisors and investors alike are advocates of transparency in ETFs for the obvious reason of efficient trading, including other justifications such as avoiding the window dressing that can occur in less transparent structures. ETFs provide that unique ability to lift the hood when one wants—not to try to be the mechanic, but rather to make sure all the expected parts are visible without any surprises.
Window dressing refers to the practice whereby managers of non-transparent pools of investment capital such as traditional mutual funds or hedge funds will make changes to their portfolio just in time for the quarterly disclosure of holdings. All their investors will see is what holdings were owned at the end of the quarter and not what changes occurred during the quarter.
During this past holiday season, the SPDR S&P 500 ETF (SPY) witnessed a massive one-week inflow of $25 billion. To be absolutely clear, there is no way to know whether a particular set of flows into SPY represents a large investment from new funds, a rotation of some sort, window dressing or something else, but window dressing at the very least remains a good possibility in this particular circumstance.
For hypothetical purposes, let’s use two fictitious companies (to avoid anything that might be construed as cherry picking): Coco Carl and Rowdy Robertson. Coco was one of the worst performing stocks last quarter, falling approximately 50%, while Rowdy was one of the best performers last quarter, gaining approximately 150%.
As an extreme example of window dressing, a portfolio manager who owned Coco most of the way down would then swap into Rowdy to conceal having held a laggard while showing the portfolio held a winner when the quarterly report was published.
Obviously, too much camouflaging would eventually lead to having to answer questions about results being inconsistent with the reported holdings. At the margin, such positioning is believed to have occurred, and that can then make for difficult conversations between advisors and their clients when trying to explain performance.
