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.
This muddled dynamic does not exist inside individual ETFs or ETF portfolios because of their transparency. The holdings of both indexed-based and actively managed ETFs are available and updated on a daily basis. Although not every financial professional is likely to check an ETF’s holdings on a daily basis, anyone who conducts reasonable due diligence with actively managed funds would become more easily aware of any attempts to window dress.
Index funds do not confront issues of window dressing and will always possess the components of the index they track, or they will follow a sampling method—owning a portion of the constituents to track their respective index—and must only address any tracking errors to their underlying index.
The periodic reporting of non-transparent investments creates an environment for this type of window dressing. While it’s reasonable to believe that most non-transparent funds will not engage in this type of activity solely for the optics, the pressure of performance in a very competitive marketplace can bring strong temptations.
Instead, advisors should think like institutional investors. Very few, in fact almost no institutional investors invest in non-transparent investments. The reason for this can vary, such as fee negotiations or specific investment limitations and restrictions the institution might have, but ask any institutional investor if transparency is critical, and the answer will be an overwhelming yes. Ask an institutional investor if they should be able to view what they are invested in at any time, and the same affirmative answer will be given.
Today’s advisor is demanding the same treatment, which is indicative of the continuing growth and usage of ETFs. More importantly, more investors and clients will increasingly demand this feature for their investment portfolios as well.