Is the SEC Costing Index ETF Investors Money?

Perhaps because it lacked empirical data about the scope of such investor harms, the SEC noted the fund companies’ concerns but implemented the “full daily portfolio transparency” requirement despite those concerns.

To be sure, many in the industry welcomed the new SEC rule as it provided clarity in place of the ambiguity and cumbersome approval process that preceded it.

This applause, however, may become less enthusiastic in light of the data recently brought to light.

Because some ETF index funds are exempt from the SEC’s daily disclosure requirement, the study’s author, Sida Li of the University of Illinois at Urbana-Champaign, was able to contrast trading by funds that disclose their portfolios daily with funds that do not make daily disclosures but track the same underlying index of stocks.

On average, the data show that the funds not compelled to disclose their portfolio holdings on a daily basis outperform the funds that are compelled to disclose “by 1.8 basis points (bps) per quarter or 7.3 bps per year.”

While the SEC is unlikely to repeal its daily disclosure rule, it is possible that investors will seek redress in the courts.

That is what happened a decade ago when the SEC first required certain hedge funds to file publicly available reports on Form 13F disclosing certain holdings. One fund manager sued the SEC, asserting that compelling such disclosure amounted to an unconstitutional “taking” of private property for a public use without paying “just compensation.”

In that 2011 case, a federal appellate court sidestepped the issue by concluding that the legal issue was not “ripe” enough for the court to consider, in part because the court found that disclosure “produce[d] no economic harm” to the hedge fund advisor. Ultimately, the court declined to decide whether the SEC had engaged in an uncompensated unconstitutional taking of property.

The circumstances are quite different for owners of ETF index funds compelled by the SEC to disclose daily holdings. The economic harm to investors appears to be quite real and significant. The $3.9 billion per year estimated in Li’s paper may be enough incentive for investors to go to court over the issue, and the issue may now be “ripe” enough for courts to consider it.