What You Need to Know
- Some $3.9 billion per year is being captured from ETFs by traders that use publicly disclosed daily portfolio information.
- Funds not compelled to disclose their portfolio holdings daily outperform those that are by 1.8 basis points per quarter, or 7.3 bps per year.
- While the SEC is unlikely to repeal its daily disclosure rule, investors may seek redress in the courts.
The exchange-traded fund market continued its explosive growth in 2021, and more of the same is expected in 2022.
According to one report, 445 new ETFs launched in 2021, compared with 309 in 2020, with hundreds more on the way this year.
When investors own shares of an ETF index fund, however, they probably don’t expect the Securities and Exchange Commission’s disclosure rules to hand some of their potential profits to other “strategic” market participants.
But that appears to be the case, according to a recent academic paper that estimated $3.9 billion per year is being captured from certain ETFs by traders who use publicly disclosed daily portfolio information to pre-position trades ahead of ETF index fund balancing trades.
A combination of SEC-required daily portfolio disclosures and “mechanical rebalancing” by ETF index funds could result in $29,000 of losses for an investor who accumulated a $2 million retirement portfolio over 30 years.
Although this issue has been brewing for years, only in December 2020 did compliance become mandatory for the SEC rule, requiring some ETFs to make their portfolio holdings publicly available on a daily basis.
In 2018, during the SEC’s consideration of the proposed rule, several major fund companies pointed out an unintended consequence of compelling public portfolio disclosure that could actually harm investors. As one fund company put it:
“… a key impediment holding [us] back from offering more actively managed ETFs is our concern about potential negative consequences associated with daily portfolio disclosure — specifically, the risks of front-running by other market participants and ‘free riding’ by market participants who are able to reconstruct and replicate our proprietary insights and strategies.”
Similarly, two other fund companies pointed out to the SEC their “concerns about ‘front-running,’ ‘piggy-backing’ and the potential ability to reverse engineer active investment strategies” and the potential that disclosure would enable “other market participants to front-run trades.”
Significantly, the SEC was told: Any costs associated with this front-running activity will likely be passed along to ETF investors in the form of wider bid-ask spreads and premiums/discounts.