Gastineau Sacks Fund Reforms, Floats Active ETF Model
December 6, 2004
Exchange-traded funds have become a hot commodity in the past few years, as investors, soured by their mutual fund experience, have become increasingly allured by their low cost, versatility and tax efficiency. At last tally, the combined assets of the nation's ETFs stood at $190.51 billion as of the end of October, according to the Investment Company Institute. That's up from the nearly $151 billion in assets at the end of December 2003.
A fundamental aspect of the ETF is that it tracks the performance of specific market index, either at home or abroad, by holding all the securities contained in the index or a representative cross-section of those securities. While this index-based model has spurred significant growth in the last year, assets still pale in comparison to most other investment vehicles. But what if ETFs were actively managed?
Recently, ETF aficionado Gary Gastineau, managing director of ETF Consultants, suggested that if an ETF's investment advisor were able to select securities consistent with the ETF's investment objectives without referring to the index, they would be the "greatest thing since money market funds." Money market funds currently hold roughly $2 trillion in assets; a number that Gastineau believes is an attainable goal for ETFs provided they adopt this unconventional approach.
As to why actively managed ETFs are necessary, Gastineau explained that mutual fund reform efforts have failed to bring about systemic change and that new governance measures are merely cosmetic. He argued that beefed up compliance rules serve only to create an additional cost that is passed along to investors and that proposed fixes for market timing will not be effective.
Innovation in the ETF arena is stifled by a high turnover rate at the Securities and Exchange Commission and an overstuffed agenda for the Commission staff, he charged. That being said, Gastineau proposed introducing active ETFs as a totally new fund product, which would require tweaking the Investment Company Act of 1940. Among the key features in his ideal ETF product is a hard 2:30 p.m. cutoff for fund trades. Anything received after that time would be priced at the following day's net asset value (NAV). Second, all fund transactions will be made through the ETF share class.
"A fund's acceptance of late-arriving orders provides free liquidity to the trader at potentially high cost to the fund's ongoing shareholders," Gastineau said. He noted that the SEC's current hard 4 p.m. close does "nothing to protect fund shareholders from the costs of providing liquidity to market timers or any other fund share traders."
An intra-day fund share proxy will be distributed through electronic quote vendors at an interval determined by the board of directors, no shorter than 15 seconds and no longer than 60 minutes. "There is no need for every-15-second value updates, and they reveal information to the fund shareholders' disadvantage," he said. He would expect the full composition of most of the portfolios to be disseminated every two weeks on a voluntary basis with a two-week lag, but he conceded that the decision should be left up to the board.
The only reason for a 60-day delay on quarterly disclosure, he argued, is that funds that belong to a large fund complex may, in aggregate, own a substantial fraction of the shares of many of their portfolio companies. In order to truly protect shareholders, there must be enough time for the entire fund family to make changes to the portfolio without having to "operate in a fishbowl."
He further stipulated under his plan that each fund will announce the maximum number of shares it will issue and cannot exceed that limit unless shares are redeemed.
"It will not be necessary to force shareholders to sell their shares to shrink a fund if the number of shares is set too high," he said. "The prospect of poor performance will take care of that." He recommended that in making a decision capping fund size, the investment manager and the fund board should consider the trade-off in value to investors of a large, low-cost investment process versus a smaller shop that generates fewer ideas but enjoys greater flexibility and perhaps imposes higher asset management fees.
Another tenet of his plan is that the investment manager may disclose portfolio information to the public as long as it is approved by the SEC and is of limited cost to the investor. The disclosure, however, should not include current trading plans and any inappropriate information on changes still in the works. Preferential treatment, when it comes to disclosure of the information, would be strictly prohibited under Gastineau's plan. He believes that certain types of supplementary information will make market makers more comfortable and encourage them to tighten their spreads.