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 portfo-
lios 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
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.
Noah Hamman is CEO of AdvisorShares.
By Noah Hamman
A Window-dressing-Free Zone
Advisors are beginning to invest like institutions, and they’re