Shenanigans! ETF Transparency Edition

Vanguard is worried about the structural flaws in indexed products that allow sophisticated traders to profit from their rules-based rebalancing trades. Only Vanguard doesn’t say it that way, because, let’s face it, it’s always easier to blame hedge funds and high frequency traders. The FT reports:

Vanguard fears that ‘’predators’’ are taking advantage of exchange traded funds at the expense of retail investors and hopes that an expected overhaul by US regulators will not mandate perfect transparency for the booming $4.8tn industry.

ETFs try to track indices and markets such as the S&P 500, the Bloomberg Barclays Aggregate bond benchmark or the price of gold as closely as possible, giving investors cheap exposure to a wide array of assets.

The vast majority disclose their holdings daily and if an index they track changes, they must then adjust their holdings before the close of trading. The daily shifts in markets means ETFs are vulnerable to opportunistic traders such as hedge funds and high-frequency trading firms who can try to “front-run” their efforts at rebalancing their holdings.

Vanguard, the industry’s second-biggest provider, chooses to disclose its ETF holdings with a one-month lag to avoid the danger of front-running, and is worried that a new rule from the Securities and Exchange Commission could force it to do so on a daily basis.

Tim Buckley, who took over at Vanguard this month, likens the predicament faced by ETF providers to the children’s tale of Little Red Riding Hood, who told the wolf where she was going, allowing him to take a shortcut to devour her unsuspecting grandmother.

“We don’t want to see full transparency for ETFs,” he told journalists at the sidelines of a conference last week. “If they know where you’re going they can ambush you. If you buy all at the close you have perfect tracking, but billions of dollars of investor money is destroyed. The money goes to the predators, and you won’t even see it.’’

Little Red Riding Hood? Seriously?

This isn’t a knock on Vanguard or its products (hell, I own Vanguard products). This is just calling a spade a spade. Pro tip: if you don’t want sophisticated traders “preying” on the inefficiencies introduced by your systematic, indexed strategy, DON’T INVEST USING A SYSTEMATIC, INDEXED STRATEGY.

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