A Simple Solution to Offering an Active ETF

Three new exchange-traded funds began trading today: Davis Select U.S. Equity (DUSA), Davis Select Financial (DFNL) and Davis Select Worldwide (DWLD). Normally such an event is not particularly noteworthy from our viewpoint. The launches of these funds are, however. They are actively managed equity ETFs based on strategies used for Davis Advisors’ mutual funds, separately managed accounts and institutional funds. More importantly, they will follow the disclosure rules long used by index ETFs.

A bit of context is needed to understand why the launch of these funds is raising eyebrows. Actively managed ETFs remain relatively few in number. Most mutual fund companies have refrained from offering actively managed exchange-traded funds—particularly ETF versions of their equity-focused strategies. One particular hurdle has oft been attributed as the reason: transparency. Index (passive) ETFs disclose their holdings daily. Most mutual funds do not.

Attempts to provide a hybrid approach, meaning ETFs with reduced transparency, have generally not been successful. One platform that did pass the Securities and Exchange Commission’s muster is Eaton Vance’s NextShares. NextShares’ exchange-traded managed funds provide limited transparency. Vanguard has its own platform and has filed to created ETF share classes for some of its actively managed funds. Last year, the SEC approved petitions from Bats Global Markets and the New York Stock Exchange for a streamlined process for listing actively managed ETFs. This was viewed as a positive for the industry, but it’s not clear that the approval resolved the transparency hurdle.

Mutual fund provider Davis Advisors has settled on a simple solution for dealing with the issue of transparency. In registration statements filed earlier this month, the company wrote: “On each day that the Trust is open for business… the names and amounts of Deposit Securities to be included in the current Fund Deposit for each Fund will be published.” Restating this in layman’s terms, the ETFs’ holdings will be disclosed daily. No lag. No complicated structure. Davis’ actively managed ETFs will follow the same rules for disclosing their portfolios as index ETFs have done since the first exchange-traded fund (SPDR S&P 500 (SPY)) was launched in 1993.

Full, daily disclosure among actively managed ETFs is not a new concept. PIMCO provides it, as does Doubleline. The difference is that these companies offer bond ETFs. Since an issuer can have many bond issues outstanding and because the trading volume in each specific bond varies, there is less concern about active traders trying to jump ahead of a bond fund manager making portfolio changes then there is for a stock fund manager making portfolio changes. There are some actively managed equity ETFs offering daily disclosure [e.g., AdvisorShares Wilshire Buyback ETF (NYSE Arca: TTFS)], but they are relatively few in number and small in size. The four largest actively managed bond ETFs alone accounted for more than $2 out of every $5 invested in the 176 actively managed ETFs in existence as of December 31, 2016, based on data from Morningstar.

Davis Advisors is better positioned than other actively managed mutual fund providers to provide daily transparency because its mutual funds have below-average turnover ratios for their respective categories. The firm intends to follow a similar approach with its ETFs. Barron’s quoted chairman Chris Davis as saying “it would be very strange if [the ETFs] ended up with a different kind of portfolio” than Davis Advisors’ mutual funds. As such, it will be interesting to see if Davis Advisors turns out to be a trailblazer or more of an exception. The headlines and trends I’ve seen so far suggest that Davis will be an exception—unless these new ETFs turn out to be quite successful.

We’ve excluded the Davis funds from our mutual fund guide (which will be updated next month) because of the loads and expenses associated with the share classes most available to individual investors. Morningstar shows the Davis New York Venture (NYVTX), Davis International (DILAX) and Davis Financial (RPFGX) mutual funds as outperforming their category benchmarks. This potentially bodes well for the ETFs, but—as is the case with any brand new financial product—it would be prudent to monitor how they perform before making a decision on whether or not to invest in them.