The rise of exchange-traded funds has been fast and furious, starting from scratch 30 years ago and rising to command almost $5 trillion in assets. Now, ETFs pose a major threat to traditional mutual funds because of the availability of intraday trading and their low costs.
Mutual fund companies have come out with a response: non-transparent ETFs. These ETFs mimic some of the proprietary elements of traditional mutual funds, but offer investors the same ease of trading as any exchange traded fund. With somewhat lower fees than their corresponding mutual funds -- but still higher than a typical index ETF -- non-transparent ETFs represent a last-gasp effort from mutual fund providers to preserve their market share and give investors an alternative to switching to regular ETFs.
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The first mover in non-transparent ETFs
American Century Investments has been a big player in the mutual fund industry for decades. It has also become the first to bring non-transparent ETFs to market. The two funds give investors potential exposure to either end of the growth-value spectrum, with American Century Focused Dynamic Growth (NYSEMKT:FDG) targeting growth investors while American Century Focused Large-Cap Value (NYSEMKT:FLV) is designed to attract proponents of value stocks.
In most respects, the two funds will act like any other ETF. However, investors won't get daily reckonings of what stocks the non-transparent ETFs hold. Instead, they'll follow more typical mutual fund disclosure rules, offering a window into their holdings on a monthly or quarterly basis. The American Century growth ETF names Amazon.com (NASDAQ:AMZN) as its top pick as of March 31, while the value counterpart has Johnson & Johnson (NYSE:JNJ) as its biggest holding.
Pros and cons of non-transparent ETFs
In many ways, whether non-transparent ETFs are good investments depends on which alternatives you use for comparison. They're cheaper than traditional mutual funds, with the two American Century offerings charging 0.42% to 0.45% in annual expenses compared to 1% or more for many stock mutual funds. However, they're more expensive than index ETFs that often carry fees of 0.10% or less.
The fact that most brokers now allow commission-free trading of stocks and ETFs eliminates a big cost problem that ETFs traditionally had against regular mutual funds. Nevertheless, these new ETFs will have relatively wide bid-ask spreads, making them less appropriate for frequent trading and better for long-term investors.
These two non-transparent ETFs don't really match up to any existing mutual fund, but it's possible that other providers will use ETFs that essentially track underlying mutual fund strategies. When that happens, it'll signal the recognition that the switch from mutual funds to ETFs is unstoppable.
The biggest risk for non-transparent ETFs
The U.S. Securities and Exchange Commission did highlight one area of concern for non-transparent ETFs. In the process of approving the new funds, two SEC commissioners pointed out that transparency of holdings has historically been a vital component of ensuring investors understand the true value of the underlying assets they're buying through purchases of ETF shares. Without knowing what those assets are, it'll be impossible to verify whether ETF prices are close to true value. At times of market stress, the SEC commissioners noted, that could cause problems.
Non-transparent ETFs do provide some safeguards against those problems, though. Even though they don't have to disclose the actual holdings, non-transparent ETF managers will provide some other information. Institutional investors who manage creation and new blocks of ETF shares will be able to use that information to decide which actions are appropriate to take in serving the general investing public. That appeased the commissioners, but the SEC will have to scrutinize future requests to make sure similar protections are in place.
See where non-transparent ETFs go
American Century had perfect timing with its non-transparent ETFs, launching in late March when markets were at depressed levels. As a result, it's already seen big gains for the two offerings. With many investors focusing too much on short-term performance, that could lead to big inflows for the two American Century non-transparent ETFs. That's a necessary step in order for the new class of investments to gain traction in the investing community more broadly -- and to give mutual fund providers a way of trying to preserve the assets they manage rather than watching interest in regular mutual funds disappear over time.
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