Eaton Vance (NYSE: EV) subsidiary Navigate Fund Solutions is working on an ETF-like wrapper for active mutual fund managers. The structure is called exchange traded managed funds, or ETMFs, and would not disclose its holdings daily.
“Their edge: a claimed 50 basis point advantage over the traditional mutual fund cost structure. While they still need regulatory approval and industry buy-in, this is a sufficiently important development,” says Nicholas Colas, chief market strategist at ConvergEx Group.
The trend to index-tracking ETFs and away from active equity mutual funds “has been tough on fund companies with no ETF offering,” he said in a note Wednesday.
According to SEC filings, ETMFs would act as a new type of open-end fund that provides confidentiality of the current portfolio holdings while maintaining the cost and tax efficiencies and protections associated with ETFs. [Eaton Vance Proposes New Active ETF Structure]
“The primary advantage of ETMFs is that its structure is consistent with how most active managers like to manage money. This would not require the same level of transparency of holdings,” Thomas Faust, chairman and CEO of Eaton Vance, said in an Ignites.com report earlier this year. “Anything you can do in a mutual fund you can do in an ETMF.” [Newfangled ETFs from Eaton Vance Would Deter Frontrunning]
ETMFs are designed to disclose their holdings in full at least once quarter with a lag of not more than 60 days, according to a report from Traders Magazine. ETMFs would trade at prices based on the net asset value at the market close each day. [ETMFs Could Change the Fund Industry]
Colas says ConvergEx attended a briefing this week from Navigate Fund Solutions on ETMFs. Here are some of the takeaways from his note Wednesday:
- According to Navigate, ETFs have a 50 basis point cost and performance advantage over mutual funds. This stems from lower operating costs (no transfer agency to pay) and better investment returns (no need to hold cash for redemptions). Moreover, this number is conservative, since ETFs do not pay sales fees or offer ongoing payments to the financial advisor who buys the product on behalf of their client.
- Mutual fund managers are typically gun-shy about offering the 100% transparency common to passive ETFs. They worry that hedge funds will scour their daily records and front run their trades or competition will offer their strategy at a reduced price. The ETMF structure which Navigate is assembling will allow active managers to only show part of their book, even as they provide regular intra-day net asset values to allow investors and traders to know the underlying value of their portfolio.
- Trading will occur during the normal 9:30am to 4:00pm hours, just like ETFs, but all trades will get the closing price plus or minus a small discount/premium. That is meant to entice brokers to make a market in these securities throughout the day.
- Rather than money managers getting capital from investors to then allocate, ETMFs will have the facility to go through the usual create/redeem process common to ETFs. Want to buy $100,000 of a mutual fund, ETF-style? Place the order with a broker, who then buys the 90% of the portfolio they know … delivers these stocks to the fund company along with the 10% cash stub, and you have your shares at the close.
Next page: More on ETMFs
More from the ConvergEx note Wednesday:
This all sounds pretty benign and maybe a little too technical to really be interesting, but make no mistake: this is potentially a huge development for a whole range of Wall Street players. A few concluding points, with some highlights about why this merits your attention:
- The Securities and Exchange Commission still has to approve this structure. Navigate is doing the heavy lifting here, and they just filed an ‘Amended Exemptive Application’ on September 12th. No telling how long it will take to get SEC approval, but the wheels are in motion.
- Once the structure receives approval, the existing U.S. mutual fund complex has billions of dollars which can move fairly quickly. Given the headline “50 basis point” cost advantage, a typical fiduciary – bank trust department, broker, financial adviser – will have to at least take a look at swapping some of their mutual fund shares for the equivalent ETF.
- There are still a host of Wall Street players which have business models based on the existing order. Brokers rely on 12b-1 fees (those ongoing payments) for their income. Institutional brokers sell their research for commissions controlled by their mutual fund manager customers. Transfer agency services still make money for mutual fund complexes. The ETMF structure dislocates most of these payment streams. No 12b-1 fees, a create/redeem process rather than manager-controlled trading, and no transfer agency.
As I left the meeting this afternoon, some of these concerns were making their way to the floor during the Q&A period. That is textbook Innovator’s Dilemma, with many existing constituents troubled by what these changes mean for their businesses. All that will have to get worked out, to be sure, for this idea to fly.
Still, the whole arc of this discussion – ETFs, mutual funds, and the differences between the two – is important for bigger reasons than just whether a broker gets his commission check. Active management is important to a well-functioning capital market. How that happens – mutual funds or active ETFs – matters very little in the end. If mutual funds do not work out a way to respond to ETFs now, it will only get harder as time goes by.