The distinct line between mutual funds and exchange-traded products has begun to blur. A new breed of non-transparent, actively managed exchange-traded products have begun trading—or will likely soon hit the market—with a structure that blends the merits of active management with an expense structure that’s more closely aligned with passive management.
These new products hold great appeal to mutual fund companies because they enable active managers to adjust their portfolios without providing daily updates on portfolio holdings. Fund providers are worried that exposing active mutual fund portfolios to daily disclosure in an ETF wrapper—which is needed for intraday trading—runs the risk of front-running by professional traders such as hedge funds.
The Securities and Exchange Commission has been slow to sign off on the concept of non-transparent active ETPs. Precidian Investments, for example, has sought to launch its ActiveShares platform of funds, but repeated applications were rebuffed by the SEC. Regulators were concerned that the pricing methodology, known as “verified intraday indicative value” (VIIV) was not a precise enough way to calculate share prices. The SEC had further concerns that insiders may have access to portfolio moves in real time, which could lead to illicit trading. Precidian confirmed it was still pursuing approval from the SEC.
In August 2016, Fidelity Investments filed its own application with the SEC to operate a non-transparent, actively managed exchange-traded fund. According to the fund giant, its approach provides for a 30-day disclosure delay of the holdings. To address the SEC’s concerns about accurate intraday pricing, Fidelity would create a tracking basket comprising the proposed exchange-traded active fund’s most recent publicly disclosed holdings and representative ETFs (which mirror the current portfolio characteristics) to be published daily along with an updated measure of value of the tracking basket to be disclosed every 15 seconds throughout the trading session.
“The key point for us is that what we filed for is called an exchange-traded active fund and that it technically falls in the ETP bucket, but is not an ETF,” says Fidelity spokesman Jeff Cathie. “Our proposed design seeks to offer a single investment vehicle that blends the features from exchange-traded products with the alpha generation of Fidelity’s active management capabilities.”
He notes that Fidelity “looks forward to an active, constructive dialogue with the SEC.”
If and when Fidelity and others do get SEC approval, they will have to play catch-up to a suite of non-transparent exchange-traded products from NextShares LLC, a division of Eaton Vance. In March 2013, Eaton Vance first filed with the SEC for exemptive relief from certain provisions of the Investment Company Act of 1940 to bring its exchange-traded managed funds structure to market. (Like with Fidelity, NextShares places its funds in the ETP category.) It subsequently made four amended filings for permission to roll out these products before the SEC finally granted approval in late 2014.
In early 2016, Eaton Vance launched the first three NextShares exchange-traded managed funds. Look for more of these funds to debut in 2017.
NextShares funds offer expense ratios that fall in between those of mutual funds and ETFs, as well as other attributes.
“NextShares should always be at least as tax-efficient as mutual funds, and sometimes they will be more tax-efficient,” says Stephen Clarke, president of NextShares. These funds also have lower trading costs and need to hold less cash in reserve than mutual funds.
That’s because fund managers need not worry about share redemptions that can trigger capital gains at an unwanted time. NextShares are redeemed on an in-kind basis by an authorized purchasing agent, who agrees to buy the underlying shares in the fund. That’s a similar approach used by traditional ETFs.
A key difference between the ActiveShares approach and the NextShares approach pivots on the funds’ pricing mechanisms. As noted earlier, ActiveShares have a complex, real-time pricing process based on the current trading spreads of the underlying holdings.
NextShares funds employ net asset value (NAV)-based trading where fund shares are purchased and sold on an exchange throughout the trading day at market-determined spreads to the fund’s ending NAV on that day.
Next Phase
The NextShares team aims to encourage the adoption of these funds by a broad range of fund sponsors. “We have streamlined the effort, which should help other firms bring funds to market more quickly,” Clarke says.
He notes that the move to license the NextShares approach wasn’t just to collect royalties. “The SEC thought it was appealing that Eaton Vance wasn’t going to keep this approach all to themselves,” Clarke adds.
In addition to Eaton Vance, Ivy Funds has three products trading on the market that use the NextShares format, while Gabelli has one. As of December, 14 investment management companies were licensees of the structure, including Eaton Vance. According to an Eaton Vance spokesperson, a 15th will be added in the near future.
For its part, Eaton Vance in last year’s first quarter launched the first three exchange-traded managed funds: the Eaton Vance Global Income Builder NextShares (EVGBC), Eaton Vance Stock NextShares (EVSTC) and Eaton Vance TABS 5-to-15 Year Laddered Municipal Bond NextShares (EVLMC), which sport net expense ratios of 0.90%, 0.65% and 0.35%, respectively.