The splash ETFs made when they hit the market in the 1990s displaced a lot of mutual fund market share.
That is because investors have voted with their dollars for exchange-traded funds’ tax-efficient structure, lower cost, transparency and tradability.
Two decades into the ETF era, actively managed mutual funds, which made up 95% of the market in 1998, now total just 76% of the fund market, with ETFs now neck and neck with passively managed mutual funds, each holding a 12% market share, according to the Wall Street Journal.
Attempts to combine the advantages of active stock selection with ETFs’ favorable structure continue apace through actively managed ETFs.
But progress has been slow, with active ETFs amounting to little more than 5% of assets since the first active ETF launched five years ago.
A key reason for the languid pace? ETFs’ vaunted transparency.
Top active managers want to shield their portfolio decision-making from copycats, something hard to do with ETFs, which reveal trades daily, unlike mutual funds, which need not disclose their holdings more than once a quarter.
A potential breakthrough may be at hand, however, as a small startup with a big backer — Navigate Fund Solutions, a wholly owned subsidiary of Eaton Vance — is shepherding what it calls exchange-traded managed funds (ETMFs) through the SEC approval process.
“This is a way to deliver active strategies with better performance and improved tax efficiency,” says Stephen Clarke in an interview with ThinkAdvisor.
Clarke is trolling the halls of the Morningstar Investment Conference to make the case that a better mousetrap exists for investors who prefer actively managed funds.
If Clarke can convince the Securities and Exchange Commission, financial advisors and retail investors of ETMFs’ virtues, then the fund market may once again take on a different shape as it did with the advent of ETFs.
The reason for ETMFs’ “better performance,” according to Clarke, is that “the horse is carrying a lighter jockey.”
The portfolio depends entirely on the manager’s investment selection, but “if you put the same portfolio in a mutual fund and an ETMF, the ETMF ought to outperform the mutual fund based on its lower operating costs and improved trading efficiency,” Clarke says.
What would this mean to advisors who prefer actively managed mutual funds?
“I would estimate a difference of 50 basis points of annual performance improvement,” Clarke says.
So a standard advisor-sold mutual fund whose expenses average 120 basis points, but which could go as high as 220 basis points depending on share class, could see its cost shrink to 70 basis points.
That’s still higher than the estimated 20 basis points of a similar ETF, but, again, ETMFs are meant to compete with existing mutual funds.
The cost advantage stems from applying aspects of the ETF structure while — in contrast to active ETFs — retaining the mutual fund’s portfolio confidentiality.
By using the same trade settlement structure as ETFs, ETMFs reduce transfer agency costs from an average of 19 basis points in a mutual fund to less than a basis point in the exchange-traded format.
Administrative and regulatory fees would remain the same, as would management fees, but recordkeeping costs would be materially reduced and 12b-1 fees would be completely eliminated. (ETMFs would thus be most suitable for advisors paid through AUM-based fees rather than B-share commissions.)
The most significant cost reduction, however, stems from eliminating the burden of accommodating shareholder inflows and outflows. Currently, mutual fund managers have to raise cash to fund redemption requests, often having to sell shares and realize capital gains in the process.
By using ETFs’ system of issuing and redeeming shares in kind, ETMFs eliminate a chunk of mutual funds’ cost structure, as well as addressing the “cash drag” of having to maintain a level of uninvested shareholder cash to meet potential redemption requests.
This ETF-style shareholder flow process accounts for most of the 50-point advantage ETMFs have over mutual funds.
“We approximate that improvement at 30 basis points — that’s a conservative expression of the likely performance advantage of eliminating cash drag,” Clarke says.
Advisors who find Clarke’s case convincing need not confine their choice of managers to Eaton Vance nor need fund managers who like ETMFs be employed by the Boston-based fund firm.
Perhaps shrewdly, Eaton Vance created Navigate Fund Solutions as a separate entity specifically in order to market the new mousetrap across the mutual fund industry, to gain broad acceptance for the concept as well as generate additional revenue.
The fund firm did not invent the ETMF.
The idea was rather the brainchild of ETF consultant Gary Gastineau, who patented what he called “NAV-based trading,” and then sought regulatory approval from the SEC.
The SEC advised Gastineau that he needed a mutual fund partner. Seeing merit in the idea, Eaton Vance acquired the intellectual property from Gastineau, who remains a consultant to Navigate.
Clarke’s task now is threefold.
He must see the ETMF through the regulatory approval process. An exemptive order application was filed in March 2013 and awaits a vote of the SEC commissioners granting the order. Simultaneously, the SEC division of markets must approve listing and trading standards filed by an exchange; Eaton Vance’s partner exchange, Nasdaq, filed that so-called 19b-4 document in February.
Clarke, while “careful and respectful” of the process, says he is “optimistic enough” about approval prospects.
Once approved, Navigate’s second step will be to, “in partnership with Eaton Vance, introduce a family of ETMFs that mirror the capabilities that Eaton Vance offers in mutual funds.”
Step three will be the full commercialization of the concept through licensing the intellectual property to other fund companies.
Clarke calls advisor education a critical component of the success of ETMFs, and says Eaton Vance wants to “link arms” with its competitors to that end.
“It’s much more powerful to [educate advisors] with a consortium of firms than to try to do it alone,” Clarke says.
Eaton Vance is holding discussions with its broker-dealer distribution partners and spreading the word through the Nasdaq and its market maker partners. And Clarke, of course, is making the rounds at the Morningstar Investment Conference.