Eaton Vance received SEC approval late last year to launch a series of actively managed, non-transparent products that will mirror the firm’s mutual funds while combining attributes of ETFs and mutual funds. This latest innovation, known as an Exchange Traded Managed Fund (ETMF), fuels speculation about the entry of other well-known mutual fund firms into the ETF business.
Active ETFs aren’t a new thing, as firms such as PIMCO, First Trust and Wisdom Tree are quick to point out. However, bond and currency ETFs dominate the active ETF category, and firms with a heritage of success managing active equity mutual funds have for the most part held back from offering ETFs.
It’s likely that Eaton Vance (EV) will be the first of many well-known firms to offer actively managed ETF-like products. Just this week, the SEC announced it will likely approve an application from American Funds to launch a series of such products by Feb. 27, while Mario Gabelli’s GAMCO Investors (GBL) said it will file with the SEC to sell ETMFs under its NextShares brand.
Consequently, in this posting we'll discuss recent developments, while offering a general framework for how to evaluate what is likely to be a steady flow of new products.
Looking for a Competitive Edge
I began writing this article in Boston shortly before the Super Bowl, preparing to go to the game with my wife, a lifelong Patriots fan. Pre-Super Bowl stories about deflation in the Eurozone were replaced by conspiracy theories about deflation of footballs, though now we know that the Patriots thrillingly beat the Seattle Seahawks in Super Bowl XLIX.
There are parallels between investing and sports, as in both arenas participants try to find advantages inside and at times outside the rules. In sports, it can involve modifications to equipment or playing fields, or advance knowledge of what the other team is going to do. In investment management, it’s not all that different.
From the early days of Wall Street, investors have sought information about the trading activity of large investors, looking at a wide variety of information to identify opportunities to trade ahead of large blocks of stock. Michael Lewis recently wrote about high frequency traders tilting the playing field in their favor, by getting trading information milliseconds ahead of other market participants.
ETFs in traditional form offer complete transparency, with market participants having real-time visibility into the underlying holdings of the ETFs. The first generation of actively managed ETFs offer full transparency as well, with real-time visibility seen as less of a negative for portfolio managers managing index funds or bond funds.
Traditional equity managers, particularly those who hold large positions in companies, have been interested in actively managed ETFs but to date have been reticent to be first movers out of fear that they would telegraph their buying and selling intentions to Wall Street traders. In that context, it makes sense for the large active equity managers to want an ETF structure that maintains portfolio holdings confidentiality, reporting holdings only monthly like a traditional mutual fund.
The Eaton Vance ETMF structure and competing approaches from the likes of Precidian and BlackRock (BLK) are attempts to provide other benefits of the ETF structure – continuous trading, low expense ratios, tax advantages – while preserving the confidentiality of the mutual fund structure.
A Less Precise Process?
There are meaningful differences in approach between new-style ETFs and the ETFs investors have grown to know and love! The Eaton Vance ETMFs will trade more like mutual funds. Buy and sell quotes won’t be in dollars and cents. Instead, during the trading day investors will see their trading cost relative to a fund’s net asset value, e. g. “NAV + $2.00.”
After the market closes, when the net asset value is determined, investors will get confirmation of the purchase price. That leaves room for ETMFs to be far less precise than most ETF investors have come to expect, and much more similar, in how they are bought and sold, to mutual funds. Another difference between ETMFs and ETFs is that ETMF redemptions will be made using “baskets” of securities, similar to current bond ETFs, rather than “pro rata slices” of portfolio holdings as is the case for equity ETFs.
ETMFs’ Primary Advantages
The Eaton Vance ETMF structure provides some advantages relative to the mutual fund format. The exchange traded structure reduces costs typically borne by mutual funds, providing potential cost savings to be passed along to investors.
We expect actively managed ETFs to have higher expense ratios than index ETFs, but lower expense ratios than corresponding mutual funds. The ETMF structure also provides tax advantages relative to corresponding mutual funds, with benefits tied to the avoidance of being forced to sell securities in response to outflows from the ETF/ETMF.
It’s important to note that the tax advantages associated with active ETFs are likely to be lower than provided by index-based ETFs. Actively managed ETFs with high investment-related portfolio turnover will be more likely to have capital gains to distribute at year-end.
Actively managed ETFs also bypass the need to maintain spare cash to meet investor redemptions, avoiding the “cash drag” often faced by mutual funds.
Questions to Ask Before Investing:
Some questions are foundational regardless of the investment vehicle to be used.
Before looking at any structural questions it’s critical to take care of the basics, such as identifying what portfolio role that you’re looking to fill, deciding whether an active or passive approach is preferable for the role, and identifying and completing due diligence on prospective investments.
With that work completed, examining differences between mutual funds and ETF vehicles becomes an extended part of the investment process.
- How will the ETF differ from the mutual fund that it is modeled after? For example, PIMCO’s ETF version of their flagship Total Return Bond Fund doesn’t use derivatives, a stark contrast with the mutual fund, which makes extensive use of derivatives. Other managers that offer ETFs that mirror mutual funds may implement trades for the mutual fund slightly differently than for their ETF. That’s not necessarily good or bad, but it’s important to understand the differences.
- What are the total costs of ownership for both products? Expense ratios are just the start of the cost story.Factoring in trading costs is a must, as trading commissions and wide bid-ask spreads on less liquid ETFs can quickly erode the cost advantage of an ETF.
- Will this fund be part of a buy and hold portfolio or will it be actively traded? As noted above, trading costs may erode the cost and tax benefits of an ETF.