PMC Weekly Review – May 28, 2019

A Macro View: Is the antiquated mutual fund structure coming to an end? 

Actively managed mutual funds have been under fire as exchange-traded funds (ETFs) have exploded over the past decade, with investors moving to low-cost solutions that track indices. A primary reason is the more favorable tax structure that ETFs provide investors, whereas mutual funds must pass on gains to the end investors, which becomes especially painful when the funds deliver negative performance as well. The approval of a new, nontransparent ETF structure will finally level the playing field is about to become more level with the approval of a new non-transparent ETF structure.

After enduring over five years of postponements and denials, Precidians’ ActiveShares received final approval by the Securities and Exchange Commission this week. ActiveShares’ nontransparent structure is an evolution for active asset managers’ ability to provide their products to investors in a more tax-efficient and low-cost manner. Many of the large asset management firms, including BlackRock, Capital Group, JP Morgan, Nationwide, Gabelli, Columbia, American Century, and Nuveen, all have embraced Precidians’ new structure through licensing agreements.

As ETFs continue to garner most of the asset flows (due to their low-cost, tax-efficient structure), many asset managers have clung to the antiquated structure of mutual funds. One reason many asset managers have done so centers on the transparency of ETFs. Asset managers have long argued that their strategies would be negatively affected if they had to provide daily transparency of their portfolio holdings. The asset managers’ ‘secret sauce’ would be illuminated for all to see and could be exploited by savvy investors front running their trades. Under the current rules for mutual funds, asset managers report their portfolio holdings only quarterly, so investors do not know what the portfolio holds on a daily basis. Although these concerns might be valid, Davis Advisors entered the ETF business in 2017 with four strategies that are mostly clones of existing mutual funds and have had no issues regarding daily transparency and front running to date. 

Whether investors will adopt the nontransparent active ETF structure in the manner in which they have embraced traditional ETFs and the transparency they provide remains to be seen. Traditional ETFs’ openness has enabled investors to make more effective asset allocation decisions by knowing exactly what is inside the portfolios. Additionally, investors have accepted passive management, as they have been inundated with evidence that active managers have not outperformed their respective market indices to generate alpha. Fees are another headwind, as investors have become accustomed to the deluge of cheap beta exposure that is available via ETFs. Even under the ActiveShares structure, active management will continue to be a pricier option given the number of resources needed for fundamental bottom-up research. Despite a more efficient structure, active managers must overcome these issues if they are to compete effectively in the current investment management landscape. 

Thus far, Eaton Vance, through its NextShares product, has been the sole provider of nontransparent active ETF’s. Eaton Vance launched NextShares in 2016, but has had a difficult time amassing assets due to an inferior structure. Eaton Vance tried to block the approval of ActiveShares at the last minute in an attempt to stifle the competition. Besides Precidian and Eaton Vance, asset managers like T.Rowe Price and Fidelity Investments, along with others are working on similar structures as asset managers are looking for new ways to drive asset flows and become more competitive in a more passive world. It appears that many asset managers see the new non-transparent structure as their panacea, but unless they can deliver on investors’ performance expectations, they will continue to see outflows. 

The jury is still out on whether nontransparent active ETF’s can help active asset managers compete more effectively in the current environment, but the new structure is a step in the right direction. ActiveShares combines the benefits of the ETF wrapper with active management while also protecting portfolio managers’ intellectual property. Ultimately, the fate of active asset managers lies in their ability to provide consistent excess returns with lower risk at a reasonable cost. In the long run, investors will be the primary beneficiaries, as nontransparent ETFs provides them with more tools for their toolbox, helps even the playing field between active and passive investments, and delivers more ability to diversify one's portfolio. 

Michael Pajak, CAIA
Investment Analyst

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