Eaton Vance has proposed a new form of fund that is a hybrid between a mutual fund and an exchange-traded fund, called an exchange-traded managed fund (ETMF).
If approved by the Securities and Exchange Commission, the investment vehicle could make it unnecessary to disclose portfolio holdings every day-and in so doing potentially reshape the mutual fund industry, which has relied on infrequent disclosure of holdings to protect the ability of managers to achieve above-average returns and avoid front running.
ETMFs provide many of the cost-savings benefits of ETFs, but in order to make the mechanism attractive to active portfolio managers, ETMFs have been designed to disclose their holdings at the same frequency as mutual funds. Like mutual funds, "all ETMFs will disclose their holdings in full at least once quarterly, with a lag of not more than 60 days," according to Eaton Vance's filing.
This protects good managers from having their strategies mimicked, daily. "A good portfolio manager values the research that they've done in terms of determining which securities they want in their portfolio and the idea of having to reveal changes every day doesn't work for them," said Gary Gastineau, principal at ETF Consultants.
Gastineau, along with his partner Todd Broms, developed the structure for ETMFs and sold the patents to Eaton Vance in 2010. They "continue to work with the fund firm and have an interest in the development, launch and success of the product," Gastineau said.
Another difference from ETFs is that ETMFs will trade at prices based on a net asset value that will be determined at market close each day. "Because ETMFs will trade at prices based on their NAV, investors will be able to buy and sell shares at a known premium or discount to NAV," and benefit from trade execution cost transparency, according to the filing.
"This feature of ETMFs distinguishes them from ETFs, whose shares can only be purchased and sold in the secondary market at prices whose variance from underlying portfolio value normally is not known to individual investors and cannot be controlled by them," according to the filing.
If you buy shares at the NAV plus a penny, then your transaction cost is a penny a share for that fund, Gastineau noted. "In the traditional ETF, where you have a value every 15 seconds but you don't know what the value is the moment that you transact it, you wouldn't know what your cost of trading was. And so with ETMFs you don't have the transparency of the portfolio of an ETF but you have transparency of cost," he said.
Because they are traded in the secondary market like ETFs, ETMFs also would offer lower expenses in terms of the costs associated with accommodating shareholders' inflows and outflows, according to the Eaton Vance filing. The cost to investors of mutual funds for providing this liquidity averaged 75 basis points a year over 1995-2005, according to an academic paper by Roger Edelen, Richard Evans and Gregory Kadlec cited in Eaton Vance's filing. But with the ETMF structure, those costs would be isolated to purchasing and redeeming shareholders.
"The costs of accommodating (mutual fund) shareholder flows have two main components: (a) the trading costs (commissions plus market impact) incurred by the fund in connection with securities transactions to resize its portfolio positions in response to growth or shrinkage in fund shares outstanding ("flow-related trading costs") and (b) the foregone returns on portfolio cash held for flow-related reasons ("cash drag"), according to the filing.
With ETMFs, on the other hand, "flow-related fund costs will be substantially offset by imposing transaction fees on each creation and redemption of shares, sized to cover the estimated cost to the ETMF of processing the transaction and converting the basket to the desired portfolio composition," the filing says.
ETMFs would also offer reduced transfer agency costs, according to the filing.
While transfer agency costs for mutual funds average 19 basis points for retail mutual funds and 8 bps for institutional mutual funds, ETMFs, like ETFs, would have transfer agency costs of less than 1 basis point of net assets annually, according to the filing.
"The purpose of this is to create an investment that works better for long-term investors because the transaction costs associated with getting into and out of the fund are born by the people who are getting in and out," Gastineau said.
A Family of ETMFs
If its application to the SEC is approved, Eaton Vance plans to launch a family of ETMFs that mirror existing Eaton Vance mutual funds.
Asked how the ETMFs will be marketed against the firm's existing mutual funds, Stephen Clarke, president of Navigate Fund Solutions, an Eaton Vance subsidiary, said, "investors will determine which features are more desirable for their needs." Longer-term investors would likely opt for an ETMF while shorter-term investors would remain in a mutual fund, he said.
The licensing fee charged to investment management firms will likely be in the single-digit basis point range, based on assets under management, Clarke said.
Asked if there were any sticking points in discussions with the SEC about the ETMF concept, Clarke said, "We were encouraged enough by our conversations with the SEC to file."
Separately, BlackRock filed in Sept. 2011 for permission to offer a variation of an ETF that would also not report contemporary portfolio holdings. Gastineau said that the Eaton Vance structure is different. For instance, the Blackrock model does not provide for NAV-based trading as ETMFs would, he said. A spokeswoman for Blackrock declined to comment.
Impact on Mutual Funds
If the SEC approves the Eaton Vance proposal, there may well be a large shift of mutual fund assets to the new model. "I can't see any reason why anyone other than someone who wants to be a short-term trader would want to invest in mutual funds instead of ETMFs. If the world was rational there would be no more mutual funds," said Gastineau.
Avi Nachmany, director of research for Strategic Insight, said that the tax benefits of ETMFs, like those of ETFs, would give active funds a new value proposition for investors concerned about paying taxes on capital gain. Last year for equity funds that paid capital gains, the effective gains were about 2.8%, Nachmany said.
"Like ETFs, ETMFs that utilize in-kind distributions of securities to meet redemptions could largely avoid this adverse tax effect," the filing says.
But Ben Johnson, director of passive funds research at Morningstar, said that the lack of portfolio transparency might prevent market makers from buying into the idea of ETMFs and participating. "We'll have to see what this looks like in practice once you get these products in a live trading environment," he said.