In November, Eaton Vance received something it had been working toward for four years: Securities and Exchange Commission approval to offer a new class of investment product that the firm referred to as exchange-traded managed funds (ETMFs). The product, which Eaton Vance has since rebranded as NextShares, seeks to blend the alpha of managed mutual funds with the efficiencies and cost savings that have helped grow exchange-traded funds (ETFs) into an industry that last year topped $2 trillion for the first time.
For actively managed mutual funds, it’s a space that some market participants view as an enormous opportunity. Others view it as a necessity for competing with the growth that index funds and ETFs have achieved. Still others may view it as a threat.
“To me the bigger [concern] is not the short-term question but the long-term question,” said Avi Nachmany, director of research, executive vice president and co-founder of Strategic Insight. “Over a longer-term horizon, call it five years, in 2020 will we look back and say this is really a transformative innovation in the experiences of actively managed investments?”
One sign of whether actively managed exchange-traded products have the potential to be game-changers is a look at the players lining up to enter the game. Boston-based Eaton Vance, which has $296 billion in assets under management, has already licensed its NextShares to American Beacon Advisors, with $57.2 billion AUM, and GAMCO Investors, founded by famed investment manager Mario Gabelli, with $46.9 billion AUM. Stephen W. Clarke, president of Eaton Vance’s Navigate Fund Solutions, the unit set up by the firm to commercialize NextShares and take them to market, told Traders that other licensees are forthcoming.
Meanwhile, Precidian Investments has a competing proposal for a product with similar benefits constructed around a different concept. Precidian had licensed its ActiveShares to BlackRock, State Street, American Funds and Invesco Powershares. When the SEC indicated in October that it would not approve the Precidian structure, based around a concept of a blind trust, Precidian, and others who had submitted applications based on the model (including BlackRock and American Funds), withdrew their application.
One month after the SEC’s rejection of the Precidian model, when news broke that Eaton Vance’s NextShares would be approved, market observers reacted with shock, sending shares of Eaton Vance up 17 percent to their highest level in nearly seven years.
Precidian has since resubmitted its ActiveShares filing, while the others seem to be taking a wait-and-see approach. American Funds received approval for actively managed exchange-traded products in early February, but that was for transparent funds that disclose portfolio holdings and don’t carry the benefits of protecting investment strategy that NextShares and the proposed ActiveShares offer. “It’s important to stress we have no plans in the near future to offer active ETFs of any kind,” American Funds spokesman Tom Joyce said.
The Seeds of an Idea
The genesis of NextShares dates back to November 2010, when Eaton Vance acquired Managed ETFs LLC, a firm co-founded by Gary Gastineau and Todd Broms. Along with that acquisition, it acquired a number of patents that included one for the net asset value (NAV)-based trading that is at the heart of NextShares.
What makes NextShares unique in the market is that unlike ETFs, NextShares are non-transparent, which means active fund managers, like mutual funds, will not have to disclose their daily holdings. Daily disclosures are a sticking point for active mutual fund managers because they give rise to fears that active strategies will be front-run. This is the key reason ETFs are index-fund-based.
“I think it’s pretty well understood that ETFs have performance and tax advantages when compared to mutual funds,” Clarke said. “Until the advent of exchange-traded managed funds, the only way to access those performance and tax advantages was through daily transparent ETFs, which most active fund managers have avoided because of the requirements to disclose their holdings on a daily basis.”
In lieu of daily disclosures, NextShares will follow mutual fund disclosure requirements, which are typically on a monthly or quarterly basis, usually with a lag. Critically, the reason daily disclosures are required for ETFs is to promote tight arbitrage between the trading price of the ETF and the net asset value of the fund. In NextShares’ NAV-based trading model, market-makers aren’t taking on intraday risk because all pricing is based upon end-of-day net asset value, Clarke explained. “Market-making is simpler and doesn’t require holdings disclosure to operate effectively,” he said.
The first phase of moving the concept of NAV-based trading from a series of patents purchased in late 2010 to an approved product that is preparing to launch involved in-depth conversations with regulators. “I would describe the early stages of development as a period when we initiated a dialog with the staff of the SEC and began working together to educate them about the concept while learning about the issues they were interested in understanding more fully,” said Clarke, who was hired as president of Navigate Fund Solutions
in 2011.
The first meetings with the SEC took place that year, Clarke recalled, describing an ongoing constructive dialog that continued for many months before the initial filing was made. “It was a lengthy period, by design, and a thorough process of working with the staff,” he told Traders.
Laying Down the Rails
Flash forward a few years, and the firm is engaged in laying the foundation for the launch of NextShares, currently targeted for the third quarter. The groundwork involves a multi-pronged effort to present the concept to multiple different constituents in the market.
“We are working with fund sponsors, the Nasdaq stock market, broker-dealers, market-makers, financial advisors and other industry partners to introduce NextShares to the marketplace,” Clarke said.
Nasdaq is NextShares’ partner stock exchange. NextShares will be listed on Nasdaq, and at least initially the exchange will be the exclusive trading venue for the products, though over time other exchanges may eventually trade NextShares as well under unlisted trading privileges.
“We have been working with Nasdaq for three years to develop a centralized trading capability to support NAV-based trading,” Clarke said, adding that Nasdaq is making final adjustments and preparations to support the trading of NextShares later in the year.
Market-makers will need to be on board, too. Similar to ETFs, NextShares will rely on “authorized participants” to create and redeem the baskets of shares that make up NextShares. The process will have certain differences, however. For example, the actual creation basket will not necessarily be the pro-rata representation of the portfolio. To give managers flexibility to protect confidential trading information, the basket is only required to hold the current holding of the fund, but not on a pro-rata basis.
“The creation-redemption process is similar for ETFs and NextShares, and the people who are engaged in this effort are the same, but the market-making activity is different because NAV-based trading is different,” Clarke pointed out. Navigate has been introducing the ETMF concept to major players who make markets in exchange-traded products for three years, Clarke said, adding that the concept has been warmly received because “trading is a simple and reliable profit opportunity for market-makers.”
In terms of reaching investors, broker-dealers will play a pivotal role in the process. Unlike mutual funds, where an investor can transact directly with a fund, NextShares are exchange-traded products, which means investors will need a broker to trade them.
“Broker-dealers are critically important components of the ecosystem that will support trading of NextShares, and as a result, working with broker-dealers has been one of our top priorities,” Clarke said.
Much as Nasdaq has made adjustments to accommodate NextShares trading, broker-dealers will need to make some system adaptions to support the NAV-based trading model as well.
“We have been educating broker-dealers about what the new structure is and how it works, and developing approaches customized to how it would best be implemented within their operating environment,” Clarke said.
Clarke added that broker-dealers universally appreciate the better-performing, more tax-efficient structure of NextShares and its benefits for investors. What broker-dealers want to know is whether the product will be offered by leading fund sponsors. Navigate is working hard to introduce the product structure to fund sponsors to increase the number of licensees and boost the associated interest from the broker-dealer community.
It’s this process of coordinating the sale of a concept on several fronts that can be the most arduous and challenging aspect of launching a new product. “This is not a conversation about one company with one idea; it’s a conversation about whether there is significant adoption across a large number of investment management firms to adopt this type of technology I call active fund 2.0: the ability to deliver the benefits of active and the cost and tax advantages of ETFs,” said Strategic Insight’s Nachmany. “This is not something that happens and very quickly changes the industry; there are certain levels of operational complexity.”
It’s hard to tell how quickly or evenly the financial community will react. Christine Jockle, executive director of corporate communications for Morgan Stanley Wealth Management, said the firm had “no immediate plans” to offer exchange-traded managed funds. However, at Bank of America Merrill Lynch, Jason Crosby, global head of portfolio product distribution, confirmed that the firm is on board.
Crosby said that BAML supports initiatives that “promote product expansion and innovation,” adding: “We are working through the operational requirements to offer NextShares exchange-traded managed funds to our clients when available.”
A Coordinated Attack
To make the greatest impact with investors, Navigate is hoping to coordinate the rollout of NextShares in conjunction with quality licensees.
“We expect Eaton Vance, our parent company, and all the other fund sponsor licensees to begin introducing their investment strategies in this structure to the marketplace in a coordinated fashion, where the NextShares concept would be introduced to investors in a common voice,” Clarke said. “We would be working together to educate the marketplace about the structure, but the fund sponsor would be speaking about its own capabilities in its own voice.”
The NextShares concept is applicable to all asset classes, according to Clarke, and a look at the firms that have gone public with plans shows that NextShares promises to covers a wide swath of asset classes. Eaton Vance filed paperwork to offer 18 funds, broadly representative of the company’s mutual fund investment strategies. The 18 Eaton Vance NextShares funds include U.S. equities across all capitalization sizes; international equities from developed, emerging and frontier markets; taxable bonds; tax-free bonds; and alternative investments in a global macro portfolio that invests mainly through the use of derivatives American Beacon Advisors has five funds planned for its initial NextShares launch, covering different types of equities and equity-related products including mid-caps, large caps and global equities as well as emerging markets. GAMCO could not be reached.
A coordinated launch, Clarke said, would enable multiple funds to reach different pockets of the investment community through a variety of channels.
“Different fund sponsors have different ways of selling their products – some go direct, some have a wholesaling force that works with intermediaries and financial advisors. We are talking to a variety of fund sponsors that have different ways of distributing their funds, so there is no prescribed method for bringing your fund to market,” Clarke said. “Each fund will operate in a way that leverages its own strengths.”
The end goal of reaching investors could wind up being achieved through a coordinated trickle-down effect from different funds reaching through the network – or, as Nachmany envisions, interest might trickle up from another direction.
“On the mutual fund side, on the question of adoption from traditional brokers, etc., I think a lot of it could happen because the financial advisors will demand it from their parent company,” he said. “This is clearly better for the clients of those financial advisors. Transformative experiences evolve over time.”
