The SEC recently approved a new type of actively managed Exchange Traded Product (ETP or ETF) for NYSE-listed global investment giant, Eaton Vance. While the fund will be branded as NextSharesTM, those in the investment world know it more commonly as an ETMF, or Exchange Traded Managed Fund — a hybrid of an actively managed ETF and a mutual fund.
Since the approval of NextSharesTM, several other fund companies have licensed the concept and received exemptive relief for the structures. However, while ETMF issuers are gaining SEC approval, and investor interest, the timing of when investors will actually find them listed on an exchange is still uncertain.
Currently, passive ETFs are the go-to when it comes to ETF investing, following a passive investment strategy by attempting to replicate an index. Conversely, an actively managed ETF, not as commonly used, is a fund traded on an exchange that does not follow a stated passive index; instead, fundamental research and investment strategies give the portfolio manager flexibility to buy and sell securities throughout the day.
Fund companies have been aggressive in trying to bring more actively managed ETFs to the marketplace for two primary reasons: lower cost and better tax efficiency. Overall, the structure of an actively managed ETF is less costly than an actively managed traditional mutual fund because it is traded directly on an exchange. From a tax perspective, the structure allows market participants to buy and sell ETFs by creating and redeeming units that are principally transacted in-kind, providing a very efficient tax structure. Creation units, the mechanism used to buy and sell shares directly with the ETF, generally consist of 50,000 shares and are created and redeemed with a basket of securities — therefore generating no capital gains for tax purposes.
A significant hurdle for actively managed ETFs to gain more traction is the market demand to provide transparency into the portfolio holdings on a daily basis. Market participants require this transparency so that they can accurately price ETF shares as they trade on the exchange throughout the day. The daily requirement is far more frequent than traditional mutual funds, which only disclose their holdings quarterly.
There are a couple of other challenges for actively managed ETFs currently in the marketplace. Daily disclosure of the ETF portfolio opens the ETF up to the potential for investors to “front run” the portfolio and participate in the investment strategy without incurring investment advisor fees. Additionally, there is the potential for investors to arbitrage the actively managed ETF. This would allow an authorized participant to purchase the shares of the ETFs that are mispriced on the open market, redeem them to the ETF in-kind and receive the actual net asset value (NAV) of the portfolio.
An ETMF, which serves as a hybrid between a traditional mutual fund and an ETF, removes some of the challenges and downsides of its relatives. ETMFs will be listed and traded on an exchange similar to an ETF, but it will be actively managed and will trade throughout the day based on the NAV at the end of the trading day, plus or minus a trading cost. ETMFs also will not be required to disclose the portfolio throughout the day. The orders will be tallied at the end of the day, when the ETMF will price its NAV based on the value at the close of the market, plus or minus a premium or discount when the trade occurs.
The benefit of these new products is that the investor can invest in an ETMF that has the same benefits of a traditional mutual fund, including active management; a wide range of investment strategies and none of the risks mentioned above of the actively managed ETFs currently on the market. In addition, the ETMF will in theory have the same tax efficiencies as an ETF. It will also have a lower cost structure than traditional mutual funds because the investor can buy the product directly through an exchange, eliminating the fees mutual fund intermediaries currently charge.
All of the potential benefits of an ETMF will depend on the exchanges’ ability to complete the 19b-4 process. SEC Form 19b-4 is used to inform the SEC of a proposed rule change by a self-regulatory organization (SRO) pursuant to Rule 19b-4 under the Securities Exchange Act of 1934. In the case of the ETMF, the exchange that the ETMF will trade on needs to file this form with the SEC’s Division of Trading and Markets to be approved to list the security on their exchange.
However, to date none of the new ETMF products approved by the SEC have received their 19b-4 approval. This is because the exchanges still need to upgrade their systems and technology to accept the orders throughout the day based on a “proxy” price (since the portfolio will not be released throughout the day, and the price will not be determined until the closing of the market).
The ultimate benefits of ETMFs aren’t clear for both investors and advisors. It will take some time, but the sponsors and, for now, NASDAQ are working to solve the logistical and operational challenges so ETMFs will likely soon become a viable option for investors’ portfolios.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.
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