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Will a New Type of Fund Give Active Managers a Fighting Chance?

Exchange-traded managed funds seek to lower the costs and increase the tax efficiency of active management.

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During the past 15 years, actively managed U.S. equity funds have suffered cumulative net redemptions of $367.8 billion, while passive domestic and international-stock funds have attracted a combined $1.89 trillion. Might the former group of funds be able to learn something from the latter?

Per  Eaton Vance's (EV) Navigate Fund Solutions unit, the answer to that question is yes. Navigate has obtained approval from the SEC to offer a new type of fund--the exchange-traded managed fund (ETMF)--which seeks to combine some of the best features of exchange-traded funds and traditional actively managed open-end mutual funds.

Navigate seeks to avoid some of the tax events that afflict--yes, afflict--traditional actively managed funds. In a traditional open-end fund, when investors redeem their shares, the fund often has to sell assets that have appreciated, creating a realized capital gain for those who remain in the fund. Similarly, when a manager sells a stock because it has reached or exceeded a fair value target, that action also often creates significant realized gains that can create big tax bills for long-term, buy-and-hold fund investors.

By contrast, ETFs often avoid these taxable events. When individual investors wish to liquidate an ETF, they simply sell it to another investor, avoiding the need for the manager to sell potentially highly appreciated shares. When a so-called authorized participant redeems shares--authorized participants are institutions that have the ability to create and redeem shares of an ETF--the ETF manager does not need to sell shares from the portfolio. Instead, the manager can simply make an in-kind distribution of shares, thereby avoiding a tax-inefficient sale. ETMFs based on Navigate's methodology will mimic this tax-efficient approach.

Stephen Clarke, the president of Navigate, said that he expects an array of ETMFs--from fund shops including Eaton Vance, Gamco Investors (GBL), American Beacon, and  Hartford Financial Services Group (HIG)--to launch late this year or early in 2016. For example, Eaton Vance has filed to provide both equity and fixed-income ETMFs.

While index-based ETFs have long offered these tax advantages, the industry has struggled to launch actively managed exchange-traded products. Indeed, the industry's initial push to offer actively managed exchange-traded products predictably foundered 15 years ago. The problem? The SEC demanded full, continuous transparency of holdings for actively managed ETFs, similar to the sort of disclosure that is available for passive exchange-traded vehicles. However, fund managers--understandably fearful that continuous portfolio disclosure would lead to front-running by traders--elected not to provide it.

Navigate's patented methodology seeks to avoid the need for continuous disclosure. Rather than trading throughout the day, Navigate-inspired funds will trade just once per day, at the close of business. Investors who enter a trade during the day will, according to Navigate, pay a slight premium to net asset value to buy shares or receive slightly less than NAV to sell them. For example, investors might agree to buy shares at a price a penny or two above the end-of-day NAV.

Because transactions in these ETMFs will occur just once per day--which is similar to how most mutual funds work--the SEC's portfolio disclosure requirements will mimic those for traditional open-end funds. That is, the SEC will mandate that exchange-traded managed funds disclose their full portfolios at least once per quarter. Authorized participants, which are responsible for creating and redeeming shares, will know what securities are in the "creation basket"--essentially what securities will be added to or subtracted from the fund on a given day--but this basket will not exactly mirror the overall portfolio.

Aside from potential tax savings, ETMFs should keep long-term investors' costs down in other ways. Traditional open-end mutual funds bear a lot of costs of investors moving into and out of funds, including transfer agency fees and trading costs related to purchases and sales within the portfolio. Existing actively managed funds also tend to hold small amounts of cash to meet potential investor redemptions. Over long periods of time, the stock market tends to rise, so this cash creates a drag on returns. Including the 12b-1 fees that many funds charge, these combined extra costs may subtract more than 70 basis points per annum from traditional open-end funds' returns, according to a study by Navigate. You do not have to agree with Navigate's precise calculation to recognize that these costs are real and could negatively affect investors' long-term returns. (See Jack Bogle's recent Financial Analysts Journal article for another comprehensive effort to quantify the avoidable costs of the current roster of actively managed funds.)

Given that ETMFs will be a new product type, their success is not assured. Fund firms that sponsor these funds will need to engage in a lot of investor education, just as ETF sponsors did when those funds were new. Exchange-traded managed funds will not appeal to investors who seek to trade more frequently, nor will some index aficionados find them attractive. For ETMFs to be successful, a number of market participants and financial-information providers will ultimately need to make changes to their systems to accommodate these new product types. (Navigate has established an implementation team to work on these issues.) Finally, the fund firms that will initially launch ETMFs are solid, but they don't have the cachet and heft of industry heavyweights like Vanguard or  BlackRock (BLK).

Despite those hurdles, I am cautiously optimistic that exchange-traded managed funds will ultimately attract meaningful assets. ETFs have prospered because, for many people, they are superior to traditional mutual funds. Similarly, if implemented skillfully, ETMFs should have significant advantages over currently available actively managed options. As such, they should provide meaningful benefits to investors and may give active managers more of a fighting chance in their competition with passive strategies.

Scott Cooley does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.