Photographer: Luke Sharett

Three Hurdles for the New Breed of ETFs Launching Today

Mutual funds create their own version of exchange-traded funds

After all these years, actively-managed mutual funds have finally found a way to have their cake and eat it too when it comes to exchange-traded funds that have long been taking a bite out of their business.

The question is, is it too late?

Eaton Vance Corp. today will launch the first-ever non-transparent actively-managed ETFs. Their new creation is called an exchange-traded managed fund (ETMF) and goes under the brand name NextShares as seen in the picture below.

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Photographer: Balchunas, Eric

 

ETMFs work just like regular mutual funds where you buy into the fund at the net asset value, or NAV, at the end of the day. The twist is that you can now buy it on an exchange anytime during the day and lock into that end-of-day NAV plus or minus some amount. It is called NAV-based trading.

The new product finally opens the door to the ETF world for many of the big mutual fund names—such as Hartford Funds and Gabelli Funds LLC. These firms–along with about a dozen others have licensed the structure from Eaton Vance and will now be able to get all the advantages of the exchange-traded wrap, such as lower costs and tax-efficiency, without having to show their holdings daily.

But will it matter? After all, actively-managed ETFs that do show their holdings daily have been around for well over half a decade and they have only raised $23 billion in assets, which is only about 1 percent of the $2 trillion in ETFs outstanding. Just ask mammoth fund companies Franklin Templeton Investment Funds or Fidelity, who have less than $500 million combined in their active ETFs despite the fact that some of those funds have outperformed.

Pacific Investment Management Co. has been a rare bright spot when it comes to active ETFs, but even it has had relatively small success with about $7 billion in active ETF assets after five years. Many of these big mutual fund companies came to power in the 1980s and 1990s when mutual fund portfolio managers became stars and the money came in through 401k plans like fish jumping into a boat. It didn’t matter that the many of the funds had high fees and underperformed.

Meanwhile, the ETF industry has changed the game entirely through tremendous innovation and cutthroat competition—in both design and fees. Here are three trends that ETMFs will have to grapple with if they are to gather assets from ETF-minded investors.

1. Vanguard and the Rise of Passive Investing

The Vanguard Group Inc. isn’t new per se, but their dominance certainly is. Vanguard is now eating up ETF dollars like Pac-Man at a power pellet factory. Even in a year marked by outflows, Vanguard has raked in $7 billion. Vanguard is the antithesis of traditional actively-managed funds and has tapped into a strong trend for passive investing. Last year, passive investment vehicles took in about $400 billion while active lost about $150 billion.

2. Out- Smarting Smart-Beta 

Of course there are some ETF investors who are looking to beat the market. But, many of them have been choosing smart-beta ETFs over actively-managed ETFs to do so. The term 'smart-beta' describes rules-based ETFs that use something other than market cap (aka ‘beta’) to select or weight their holdings. By selecting or weighting stocks on factors such as dividends, volatility, value or momentum, smart-beta ETFs have essentially packaged up the market-beating strategies of active managers into a low-cost and passively-managed vehicles for half or a third of the cost.

Smart-beta ETFs have approximately $400 billion in assets, or 20 times that of actively-managed ETFs. With 20 percent of the $2 trillion in ETF assets, smart-beta ETFs fill the giant canyon that exists between active and passive and that’s bad news for the former group because it cuts right into their target market.

3. ETF Managed Portfolios Are Another Competitor

Another new alternative to active mutual funds are ETF managed portfolios. These are all-ETF portfolios run by asset managers, sometimes called ETF strategists. These off-the-shelf solutions are being used by advisors to achieve goals that they may once have used an active mutual fund for. There are over 600 of these managed portfolios from roughly 150 firms with assets of north of $70 billion, according to data from Morningstar Inc.

The good news for ETMFs is they should appeal as a better, cheaper deal for existing mutual fund investors and could intercept some of the money that may have been going over into ETFs. After all, there is over $10 trillion invested in stock and bond mutual funds and some of that may follow these firms into their ETF structure and into their own brave new ETF world.

Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. This piece was edited by Bloomberg News.

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