In a March 2019 blog titled ETFs – Looking into the future, I referenced an earlier blog post from February 2018, ETFs: An industry in flux. I wrote in this earlier blog that, subject to regulatory approval, I hoped to see a great deal of product innovation in 2018—namely actively-managed, non-transparent ETFs. Well, it seems that at last, and better late than never, the SEC has finally given conditional approval to one strategy: Precidian’s ActiveShares. This is great news for active managers, especially equity managers, who have long wanted to make certain strategies available to investors in an ETF wrapper. Unfortunately, and somewhat to my surprise, they did not approve several other similar structures at the same time—notably applications from Blue Tractor’s Shielded Alpha, Fidelity and T. Rowe Price, among others. For Precidian and investment managers such as BlackRock, Legg Mason and JP Morgan, which have licensed Precidian’s methodology, this is basically the SEC giving them a head start. One of these groups will likely be first to market; perhaps an offering from Legg Mason, given they acquired a stake of Precidian in 2016 and have been waiting patiently for approval. In any event, for those readers with an interest in the underlying mechanics of these structures, and terms such as “verified intraday indicative value” (VIIV) and “AP Representative” (APDR), I invite you to look at a recent whitepaper from my colleagues at ALPS titled, Non-Transparent Exchange Traded Products: A Revolution 25 Years in the Making.
I am eager to see a head-to-head competition—not only to determine once and for all whether these structures will work (something that is by no means guaranteed), but also to witness the potentially disruptive effect that these new wrappers may have on the investment and wealth management industry. For example, in much the same way that cheaper Collective Investment Trusts (CITs) are gradually cannibalizing mutual funds in the 401(K) market, I believe active, non-transparent funds may have a similar impact, but this time in the fee-based advisory world. “Why,” you might ask? Because while we know ETFs are more tax efficient, strategies offered in an ETF wrapper are, similar to CITs, likely to be cheaper than the equivalent mutual fund version. Simply put, ETFs don’t have underlying fees like 12b-1’s, transfer agent fees or sub-TA fees, and nowadays in the absence of some other extraordinary factor, and all other things being equal (i.e., investment strategy), price is pretty much everything. For “gatekeepers” (the investment professionals charged with evaluating investment managers and putting together portfolios), whether a fund gets access to a distribution platform is likely to become even more complicated—an especially important consideration given the economics of the industry. In general, investment manager profit margins are higher than those of most distributors; and yet, the lack of distribution access can doom a fund and product innovation to failure. It is a dichotomy that would seem to indicate that, over time, investment manager margins are likely to come down.
The various fees or revenue sharing paid by mutual fund companies represents a significant income stream for distributors. Traditionally, and despite the best efforts of some managers to innovate with share class structures such as so-called ”clean” shares that remove some of these extraneous expenses, these fees have been paid by fund shareholders. They are also somewhat opaque, with “who pays?” and “who gets what?” located in documents that the average investor often does not examine. ETFs, on the other hand, are very transparent in terms of the disclosure of daily portfolio holdings and fees, so if any revenue sharing occurs, the payment comes directly from the investment manager and not the fund. Now, while active, non-transparent ETFs will no longer disclose portfolio holdings on a daily basis, their fee structure will remain extremely clear and likely cheaper. As a result, it is very possible that you could see large amounts of assets switching from the mutual fund to the ETF wrapper. At the same time, it is very unlikely that distributors will be happy to give up accompanying revenue streams that they previously received. In some form or fashion, investment managers will be expected to make up this shortfall, so naturally there is going to be additional pressure on investment managers’ bottom lines if significant demand develops for active, non-transparent ETFs. All of this at a time when management fees for active funds are already under significant downward pressure.
A final word—while these new structures represent yet another positive product innovation, they are by no means the end of the line for mutual funds. One innovative structure, Eaton Vance’s NextShares, did make it past the regulator and seemed to have promise, but struggled in the end because it did not fit neatly into the existing distribution ecosystem. Ultimately, while Precidian’s ActiveShares looks to have an easier way forward because it utilizes the same trading architecture as traditional ETFs, true success will require “buy in” from both the home office and financial advisors. Also, these new structures are not necessarily well-suited to strategies with capacity constraints that might be subject to closures. As an example, a small cap strategy in a mutual fund structure can close to new investors or new investments altogether if the manager believes that doing so is in the interest of fund shareholders. In an ETF, this is not possible due to the creation/redemption process which keeps the fund’s market price in line with the underlying NAV. Absent this mechanism, the fund effectively becomes a closed end fund. And let’s not forget the importance of the sales force charged with raising assets. For mutual fund companies it is a relatively straightforward process to track sales and allocate credit to the appropriate individual. ETF sales and redemptions on the other hand are hard to track and require a significant amount of resources and time. In an industry that still compensates salespersons with base salary and a significant commission, one might wonder whether even more ETF sales will accelerate a move towards a base and discretionary bonus compensation culture that is less eat-what-you-kill and more consultative. More transparency, a greater ease of doing business and a more consultative, less transaction-oriented sales culture may be just what the industry needs in the long run.
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Asset Management, Wealth Management