Actively managed exchange traded funds are a hot topic in the asset management industry these days. To date, most ETFs have been structured as passively managed index funds, because of concerns that the daily portfolio disclosure requirements of ETFs are inappropriate for actively managed funds. Regulators have rejected proposals that would allow active ETFs to keep their portfolio holdings confidential.
However, Eaton Vance Management recently received approval from the US Securities and Exchange Commission for a new type of fund, branded as NextShares, which addresses these disclosure concerns. Yet NextShares are not the same as ETFs; they are hybrid vehicles that combine elements of traditional mutual funds with certain features of passively managed ETFs. In other words, NextShares are a compromise, but one that stands a good chance of success.
On the plus side, NextShares preserve one of the main features of ETFs in the US, namely their tax efficiency compared with traditional mutual funds. ETFs normally generate fewer capital gains for investors, a result of their approach to handling investor purchases and redemptions.
Investors in an ETF do not deal directly with the fund. Instead, transactions go through intermediaries, called authorised participants. Only these intermediaries may purchase shares from the fund, which they then resell in the public market to investors. Therefore, when investors want to cash in their ETF holdings, they sell them on the exchange. To keep supply and demand for shares in balance, authorised participants may purchase the shares in the open market and redeem them with the fund.
This intermediated structure creates tax advantages for US investors. As with traditional mutual funds, investors in ETFs pay taxes on the dividends and interest earned. However, the authorised participants effectively absorb capital gains generated by trading in the portfolio. As a result, unlike mutual fund investors, ETF owners normally only pay taxes on capital gains when they sell their ETF investment. By using the ETF structure, NextShares capture this tax advantage for investors.
Also on the plus side, NextShares keep things simple for investors and their financial advisers by using exchange trading. Traditional mutual funds can be administratively complex, since they normally offer multiple classes of shares and other investor benefits, such as systematic withdrawal plans and rights of accumulation. The exchange trading feature of ETFs strips away this complexity, to make buying and selling a fund just as easy as buying any other stock.
But there is one big potential negative with NextShares: they will be providing neither daily listings of portfolio holdings nor frequently updated intraday valuations. This information is essential to the trading of ETF shares. In fact, authorised participants use it to ensure that the prices paid for shares on the exchange remain close to the value of the underlying portfolio. For example, if the price of shares on the exchange is well below the value of the fund’s assets, authorised participants will buy shares on the exchange at the market price and then sell those shares back to the ETF for what they are truly worth.
This disclosure imposes little burden on index ETFs, because their holdings are clearly defined and change infrequently. However, for actively managed ETFs, daily disclosure creates risk, because it provides insight into the fund’s trading activity and makes it easier for other investors to profit by front-running the fund. Traditional mutual funds mitigate this problem by publishing portfolio holdings only monthly, often with a 60-day delay.
NextShares will follow the lead of traditional mutual funds and publish lists of holdings only periodically and provide a valuation of those holdings only at the end of the day. And while investors will be able to buy and sell NextShares on an exchange throughout the day, at a price determined by market movements, transactions will technically be completed only at the end of the day, with the final price determined by the end-of-day valuation of fund holdings. Given these complexities, it seems unlikely that there will be active intraday trading in NextShares, as there is with ETFs.
In sum, NextShares provide the tax efficiency that have made ETFs so popular with investors while avoiding the disclosure requirements that are a burden to active managers. While they do not offer all the advantages of ETFs, they may prove a viable alternative to traditional mutual funds for actively managed portfolios.