Who Will Buy The New ETMFs?

As a person who thrives on innovation in the financial markets, I appreciate the notion of what the new, just-launched exchange-traded managed funds are trying to do.

If successful, a new structure for active investment strategies might be able to bring down expenses and improve the tax efficiency for holders relative to overpriced mutual funds, goals we can all applaud. But—since ETMFs are neither ETFs nor mutual funds—they require a whole new educational process for investors to understand before they take the plunge.

When bringing any new product to market, you have to really understand who the initial adopters will be. Any type of fund—new structure or not—needs to get to a critical mass in order to offer market participants reasonable liquidity and the fund sponsor enough scale to operate profitably.

New Folio Account Needed

Who will be the initial adopters of ETMFs? Bear in mind that to invest in one, you can’t place an order in your existing, traditional brokerage account at companies like Merrill Lynch, Fidelity or Scottrade. You need to open an account at Folio, the only brokerage that supports the order type that ETMFs require. That new order type may be a little challenging for investors to understand.

Unlike with ETFs, you can’t get a real-time quote on the value of the shares and prepare your order accordingly; that is, ETMFs don’t trade with such familiar order types as market orders and limit orders.

Rather, investors need to place an order relative to the future net asset value (NAV) of the fund, based on where it will end up closing at the end of the day. You would place an order on the form of “NAV+0.01” or similar, where the seller/counterparty agrees to settle with you at the end of the day at the specified premium or discount to closing NAV.

This type of trading will require effort for investors and their advisors to get comfortable with it. Whenever there’s built-in friction for people to adopt a new product, there needs to be a compelling reason to overcome that friction. For ETMFs, that reason has to come down to the hope for superior performance derived from the skills of the active manager.

How Do You Make The ETMF Decision?

The first ETMF came to market today: the Eaton Vance Stock NextShares. Even if we go so far as to assume the manager is talented and has the opportunity to outperform passive ETFs, how are investors to make the decision to invest in this fund, even over traditional mutual funds? Based on past performance?

The fund’s prospectus states that the fund (in a structure pre-ETMF) outperformed the S&P 500 Index in 2015: 4.83% versus 1.38%. But it underperformed on a five-year basis. That’s certainly not bad for an active strategy, but is it enough to get investors to go through the process and open up accounts at Folio?

Perhaps ETMFs will be more like annuities … pushed through a sales channel and “sold” more than “bought”? If so, are the sales incentives in place to give them a fighting chance against ETFs and mutual funds? Or are ETMFs potentially a solution in search of a problem?

I would like to see the structure work to make active management cheaper for investors, but I’m afraid the hurdles that advisors and investors face in adopting ETMFs will be too high. I'd love to hear your thoughts in the comments sections.

Contact David Lichtblau at [email protected].