A Close Look At Eaton Vance's ETMFs

May 07, 2015

[An earlier version of this story incorrectly described the mechanics of so-called NAV-based trading. A corrected description appears below. We regret the error.]


It's been five years since "NAV-based trading" was embraced by Eaton Vance and became the centerpiece of what the Boston-based firm calls "exchange-traded managed funds" (ETMFs). They are, to hear fund industry sources, a genuine third option that falls somewhere between ETFs and active open-end mutual funds.

Crucially, the Securities and Exchange Commission's approval of the whole concept late last year has made ETMFs—or NextShares, to use the trademarked name Eaton Vance has come up with—a lot more than a pipe dream. The concept is probably months from real commercialization, though that hardly guarantees the success of NextShares, which has been licensed so far to three other fund firms.

The biggest problem is educating advisors and an investing public that are, arguably, already maxed out in terms of learning about changes in the investing world such as "smart beta." The promise of NextShares is to be cheaper and more efficient than mutual funds, though not cheaper than most ETFs, as some advisors are quick to point out.

Final Frontier For ETFs
"The bottom line to me is that it's a good idea," said Nicholas Colas, chief market strategist at Convergex Group, a New York-based trading firm. "It leverages an innovative idea—which is ETFs—and harnesses it to active management. This is like the final frontier for ETFs—God did not come down and say all ETFs will be passive."

To be sure, Colas doesn't mean to say that ETMFs are really actual ETFs. But ETFs and ETMFs have a number of key similarities.

It all begins with the fact that the ETMF structure behind NextShares, like ETFs, dispenses with internal trading desks that mutual funds rely on. Like ETFs, ETMFs instead make use of so-called authorized participants (APs). The involvement of APs explains why ETMFs will have annual expense ratios that are about 40% cheaper than the typical mutual fund.

But ETMFs are quite like existing open-end mutual funds too. For one, they are nontransparent, meaning portfolio disclosure is only required every quarter, with a 60-day lag on top of that. This preserves the "secret sauce" that active managers consider key to their capacity to generate alpha.

How NAV-Based Trading Works
A confusing aspect of ETMFs is that while they can be bought and sold in real time during the trading day just like ETFs, they won't actually price until after the close at net asset value (NAV). This is called a "NAV-based trade" and is the original intellectual property behind the ETMF that Eaton Vance bought from ETF industry entrepreneur Gary Gastineau. With a NAV-based trade, the final price an investor pays is NAV plus or minus a premium or discount determined at the time of trade. 

A closer look at how ETMFs are similar to ETFs illustrates why they are distinct, why they're cheaper than mutual funds and why that makes them better for some investors, particularly those who have an enduring belief in the value of active management.

Again, the adoption of APs translates into a few material ways fund companies can save money and pass those savings on to investors. To begin, they don't have to pay traders to actually manage these portfolios. That also means the transfer agent fees—one of the bigger costs—are gone.

The creation/redemption mechanism at the center of ETFs and ETMFs also allows for tax efficiency, as entire portfolios can be cleansed of higher-basis securities, much as is the case with ETFs. That leaves more money in investors' pockets.



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