On November 22nd, Eaton Vance (EV) put out a press release (pdf) that announced the purchase of assets of Managed ETFs LLC, a company co-founded by Gary Gastineau. Gastineau is also the principal at ETF Consultants and has been behind the formulation of “NAV-based trading” – a trading mechanism for ETFs that could allow actively-managed ETFs to maintain portfolio confidentiality, while at the same time providing enough information to market makers to keep the ETF share price close to the fund NAV – a solution that has been touted by the Financial Times as the “holy grail” for Active ETFs. Speaking to the Financial Times, Eaton Vance CEO – Thomas Faust said, “This transparency issue is a major impediment to the development of ETFs in the active equity space, because not many portfolio managers are willing to disclose their portfolio to the world on a real-time basis.”
In a recent article, we looked at how existing managers behind actively-managed ETFs are dealing with the lack of portfolio confidentiality. Some do it by investing solely in underlying ETFs instead of individual securities, while others do it by having multiple managers. However, at the end of the day, most conventional active managers would not want to give away their secret sauce or alpha sources to other managers and potential front-runners.
How does NAV-Based Trading benefit investors?
When Gastineau spoke to us in October, he gave us a detailed run-down of how NAV-based trading would operate and how it’s different from the existing intra-day trading.
Today, all ETFs, both passive and active, trade intra-day with executions taking place at a certain bid or ask spread away from the mid-price of the ETF shares. However, as Gastineau explained in a more recent interview after the Eaton Vance announcement, most ETF investors today have little idea what their transaction costs are going to be. “They know what their commission is, but that’s a trivial part of the total transaction cost in most cases; You don’t know what your ETF trading cost is today, in terms of the bid-ask spread and the market impact of your transaction. That is a flaw in the current market structure”, he explained.
In NAV-based trading, a process that is under patent filing, investors will have the ability to send in orders intra-day based on a “proxy price” that would represent the NAV of the fund to be calculated at 4pm, so that people who trade during the day will trade relative to this proxy price. Gastineau elaborated saying, “With NAV-based trading, you will be able to measure very precisely what your transaction cost is relative to each day’s net asset value because that will the basis on which you place your order. If you place a buy order and it’s executed at, say, a penny over NAV, you’ll know that your transaction cost is a penny a share plus any commission”.
The proxy price at which an order gets put in during the day will help ensure a fixed spread from the final day NAV when the order gets executed at market close. And since all orders get executed at the close, the daily liquidity throughout the day gets concentrated on a single value. The concentration of liquidity at the end of the day would in itself help to bring in spreads on all types of ETFs. At the moment, spreads on actively-managed ETFs are wide because there isn’t enough volume to be spread out throughout the trading day.
Since under the NAV-based trading mechanism, there is no longer a need to provide intra-day values for the ETF, a non-transparent actively-managed ETF or any other form of non-transparent ETF could trade effectively on the market. Gastineau indicated that the last thing that investors should want is full transparency of the portfolio transactions because that ultimately hurts the investors. “The important point is that the SEC has a rule requiring fund portfolio disclosure at least quarterly with a 60-day lag. If that makes sense for a mutual fund, it makes sense for an actively managed ETF. An ETF should use the same disclosure rules as a conventional mutual fund”.
How Significant Is Eaton Vance’s Move?
Gastineau had indicated that his firm has been in talks with the SEC about NAV-based trading and that the SEC had made it clear that they would need to see a demonstration of NAV-based trading. The fact that a major fund company is now behind Gastineau’s idea will add a lot more weight to the proposition for NAV-based trading. “Eaton Vance is a large, highly respected money manager and it’s a lot easier for them to bring the necessary resources to the effort than it is for a couple of individuals”, added Gastineau.
Eaton Vance’s move also shows that it is actually serious about creating a strong presence in the Active ETF space. Many market observers, including Olivier Ludwig writing for IndexUniverse have opined that the slew of applications we’ve seen to launch actively-managed ETFs are more “just-in-case” filings to keep the options open for fund companies. If they see the ETF industry continue to poach market share from their mutual fund business, then they could easily take the step to launch ETFs. Eaton Vance might just be starting to prove that notion wrong. Scott Burns – Director of ETF Research at Morningstar – spoke to Dow Jones in an article saying, “But when you start to see people starting to make moves like Eaton Vance did, you start to get a signal that this is serious”.
Of course, if NAV-based trading helps non-transparent Active ETFs does become a reality, then there is little doubt that the level of interest in the Active ETF arena from managers would increase many fold especially from those that had been waiting on the sidelines because of their lack of comfort with the disclosure requirements. That could potentially be the biggest benefit of this move from Eaton Vance. “Eaton Vance believes that non-transparent ETFs would be an attractive vehicle for some of its investment strategies”, added Gastineau. The Financial Times article also confirmed that if the patents were to receive regulatory approval, Eaton Vance will use them to sponsor non-transparent actively-managed ETFs as well as explore licensing opportunities with other sponsors.
Eaton Vance had first filed applications for the launch of 5 actively-managed ETFs back in March 2010, each of which would be fully-transparent, providing daily disclosure of holdings.
Disclosure: No positions in above-mentioned names.
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