(Bloomberg Businessweek) -- Daniel McCabe, chief executive officer of Precidian Investments, is trying to create a new kind of fund, one he thinks will help active money managers survive the unrelenting rise of exchange-traded funds. It’s been an uphill battle.
With $10 trillion in assets in the U.S., actively managed mutual funds are big business, but they’re losing market share. For years investor money has been flowing into ETFs, most of which passively replicate market indexes. Index ETFs had assets of $2.5 trillion at the end of 2016, up from $420 billion a decade earlier, according to Morningstar Inc.
Precidian’s plan is to wrap active management into something that looks more like an ETF. In doing so, it won’t replicate one of the key things many people like about ETFs—that they’re index funds, which over time tend to beat most active managers. McCabe’s bet is that investors who still want to hire an active manager will be drawn to Precidian by the other features of an ETF, such as the ability to trade them like a stock at any time of day. ETFs also have operating-cost and tax advantages over traditional mutual funds.
But Precidian faces a formidable competitor in 100-year-old, $364 billion asset manager Eaton Vance, which beat it to the punch with a rival product called NextShares. Precidian also has to persuade the U.S. Securities and Exchange Commission to sign off on its novel approach. “We recognize that anything like this requires the regulator’s approval,” McCabe says. He’s been trying for three years with Precidian. Eaton Vance’s NextShares won SEC approval in December 2014.
The tricky problem for anyone trying to make active funds that work like ETFs is transparency. Say you want to buy 100 shares of State Street Corp.’s popular SPDR S&P 500 ETF at 11:59 a.m. To determine a fair price for those shares, market participants need to know the value of all the fund’s underlying assets at that time. That’s not a problem, because this ETF simply owns the stocks in the S&P 500 index.
But most active funds like to be more discreet about their holdings. They select stocks or bonds to try to beat the market and don’t want to give other traders a way to get the jump on them. “It can be harmful to the investors,” says Stephen Clarke, president of the Eaton Vance subsidiary behind NextShares.
Eaton Vance adopted a workaround: NextShares funds get the tax and cost efficiencies that come with trading on an exchange, but their price is calculated at the end of the day, as with regular mutual funds. Precidian’s solution involves hiring agents who can see a fund’s holdings to calculate and verify its underlying value. That value would be made public every second of the trading day, even though portfolio holdings would be revealed only a few times a year. In April 2015 the SEC told Precidian that it needed to solve a long list of concerns about its approach before it could get approval.
Eaton Vance wasn’t shy about pointing out its rival’s difficulties. It used the Freedom of Information Act to obtain a letter the SEC sent about its concerns to McCabe’s lawyer—and published it. During a call with industry analysts, Thomas Faust Jr., Eaton Vance’s chairman, used it to question the viability of Precidian’s structure. “Nobody has ever done this in our industry before,” McCabe says. At the time, Faust said the company made the letter public to help the market make an informed judgment about potential alternatives to its product.
Eaton Vance expects to spend about $10 million this year on the NextShares business, adding to about $16 million spent over the past two years. It’s also on the line to pay $9 million to creators of patents underpinning the funds, regulatory filings show. The funds have less than $100 million in assets.
Precidian amended its SEC filing and is awaiting approval. On April 4, it unveiled eight funds it hopes to sell. Whatever the regulator decides, the new funds will have to prove they’re more than a marketing twist. “The trend is clearly toward passive, and ETFs are part of that trend, so they’re jumping on that bandwagon,” says Larry Swedroe, director of research for Buckingham Strategic Wealth LLC.
And even when they’re traded on an exchange, active funds still pay someone to pick investments, so they’ll cost more than index funds. One NextShares fund charges 0.65 percentage points per year, a third more than the average U.S. ETF. “Active ETFs unnecessarily blur the lines and can create undue confusion,” says Rich Messina, senior vice president for investment product management at ETrade Financial Corp.
Even so, Wall Street companies are willing to give the idea a shot. UBS Group AG and Columbia Threadneedle Investments have rallied behind Eaton Vance’s structure, with UBS announcing last year that advisers in its network could offer the funds. Asset manager Legg Mason Inc. bought a stake in Precidian last year. BlackRock Inc., the world’s largest money manager, has requested regulatory approval to sell funds using Precidian’s model. “The market hasn’t picked a clear winner,” says Spencer Mindlin, an analyst at Aite Group LLC. “Or whether there will be any winner.”
The bottom line: Investors like being able to trade ETFs all day, but that’s tough to do with funds that need to keep secrets.
To contact the authors of this story: Rachel Evans in New York at revans43@bloomberg.net, Annie Massa in New York at amassa12@bloomberg.net.
To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net.
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