Broker-dealers hold fate of new active ETFs

Despite potentially lower costs and better outcomes for investors, broker-dealers take a cautious approach to a product that could slash their revenue

Dec 3, 2014 @ 1:14 pm

By Trevor Hunnicutt

After a multiyear push and stiff competition, a product that backers want eventually to replace mutual funds won final approval from securities regulators this week.

That was the easy part.

With its long-coveted approval order in hand, Eaton Vance Corp. this week began a full-court press to market the new product, which it calls NextShares.

On Wednesday, the fund promoter distributed a 16-page white paper touting the ability of NextShares to sidestep the “avoidable structural costs of actively managed mutual funds.”

But there's a fundamental paradox that could still derail NextShares, and financial advisers are at the center of the issue.

If Eaton Vance wants its products to succeed, it will have to convince broker-dealers and financial advisers that it is in their interest to supplant a product responsible for a healthy portion of their current revenue.

The backers of NextShares want to cause the extinction of mutual funds, a lucrative product for broker-dealers.

The firms earn revenue on accounting and other back-office administration of mutual fund accounts as well as the distribution and service fees generally collected by fund distributors and paid out to broker-dealers. Those fees are known by the regulatory rule that approved their use, 12b-1. Many advisers are paid through those revenues, as well.

NextShares lack a similar well of potential revenue. Yet in order to successfully launch products and win assets, Eaton Vance will have to gain placement of NextShares on broker-dealer platforms.

That could involve significant and expensive upgrades to the technologies that enable advisers to access and trade securities and other investment products on behalf of their clients. Intermediaries such as financial advisers will be primarily responsible for selling these funds, not the fund managers.

“A lot of the firms we've spoken to are not really sure if they want to offer it at this stage,” said Bharat Sawhney of Gartland & Mellina Group, a consultant to broker-dealers on product offerings, strategy and technology platforms. “One of the bigger questions the firms have is if it will cannibalize their existing business.”

NextShares combine characteristics of mutual and exchange-traded funds. Like mutual funds, investors purchase shares in the fund at a price equal to the value of their underlying securities, plus a transaction fee. Like ETFs, they trade on exchanges and could benefit from the tax and other cost efficiencies associated with those products.

Investors will need to be informed by broker-dealers of the unique qualities of the funds when they trade, and they will place exchange orders in a way that differs from stocks or ETFs.

In order to commit to those upgrades, broker-dealers will need to see that consumers — both advisers and their clients — actually want the products, which are also known as exchange-traded managed funds.

If they succeed in that regard, it wouldn't be the first time client demand trumped the preferences of broker-dealers.

ETFs, for instance, also succeeded despite themselves.

Wirehouses, the largest of the broker-dealers, resisted adopting the generally lower-profit margin products when they were first introduced, according to Kathleen H. Moriarty, a securities lawyer who spearheaded the development of the world's first ETF, the SPDR S&P 500 ETF Trust (SPY).

Wirehouses now account for about a sixth of the third-party sales of ETFs, according to Broadridge Financial Solutions Inc.

“People began to say, if I can't buy the ETFs from you, I'm going to go elsewhere,” said Ms. Moriarty, now a partner at Katten Muchin Rosenman. “When enough of those people began to make that clear, wirehouses who said this was a joke, you started to see them hop on the bandwagon.”

Eaton Vance has already briefed most major broker-dealers on the NextShares offering, according to several people with knowledge of the meetings.

While the Nasdaq OMX Group Inc. exchange and a number of institutional traders known as market makers have indicated a willingness to trade the product, few large broker-dealers have yet publicly committed to offer the product.

Firms such as Morgan Stanley, the U.S. broker-dealer with the largest workforce of financial advisers, are taking a wait-and-see approach.

“We have no immediate plans to offer but will keep an eye on it,” said Christine Jockle, a spokeswoman for the company.

But in an exclusive interview with InvestmentNews, Alex Teyf, an executive who runs the mutual fund and ETF platforms at TD Ameritrade Inc., said the discount brokerage and custodian for independent advisers wants to offer the products.

“We feel the product is aligned with client needs,” Mr. Teyf said. “When the time is right for us to support this type of product, we would definitely be interested in making it available.”

At one point, Eaton Vance had proposed allowing 12(b)-1s. In its initial March 27, 2013 application with securities regulators, Eaton Vance's proposal included the possibility that ETMFs could assess up to 0.25% in 12(b)-1 fees annually.

Following consultation with the SEC, Eaton Vance amended its application to not include the fees. (The products also do not charge a load, a fee also used to compensate some advisers.)

“There are significant mutual fund users where it will take a while,” Thomas E. Faust Jr., the chairman and CEO of Eaton Vance, said in a recent interview. “[An adviser] whose business model is based on getting compensated through a front-end load or a distribution stream, they're not going to find this particularly interesting.”

In its newly released white paper, Eaton Vance argued NextShares could improve the outcomes of investors whose assets are actively managed.

First on the paper's list of avoidable costs: 12(b)-1s.

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