Regulators have denied for a second time a proposal for a first-of-its-kind actively managed ETF that would not have to disclose its underlying holdings, according to a letter from regulators made public on Monday.
In a letter dated April 17, the Securities and Exchange Commission said the proposal, by Precidian Investments, raised more questions about the viability of the investment vehicle than it answered. Backers say that so-called “non-transparent” exchange-traded funds would lower costs for investors and take business from mutual funds. Precidian's efforts have been supported by BlackRock, State Street Corp. and American Funds-owner Capital Group.
The denial of the request to offer the funds was made public by one of Precidian's competitor's, Eaton Vance Corp. In a highly unconventional move for a scripted industry whose executives avoid discussing their competitors, Eaton Vance released the letter and then held a conference call boosting their own competing product, NextShares, which are a hybrid that combines aspects of mutual funds and ETFs. The firm has 10 outside asset managers signed on to licence the patented investment product type, including Principal Management Corp., Gabelli Funds and Ivy Funds.
Eaton Vance said it obtained the letter through a request under the U.S. Freedom of Information Act. A spokeswoman for the SEC confirmed the letter's authenticity.
“We're working very diligently,” said Precidian chief executive Daniel J. McCabe, who said the firm planned to file its proposal a third time to address the SEC's concerns. “With these things you always want to make sure they're done right, and I'd rather be right than fast or first.”
Eaton Vance Corp. currently enjoys a monopoly over its competitors because its NextShares technology was the first and remains the only structure approved that allows an actively managed open-end fund to trade on exchanges without regularly disclosing its holdings. Portfolio managers resist showing the securities they buy, in part to prevent being taken advantage of by competitors.
But top asset managers have been slow to embrace the structure, with some expressing doubts about the usefulness and viability of actively managed ETFs in general. Most of the growth in the ETF industry — formerly a backwater, ETFs now manage $3 trillion globally — has been in index-tracking funds used by many fee-based advisers looking to lower the costs of exposure to the market. Funds with managers who actively choose stocks and bonds have remained a sliver of the ETF business.
Yet supporters of actively managed funds see an opportunity to replace mutual funds with more tax-efficient vehicles that could improve performance and outcomes for investors. And analysts have pointed to the fact that such products may benefit from an evolution of the financial advice business away from mutual funds sold by advisers who are paid commissions to sell funds and toward one in which advisers are paid a fee by investors and therefore may be more willing to select funds that offer superior fee structures and performance.
Backers of ActiveShares, the Precidian alternative still seeking SEC approval, think that structure will yield greater benefits for investors, including the ability to trade those funds throughout the day at their market price.
VHS VS. BETAMAX
“We're in a contest to persuade the marketplace that NextShares is an important new development and something that brokers and their clients should embrace,” said Eaton Vance chairman and chief executive Thomas E. Faust Jr., in an interview. “The analogy that we sometimes hear is VHS vs. Betamax.”
Eaton Vance argues that NextShares will lower the costs that undermine mutual fund performance. The funds would likely pay fewer accounting fees to brokers, be required to hold less cash for investor withdrawals and use a more tax-efficient process to liquidate securities known as “in-kind redemption.”
Analysts have said the market opportunity for such a product is in the trillions of dollars if it's able to compete with actively managed mutual funds and index-tracking exchange-traded funds.
But first, Eaton Vance has to win over a skeptical set of broker-dealers, who would offer NextShares through their affiliated financial advisers, and other money managers, to whom it sells licenses.
'CHICKEN AND EGG' DILEMMA
The challenge, which Mr. Faust described as a “chicken and egg” dilemma, is that broker-dealers have few incentives to adopt an unproven structure without asset manager backing. And asset managers will be reluctant to bet on a fund type that isn't yet being offered by brokerage firms.
So far this year, Eaton Vance's stock price has fallen 6.4% as analysts questioned whether the firm will be able to meet its goals by its target deadline, which is the end of the year. On Monday, Mr. Faust described his discussions with broker-dealers as being at a “critical juncture,” but declined to comment further. He said it was unclear if broker-dealers would officially get on board this year.
Other non-transparent structures have been proposed by Precidian, Fidelity Investments and the T. Rowe Price Group Inc. None have yet won SEC approval. For Precidian, the second denial comes as the regulator has grappled with the complexity of how the proposal maintains intraday trading while hiding its holdings in a blind trust. The SEC said the latest proposal, filed in December, didn't answer its questions fully.
"We believe it falls far short of adequately addressing the complex and multifaceted concerns detailed by the commission," said the SEC letter.
In addition, the fixes proposed by Precidian raised additional questions.
“Applicants' proposal would create asymmetry between market participants by providing confidential disclosures to the ETFs' Authorized Participants but no other market participants," the SEC letter said. "In light of that, we find it difficult to reach the conclusion that the proposed ETFs would be necessary or appropriate in the public interest."