Best investment vehicle? Are NextShares ETMF better structure than ETFs and Mutual Funds.

ETFs vs. Mutual Fund vs. NextShares ETMF

Ever wonder if there is an investment vehicle structure that takes the best of both ETFs and Mutual Funds? In February 2016, Eaton Vance did just that with the introduction of NextShares Exchange Traded Mutual Funds, for short ETMFs. The new structure is marketed for active portfolio managers although Eaton Vance NextShares are rather limiting themselves because the structure is also superior for indexing and is perfect for strategic beta. Previous posts already expressed the inefficiency of both ETFs and Mutual Funds but let’s explore why investors should be excited about this new investment vehicle.

Taking from the ETF structure:

  1. Tax-efficiency by reducing capital gains from flow related transactions. Mutual fund managers transact directly with investors using cash (although they are allowed to use in-kind transactions). Unfortunately, this often forces managers to sell securities they own to meet redemptions. Frequently, the securities sold have embedded capital gains. When the sale occurs, the mutual fund is obligated to distribute those gains to the remaining shareholders of the record date, triggering a taxable event. Depending on the investor tax bracket and the mutual fund flow activity, these capital gain distributions can significantly lower investor returns. In contrast, EMTFs just like ETFs use an in-kind redemption and subscription process and trade through brokers. What this means is that ETMF managers don’t deal directly with shareholders but instead investors buy the shares from other investors, just like stocks. This helps avoid the need of ETMFs portfolio manager to sell any securities with embedded capital gains. In the case where there are not enough buyers or sellers currently on the market (the supply and demand don’t offset), EMTF shares can be created or redeemed through market makers often called Authorized Participants (APs). When creating or redeeming ETMF shares through the market makers, the ETMF does not need to raise cash again by selling securities with embedded capital gains. Instead, the ETMF delivers securities from its portfolio directly to the market maker, who in turns sells those securities and gives the cash to the selling investor. Also, on top of that, the ETMF manager has full discretion which securities are delivered in the exchange. That means that he can pick and choose the securities with the current highest embedded capital gains, getting rid of potential future capital gains.
  2. Averts flow-related trading costs. Mutual fund inflows and outflows generated by investors force portfolio managers to buy and sell securities to keep the fund invested or to raise cash. Notice that this kind of buying and selling is not part of the fund’s strategy. Trading costs generated from this portfolio turnover such as commissions, spreads, and market impact can quickly accumulate and hurt the performance of long-term investors. In a research paper, Roger Edelen quantified the adverse effect of shareholder entry and exit costs on fund performance (Edelen 2007). He found that the trading costs attributed to the liquidity offered to entering and exiting shareholders can account for an average net reduction in annual investor return of  as much as 0.75 percent. NextShares ETMFs as ETFs use the in-kind transactions process, which allows them to externalize and pass the trading costs to whom they belong, the traders. If ETMF shares are to be created (secondary market does not have enough supply), ETMF manager will disclosure the fund’s current basket instruments to allow for in-kind purchases and redemptions of ETMF shares by market makers. Instead of selling or buy securities, ETMFs either give the market makers a basket of securities (when ETMF shares are redeemed) or the market makers buys a basket of securities to give to the ETMF manager (when ETMF shares are created). All this means is that the market maker does the trading and then passes the trading costs to the trading investor.
  3. Less cash drag: Mutual funds have to hold more cash to handle incoming redemptions. ETMFs can perform redemption in-kind, they do not need to carry high amounts of cash that reduce returns.
  4. Potential lower costs to run: ETMFs managers do not have to keep track of shareholders since they trade through an exchange. Mutual funds have the additional expense of transfer agency, reporting, and marketing materials.

In summary, the benefits are drawn from that ETMFs like ETFs can use the in-kind redemption and subscription process along with the ability of investors to trade the shares with other investors.

Taking from Mutual Funds:

  1. ETMFs use NAV-based trading which limits and makes trading costs transparent. We know that the net asset value (NAV) represents the value of each share’s portion of the fund’s underlying securities and cash at the end of the trading day. ETFs don’t trade at NAV but have a separate intra-day price not directly linked to NAV (although indirectly linked by the arbitrage mechanism).  ETFs prices can deviate substantially from the market value of the underlying securities because of imbalances in the supply and demand of ETF shares, ease of hedging for Authorized Participants, and timing. Notably, ETF market makers need to enter into intraday hedges or adjust their hedges as they buy and sell ETF shares. Because of additional risk is borne by market makers, they will often charge higher spreads and/or allow the ETF price to deviate from NAV. This makes it particularly harder if not impossible for ETF investors to measure their trading costs because they don’t have access to a reliable measure of underlying fund value at the time of trade execution (iNAV is not a reliable measure). In comparison, NextShares ETMFs are bought and sold at end-of-day NAV plus a fluctuating spread that the market makers will charge  (e.g., NAV +$0.01, NAV -$0.02). ETMFs offer market makers a profit opportunity that is not based on arbitrage and does not require the management of intraday market risk with hedges. It makes no difference for NextShares market maker whether the fund’s underlying value goes up or down over the course of the day since the transaction will always occur at the end-of-day NAV. This straightforward and reliable profit opportunity allows market makers to offer prices closer to NAV (lower spread, discount/premiums). Also, use of NAV-based trading allows investors to see exactly how much they are paying for the transaction.  Investors will know that that the precise difference between the NAV and the execution price will be their trading expense, giving investors the opportunity to use limit orders and avoid excessive trading expenses.
  2. Non-transparent holdings. Some would argue that daily transparency is good, but that’s not the case for investing.  Let’s take a look at why neither passive nor active funds should reveal their holdings frequently.
    1. Passive funds follow indices (yes, following an index doesn’t mean you are technically passive but that’s another discussion). Indices use two popular methodologies to incorporate composition changes:
      1. Rules based changes: Most indexes such as Russell, MSCI, FTSE and Dow Jones have set up rules for when constituents are included or removed. Additions and deletions are announced a few days before their index implementation.
      2. Subjective based changes: index committees are established to decide without transparency which new members are to be included and excluded. The S&P is the most popular indices that practices this approach. The changes are announced after the market close a few days before the change becomes effective.

Notice, in either case, index changes are published before the index portfolio managers (ETFs and index funds) have an opportunity to implement the change. Front running arbitrage traders compile lists of expected transactions due to index changes and study these lists for trading opportunities. That is why often prices of securities jump before index managers beginning incorporating the changes, often causing index replicators to purchase the new securities at a higher price and sell index leaving securities at a lower price. Trading transparency is costly because traders are exploiting it and anticipating a profit, in turn causing market impact costs for index managers.

b. Active fund managers do not want their holding to be known for the same reason as passive funds, front running. If the portfolio manager holdings are published on a daily basis, traders can establish which securities the manager is buying or selling. For example, the trader can foresee day-to-day that the manager has begun accumulating security XYZ and establish a position themselves to take advantage of the market impact. Also, traders can learn which fund has or is likely to receive large inflows, allowing them to determine which securities will be bought over the next few days.

Similar as in poker, one does not want other players to know their cards and their likely next move.

3. Discourages intra-day trading and speculation. I know many of you want intra-day pricing so that you can trade and speculate. Unfortunately, this is not healthy for your investment returns. Recent data shows that ETF investors trade way too often (near 900% turnover during 2015). This kind of trading should be discouraged as the hidden transaction expenses can quickly overshadow any appreciation of the assets. John Bogle has been critical of less liquid ETFs for this particular reason, and he is even asking regulators to step in. For more details why frequently trading ETFs is a mistake, see The hidden costs of ETFs.

In summary, the benefits are drawn from the facts that ETMFs like Mutual Funds use the Net Asset Value and do not disclose their holdings.

Although NAV-based trading can have some unforeseen negatives, NextShares ETMFs currently look like they have all the characteristics to one day become the preferred investment vehicle.

 

References

Edelen, Roger M., Richard Evans, and Gregory B. Kadlec. 2007. Scale Effects in Mutual Fund Performance: The Role of Trading Costs. Working paper (March 17).

Gastineau, Gary L. 2010. The Exchange-Traded Funds Manual, 2nd ed (Hoboken, NJ: John Wiley & Sons, Inc.).

 

 

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