Monday, April 1, 2013

Eaton Vance, Transparency, and Exchange-Traded Managed Funds (ETMFs)

By Tim Dulaney, PhD and Tim Husson, PhD

Eaton Vance (EV) made a splash yesterday when they announced an application with the SEC for approval of a new type of open-end fund they call "Exchange-Traded Managed Funds" or ETMFs.  The PDF of the announcement can be downloaded here.  Since the announcement, several bloggers have commented on the implications of such products, such as Brendan Conway at Barrons and Olly Ludwig at IndexUniverse.

In August 2011, the Financial Times reported the uncovering of patents -- U.S. Patent Nos. 7,444,300, 7,689,501, 7,496,531, 8,131,621, 8,306,901 and 8,332,307 according to the SEC application -- that detail the intellectual property used to create this new instrument.  At the time, Eaton Vance claimed that "ETMFs offer the potential to provide the tax efficiency and lower portfolio trading costs of an ETF and the alpha-generating ability of an actively managed mutual fund."

Eaton Vance believes that investors are harmed by the transparency of ETFs because traders can 'front-run' the behemoth passive instruments before they make their moves.  A front-running strategy attempts to take advantage of known purchases or sales of securities by large funds.  For example, if a large fund claims to purchase particular futures contracts on a certain day each month, traders might purchase those futures contracts before the fund does, anticipating a potentially significant price increase due to the fund's demand.  Front-running has been a concern with ETFs for several years, but has been a more significant issue as the ETF market continues to expand.  In fact both Blackrock and Precidian have similar filings with the SEC.

The reason why front-running is less of an issue for mutual funds is that (a) they aren't traded intraday, limiting the ability of traders to time their purchases, and (b) their strategies are only disclosed quarterly and on a lagged basis.  Eaton Vance's ETMF product would change (a) but not (b), based on the contention that decreased transparency reduces the potential for front-running, therefore saving investors the cost imposed by that kind of trading.  But the downside to keeping strategies and holdings secret is that investors do not fully understand what the fund is doing and how it plans to achieve its investment objectives.

Also, the value of actively managed funds is debatable, and there is some evidence that suggests active management on average leads to lower returns for investors and that success doesn't persist over time.  So it is unclear how much, if any, "alpha generation" investors might realize by Eaton Vance making a more mutual fund-like exchange-traded product.

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