The Magellan Global Equities Fund listed on the ASX on 5 March 2015 and is an unusual structure for the listed market, an actively-managed Trading Managed Fund or TMF. Magellan launched its first fund in 2007 and is now managing over $35 billion, including $10 billion of retail money. Previously, its funds were standard unlisted managed funds and a single Listed Investment Company, MFF. But its latest structure (ASX code MGE) is breaking new ground, and the question must be asked whether it is a significant milestone which will both generate a strong following and be copied by others.
[Upfront disclaimer: Magellan is a sponsor of Cuffelinks but our content is independent and we do not publish product promotions. This article is about a genuine market innovation that should interest our readers. While we discussed the structure with Magellan to clarify our understanding, they did not request nor approve this article.]
What perceived problems does it seek to address?
Over recent years, SMSF trustees and other direct investors have become increasingly comfortable using the ASX platform, especially through online brokers such as CommSec and nabtrade. Investments in the listed space compete with the unlisted funds available on platforms administered by major wealth management businesses. On the ASX, each of the alternative ways to invest in a listed portfolio of shares has its strengths and weaknesses, as described here and here in previous articles. In every case, there is a feature which detracts for some investors:
- Listed Investment Companies (LICs) – closed-ended funds which rely on buyers and sellers in the market for liquidity because there is no capacity to create or redeem units regularly according to demand. There is no market maker ensuring LICs trade at their Net Asset Value (NAV), which means they may trade at discounts to NAV at times of market stress when there are few buyers. On the other hand, they may trade at premiums and they are actively managed, and there are advantages in the company structure.
- Exchange Traded Funds (ETFs) – open-ended with a market-making mechanism which usually ensures they trade at close to NAV across a spread. Most are passive funds based on some type of index or smart beta. They have cost advantages but do not access the skills of an active manager.
- mFunds – ASX’s service for issuing and redeeming unlisted managed funds via the ASX operating rules and settlement service, but with no real time unit pricing, and only available through brokers who have joined the mFund service, which excludes the major bank-aligned brokers (except nabtrade). Many mainstream fund managers have also not joined. As mFund does not quote live prices, an investor must wait until after the end of trading to know the price of the units bought and sold.
Magellan’s TMF seeks to address each of these weaknesses: it is open-ended, permitting the creation and redemption of new units each day via a market-making function with the intention of preserving the price close to NAV; it is actively-managed, for investors who believe a good investment manager is worth paying for; and the price quoted is live, removing the uncertainty of waiting until the end of the day.
How does the TMF solve the perceived shortcomings, and what problems of its own are created?
Why is the structure different?
The reason ETFs are able to maintain prices close to NAV is that, as index funds, their portfolios are continuously available to external market makers. This allows a third party to arbitrage between the prices of units in the fund and the underlying securities in the portfolio which pushes prices towards the NAV. For example, assume the NAV of an ETF is $5 and a buyer bids for 100,000 shares at $5.05. A market maker may go into the market and buy the underlying shares for $5 or $500,000, deliver these shares to the ETF provider and receive 100,000 shares in the ETF in exchange. These are then sold to the ETF buyer at $5.05 or $505,000 for a $5,000 profit (less transaction costs). This removes the high bidder from the market and pushes the share price closer to the NAV. The same happens in reverse there is a seller under the NAV.
The problem for active managers using this structure is that they do not want to reveal their portfolios to the market. That is the proprietary knowledge their clients pay for (Magellan’s listed and unlisted global equity funds hold the same assets). Magellan has a base fee of 1.35% plus a performance fee, far higher than the cost of an ETF. Magellan could not allow a third party to replicate this portfolio each day and offer a cheaper alternative. The breakthrough achieved in the structure is that the TMF is only required to report its portfolio quarterly, and then with a lag of up to two months, denying the opportunity to replicate in a timely manner.
This creates a problem. If the portfolio is not available to a third party, who does the market-making to ensure to fund trades close to NAV? In the case of this new fund, Magellan is the market maker, and any gains or losses from the activity accrue to the fund. Magellan argues it has an incentive to perform this role well to ensure confidence is retained in the fund.
In practice, Magellan estimates the NAV based on the closing prices in global markets where the shares trade, and publishes the so-called iNAV on its website before the Australian market opens each morning. Buyers and sellers can trade live around this iNAV on the ASX. The iNAV may change but normally only due to FX movements. At the end of the day, Magellan works out the net position of buyers and sellers and creates or redeems units with the fund, and then buys or sells the underlying shares when liquid markets for those stocks open overseas. Magellan’s global fund has a concentrated portfolio of major stocks in highly liquid markets and its activities have negligible impact on the market price.
What are the potential shortcomings?
We have listed at least one Achilles’ heel for every competing structure, so what is TMF’s?
The main issue is the ability of the fund and Magellan to accurately reflect the NAV at all times, including in stressed markets, without significantly widening the spread. What can potentially go wrong?
Magellan is acutely aware of the risks, as described in its offer PDS. MGE is a global fund which invests in stock markets which are closed during the ASX trading day. It is not possible for Magellan (as the market maker) to hedge the fund’s market-making activities or always know the exact NAV. It states:
“The iNAV published by the Fund is indicative only and might not be up to date or might not accurately reflect the underlying value of the Fund.”
For example, consider this (unlikely) circumstance:
- An investor sells 200,000 MGE shares at midday in Australia at $2.50 for $500,000. This price is the iNAV based on New York’s close the previous day, and there has been no change in FX rates.
- A bomb explodes at the NYSE. In Asia, the S&P500 falls 10% on futures markets (Magellan believes hedging their portfolio in this time zone using futures is expensive and inefficient).
- Offshore stockmarkets open and prices are still down 10%. To match the sale done in Australia, the underlying shares are sold for an equivalent of $2.25 and the fund loses 10% or $50,000 on this trade. This cost is borne by all investors in the fund.
This is an extreme event for illustration purposes, but risk management is about covering extreme events. Magellan says it has in place strategies based on back-testing of the same underlying fund since inception, but it is not explicit about these techniques. Magellan has the ability to widen spreads in uncertain conditions, and it’s entirely possible that the fund will make money from this trading activity.
Is it a game changer?
Magellan’s fund is well-suited to the structure because it holds highly liquid companies that can be bought and sold offshore without moving the price. The shares are less likely to respond significantly to announcements in the Australian trading day, as the major holdings are companies like eBay, Microsoft, Oracle, Visa and Nestle. This improves the accuracy of the NAV estimate.
In addition, Magellan has massive brand recognition among advisers, brokers and direct investors like SMSFs. As a global fund, Magellan’s TMF will be supported by Australian brokers who would not promote an Australian equities fund, because the latter would be too much of a competitor to their core business in local equities. The value of broker support for a listed security should not be underestimated.
The types of funds less suited to the structure are those with less liquidity in the underlying shares, where it is difficult to estimate the NAV during the Australian day, such as a global small companies fund where the price may depend on volume traded. Some Australian funds may be open to arbitrage activity, such as the recent 60% fall in the price of Sirtex and its impact on Hunter Hall funds. Would the market react quicker than the market maker and sell at a NAV set too high?
My conclusion is that the Magellan structure will have most attraction for large cap portfolios with major managers in global equities who have the resources and capital to make markets and respond quickly to changes. The ASX is known to be fielding many enquiries from other fund managers and the Magellan structure will be replicated. It will encourage the move away from retail platforms and onto the ASX. It will take business away from mFunds, where the dependency on specific broker participation and lack of live pricing are drawbacks.
It’s not likely to be a major competitor to ETFs, which will continue to have cost advantages and appeal to those who do not believe in paying for active management. It’s likely to complement ETFs by allowing a total ASX-based solution, where an investor may have a ‘core’ ETF and a ‘satellite’ TMF with fees for a different type of exposure. LICs will continue to have a following, aided by their company structures and use by several high profile managers such as Wilson Investment Management. Boutique LICs, such as the recent Future Generations and Global Value Fund offers, would not have the resources to manage a TMF.
As new active funds are listed in this format, the ASX’s suite permits a diverse portfolio without paying higher fees for the traditional choice and administration strengths of retail platforms. The ASX itself becomes more of a competing platform.
In the short time between launch on 5 March 2015 and 24 March 2015, about 26 million units in MGE traded at around $2.50 with narrow spreads, usually only 1 cent. Net amount issued to 1,500 investors was about $60 million, equivalent to the launch of a new mid-sized LIC. It’s not quite game changer territory, but that sort of success will invite many competitors.
Footnote: Since this article was published, we have been advised by Aurora Funds Management that the Aurora Sandringham Dividend Income Trust (ASX code AOD), listed in November 2005, was the first (open ended) exchange traded managed fund (ETMF) in Australia. In 2006, they commenced self-market making for this fund. In addition, ETF provider BetaShares has a range of listed funds with some variance on normal indexing which the ASX labels MF, or Managed Fund.
Graham Hand has worked in wealth management and banking for 38 years and is the Editor of Cuffelinks.