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Is Magellan's listed fund a game changer?

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[Upfront disclaimer: Magellan is a sponsor of Cuffelinks but our content is independent and we do not publish product promotions.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.

9 Comments
Brian Long
May 25, 2015

It's impressive but remember that the fund has a medium term investment objective.

Dugald Higgins
May 25, 2015

Increasingly, investment strategies (from fund managers) can be accessed via multiple channels as is the case with Magellan and others. While each of these structures tend to bring their own strengths and weaknesses to the equation, the investor is increasingly being offered great choice with different channels appealing to different segments of the investing public. I feel this is an important advance as those manager who resist the direct investor movement might be missing the point. FUM in a strategy is still FUM, regardless of how it gets there. Whether it's an ETF, LIC, managed fund or some other structure, the provision of greater choice has to be a positive. But only as long as these vehicles are structured properly for the long term and not as as a knee jerk reaction. For example, I suspect that many of the new crop of LICs hitting the market over the past 2-3 years will not survive over the long term as too many of their instigators seem to be more interested in getting on the bandwagon rather than building solid underlying business through this structure. As always, you have to be diligent in sorting the wheat from the chaff!

Tim Richardson
March 31, 2015

Graham – Thanks, very interesting article. A couple of thoughts:
1) The TMF structure seems to have a lot in common with the SICAV and OEIC structures in Europe and the UK respectively – which have attracted huge inflows over many years
2) Your point that this isn’t a game-changer in itself is fair, but it is a symptom of a longer-term trend to make life easier for anyone wishing to escape the costs associated with vertically-integrated platform groups and towards more self-directed investing

Frank Casarotti
March 31, 2015

The key distinction between MGE and a LIC is that MGE is an open-ended trust, while an LIC is a closed-ended company. As such, in respect of MGE, capital raisings or reductions occur daily as MGE can issue or redeem units continuously and does so at the NAV, in the same way as Magellan’s unlisted funds. This is very different to a LIC which, like all listed companies, raises new capital usually via DRP, placement and right issue techniques which may result in investors being diluted (in respect of rights, where rights are non-renounceable and not exercised by the investor). MGE has no intention or ability under its constitution to issue primary units to dilute existing unit holders. MGE units are traded in the secondary market on the ASX and may at times trade at prices different to the NAV.

Liam
March 28, 2015

Thank you for the informative article Graham. I for one have embraced this fund for my clients, especially those with a dislike of platforms and it beautifully compliments our ETF, LIC and Direct Equity holdings. I did 5 trades over the last few weeks and it took about 10 minutes in total. I just did an application for another favoured managed fund and just one client application and supporting documents took 25 minutes of my time and 1 hour of my assistants. I for one look forward to more time to read Cuffelinks and less filling in paperwork that adds no value.

Ryan
March 28, 2015

Graham, thanks for the very informative article. What I don't clearly understand is the manner in which the fund is established. Magellan have injected $50m. Does MGE simply issue more shares at NAV when there is more demand than supply? Is there any risk to retail shareholders from dilution from capital raisings (as the LICs commonly do via discounted placements to institutions / such as TGG and more recently HHV)!

Peter
March 27, 2015

Good Morning, i was trying to send a thank you for your article on Magellan Global as i had recently bought 5000 and Have been a supporter of the group since 2007. People like me at my age are not experts when it comes to computers Keep the articles coming please

Graham Hand
March 27, 2015

Geoff, thanks for your kind feedback.

On the differences between MGE and an unlisted fund:

1. With MGE, you know exactly the price of the units when you invest, as you do if you buy BHP. If you apply for an unlisted fund or use mFunds, you don't know the unit price until some time later, at best that night. This is particularly important for a global equity fund where the unit price depends not only on share prices but FX. So, for example, if I think the AUD is about to fall due, I can set myself with MGE immediately in a way I cannot with an unlisted fund.

2. Your point about not needing to fill in an application form is a big factor. For me, the 15 pages of application for my SMSF, including certified copies of my 94 page trust deed, supply of passports for my wife and I as trustees, certified copy of a recent utilities statement, maybe a document from my accountant confirming the fund's status, is a major hurdle in an investment decision. A fund manager told me they monitor the stages of visits to their online application and many people drop out after starting the process.

Within funds management businesses, an enormous amount of compliance time is spent on the application form. Plus there's considerable legal and administration costs, where most applications are missing details and need to be followed up before the money can be accepted - during which time the money sits in a bank account, not in the market.

I believe this range of investment choices on the ASX (ETFs, LIC, mFunds and TMFs) for people with a broker relationship, and no need to fill out forms or pay a platform fee, is a significant development. Unlisted funds need a complete overhaul of their application processes.

Cheers, Graham

Geoff Warren
March 27, 2015

I thought your article on MGE was excellent.
Mulling it over, I am wondering what is the practical difference between MGE’s market-making function, and an open-ended fund that facilitates applications and redemptions at a buy-sell spread around NTA? On the surface, it looks to me like the only difference is the investor trades through the ASX, rather than filling in an application or redemption form. But then again, I could be missing something.

 

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