Exchange traded funds (ETFs) have a brief but impressive history. Since the launch of the original SPDR (aka ‘spiders’) ETF, which tracks the US S&P 500, they’ve branched out to cover a multitude of sector and geographic indices around the world.
There are now a total of 5,500 ETFs around the world, representing a total of US$2.8 trillion. For various reasons (which we’ll come to), though, ETFs have been pretty much limited to funds that track particular indices as opposed to ‘actively managed’ funds, which aim to beat an index through picking the right stocks.
So there’s been much excitement (have you noticed?) over Magellan Financial Group’s (ASX: MFG) plans to bring the exchange-traded concept to its actively managed Magellan Global Fund, through a new vehicle called the Magellan Global Equities Fund, which began trading last week on the ASX Aqua platform under the code MGE.
It’s being described as an ETF (although not by Magellan itself), but there are some important differences, and to understand these we’ll need to take a step back and examine the structure of the two traditional fund investments: unlisted managed funds and listed investment companies.
Unlisted managed funds are ‘open-ended’, which means everyone puts their money in and takes it out at the underlying value of the fund’s assets, known as the ‘net asset value’, or ‘NAV’. When you invest, you don’t buy units from someone else, but rather the fund issues you with new units (and it takes them back, aka ‘redeems’ them, when you want out).
This provides the certainty of knowing you’re getting your money’s worth in terms of the underlying asset value – although you won’t actually know what that value is until some time after you’ve sent in your application.
The process does, however, cost a lot in terms of administrative fees – issuing and redeeming all those units – not to mention the hassle of completing a host of forms for regulatory and other purposes. Importantly, the admin fees don’t ‘scale’ very well, so they don’t decrease a great deal proportionately as a fund gets bigger.
To invest in a listed investment company (LIC), on the other hand, you actually buy the shares from other investors. This means they’re ‘closed-ended’ – the number of shares in them stays the same, which saves a lot in terms of admin costs and means you won’t need to fill in lots of forms (because, as with other shares, your investment will ride on the back of all the forms you filled in to open your broking account). The larger LICs, in particular, can benefit from economies of scale on their management expenses, so they can have significantly lower costs than managed funds.
But if you want to buy shares in an LIC, you’ll need to find someone who’s prepared to sell (and vice versa), which means that prices are set by market forces and you might pay more or less than the underlying asset value (known in the game as a ‘premium’ or ‘discount’).
So, although they can be a better bet (particularly the biggest ones), LICs are more the preserve of savvier investors that already have broking accounts and can weigh up any discount or premium to NAV.
ETFs aim to get the best of both worlds. They do this by operating like ‘open-ended’ managed funds to the big banks that act as their ‘market makers’ (that is, ensure a liquid market by always offering to buy and sell the units), but like closed-ended LICs to the rest of us. So costs are minimised because there’s no need to issue and redeem units to a host of retail investors, but the price is kept very close to NAV because the market makers can go along and swap their units for the underlying assets (or vice versa).
All well and good. The key point here, though, is that to weigh up the value of swapping the underlying assets, the market makers actually need to know exactly what’s in the underlying fund. With a fund that tracks a particular index, they’ll know this but for an actively managed fund they won’t. Active managers understandably don’t want to give away the precise details of their portfolio, else people could mimic it at a fraction of the cost.
Magellan Global Equities Fund
Which, finally, brings us to the new Magellan Global Equities Fund (ASX: MGE). As an active manager, Magellan won’t give away the exact composition of its portfolio (which for MGE will mimic exactly the successful Magellan Global Fund), so there are no market makers ready to swap units for assets. What Magellan has done, though, is to establish a structure whereby its fund acts as the market maker itself, quoting a price every 15 seconds throughout the day, and giving investors the opportunity to invest via the ASX.
It will then net off the buyers and sellers at the end of the day and issue or redeem units as necessary, much as managed funds do already. The difference is that investors will have certainty over the price they’re paying for the fund, and that price should be kept very close to the underlying NAV. Investors will also be able to ride on the back of their broking account in terms of regulation, so there won’t be lots of forms to fill in.
There’s still the host of retail investors to deal with, though, so it’s not clear that Magellan (or its investors) will be able to save much, if anything, in terms of costs. These will therefore be identical to the unlisted Magellan Global Fund, except that if you invest via a broker, you will have to pay broking costs – that’s the price you pay for the pricing certainty and convenience. From Magellan’s point of view, the benefit is that it gives investors another convenient way to invest in its funds.
There are some similarities with the ASX’s mFund service, which enables investors to invest in open-ended managed funds through their brokers – but while mFund saves investors the hassle of filling in lots of forms, it doesn’t provide the pricing certainty offered by Magellan’s new structure.
Bear in mind, though, that investing through mFund (or indeed applying directly to a managed fund) will still guarantee you an investment at NAV, it’s just that you won’t know what that NAV is when you invest. (The Magellan Global Fund isn’t available through mFund, no doubt partly because MGE offers the same advantages in addition to the pricing certainty.)
Which is best?
So, if your investment decision depends on markets hitting a particular trigger, and you feel the need to lock in a price at a particular point in the day, then MGE will enable you to do this. If you’re a long-term investor, however, who’s aiming to access Magellan’s expertise over many years or decades, you’ll probably find that it makes little difference.
In which case, it will probably come down to whether it’s worth paying the brokerage in return for the convenience of sidetracking the traditional application process and form-filling. This will be a personal decision, depending on the size of the investment (which will influence the size of the broking commission) and whether you wish to make regular additions (which, once you’ve set things up the traditional way, can be made at no expense and without any forms).
So is the Magellan Global Fund – or MGE – worth investing in at all? For those wishing to get some exposure to overseas stocks and don’t want to buy them directly it certainly has its attractions. The costs (1.35% a year plus 10% of any returns over the higher of the MSCI world index or the 10-year Australian government bond yield) are quite high, but so far they’ve been worth it, with the fund returning 12% a year since inception in July 2007, compared to 4% a year for the MSCI world index.
Magellan’s strategy of making long-term investments in high-quality businesses trading at discounts to their underlying value (much as described by Warren Buffett) is sound, we’d expect it to keep delivering returns ahead of the market if implemented successfully, and we’d expect manager Hamish Douglass to be able to do that. However, we’d expect the level of outperformance over the long term to be a few per cent, rather than the 8% achieved thus far.
The obvious alternative would be Platinum Asset Management’s (ASX: PTM) Global Fund, managed by Kerr Neilson, which also operates a smart strategy and has been successful so far, with a return of about 14% a year since inception in 1995, compared to 7% for the MSCI world index. A sound approach might be to invest a little in both.
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