Tom Faust has had enough of the war on active managers. The CEO of Boston’s Eaton Vance, a 91-year-old publicly traded investment management company with $303 billion in assets, is arming his stock and bond pickers with a tool he believes will level the playing field and slow the encroachment of passive strategies into his industry. Eaton Vance is rolling out a new exchange-traded fund designed specifically for active managers by eliminating the need to continually broadcast their best ideas to the market.
But Faust isn’t stopping there. He’s licensing his firm’s patented ETF, called NextShares, to his competitors, hoping the collective power of mutual fund companies will make the product the next big thing and save active managers from extinction. Faust, whose family ran a sawmill in tiny Helena, Arkansas, and who boarded a plane for the first time in 1976 on his way to study mechanical engineering and economics at the Massachusetts Institute of Technology, believes that NextShares will lower costs enough for active managers to win back investors who have abandoned them in favor of cheap index funds. NextShares are expected to outperform identically managed active equity mutual funds by an average of 60 to 80 basis points annually.
“For the first time, active strategies will be available in a structure that avoids those inefficiencies of a mutual fund that have dragged down active management,” says Faust, 56, who saw firsthand the ravages that the decline of the industry and farm economy took on his hometown. “This is about better performance for investors, and from a business standpoint, it puts active managers in a position to be more competitive and slow down the rate of conversion of the fund business from active to passive.”
The CEO, who joined Eaton Vance in 1985 as a natural resources analyst, is betting that innovation will help power his firm’s revenue and profit growth. Though Eaton Vance reached a high in assets under management in 2014 and had record revenues and earnings, fund companies that use original research to try to beat the market are under pressure. Last year investors favored passive strategies over active ones in every U.S. equity category as well as some bond strategies. ETFs have added fuel to the index trend as firms race to offer a new twist on the hot-selling, low-cost products and as advisers add them to model portfolios.
As an engineer who has spent most of his career in money management, Faust has long loved applying his training to new products and acquisitions. He and the previous CEO, James Hawkes, spent the late 1990s and early 2000s diversifying the company beyond its conservative roots managing money for wealthy investors. In 2003 they acquired Parametric Portfolio Associates, which provides low-fee investor services like tax and risk management. Faust saw a company that would help Eaton Vance diversify away from traditional active management, have an offering at a different price point and expand into the institutional market, a small part of its business at the time. Parametric has grown its earnings and assets 40 percent annually.
Eaton Vance also became the largest raiser of new closed-end fund assets from 2003 to 2007. But during the financial crisis, the funds traded at big discounts to the value of their underlying holdings as buyers disappeared and the market for auction-rate preferred shares dried up, ending their financing source. The closed-end funds market never recovered. Faust needed a new source of growth.
Faust, who became CEO in 2007, was initially attracted to ETFs for prosaic reasons — they could be used to lower investors’ tax bills. It was a strategy that fit well with the firm’s lineup of tax-managed equity funds. Faust quickly came to realize, though, that ETFs offered far more, such as reduced trading and transfer agency costs, which can be a big part of total fund expenses. In 2010, after four years of on-and-off-again negotiations, Eaton Vance acquired the intellectual property of Managed ETFs, co-founded by ETF pioneer Gary Gastineau. The firm held a number of patents designed for active managers.
After the purchase, the Eaton Vance team, including Stephen Clarke, president of Navigate, set to work on getting Securities and Exchange Commission approval. Matthew Witkos, Eaton Vance’s head of distribution, says Faust was personally involved in many of the details, looking at the patents like a Rubik’s Cube. “We didn’t pay much for this company because it didn’t have all the mechanical things worked out,” says Witkos. “But Tom’s a what-if guy: ‘What if we change this; what if we did this?’ He has an incredible talent for being able to keep concepts in his mind but at the same time moving all the pieces around and remembering everything he tried.”
The team met with the SEC in spring 2011, but it was a period when the agency was largely closed to new products because it was still busy implementing new regulations in the wake of the financial crisis. Two years later Eaton Vance filed for approval of NextShares; it got the commission’s okay in late 2014.
Now Faust’s firm is working to get the product to market. For its part, Eaton Vance is planning to launch 18 funds, 17 of which are based on existing strategies, including two overseen by Richard Bernstein, the well-known market guru who was once Merrill Lynch & Co.’s market strategist. Faust ultimately wants all his firm’s funds to come in NextShares format. But the real potential for NextShares is the $10 trillion in U.S. actively managed funds, which are feeling the pinch as index strategies dominate the fund business.
The Eaton Vance CEO is pleased with the roster of active managers that have signed on to NextShares, including $57 billion-in-assets American Beacon Advisors, Mario Gabelli’s $47.5 billion GAMCO Investors, $73 billion Hartford Funds and $37 billion Victory Capital Management. “This will be successful,” says American Beacon CEO Gene Needles, who was head of distribution for Invesco when it acquired ETF provider PowerShares Capital Management in 2006. “We wouldn’t have thrown our weight behind this if we didn’t think it’s the best solution we’ve seen for active. And when NextShares are successful, other firms will have to follow suit. You’ll have to have it, or you’ll lose market share.”
Faust makes the case by pointing to his firm’s research, which shows that 65 percent of a cross section of active funds would have outperformed their benchmarks from 2007 to 2013 if they had used the NextShares wrapper. Looking at the actual performance of these funds, only 43 percent beat their bogeys. “The growth of exchange-traded products relative to traditional funds is killing active managers and feeding the perception that active managers are doomed to underperformance,” says Faust.
In 1993, when the first ETF was introduced, only 2 percent of assets in the fund business were passive. Today 27 percent are passively managed. “Until the advent of NextShares,” Faust says, “the structural benefits of ETFs were only available to passive products.”
Faust believes that NextShares will change the fund management industry. “Active managers are locked into a high-cost, inefficient structure, dooming them to underperform,” he says. “But if you take those same managers and you put them in a better structure, then you can change the competitive dynamic.”
Distribution head Witkos expects active managers using NextShares to launch strategies that are truly active, look a lot different from widely used benchmarks and complement core index funds. No benchmark huggers here.
Though it has been a long road for Eaton Vance to get NextShares approved and the firm still faces challenges ahead to get investors to accept the new product, Faust isn’t sweating it: “The worst days in the investment industry are better than the best in the sawmill industry.” •
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