The next big thing in the $1.5 trillion exchange-traded funds business is being cooked up in a small office sharing an entrance with a beauty salon in the bucolic town of Bedminster, N.J. There, in a loftlike space outfitted with whiteboards, comfy chairs and a pool table, the four principals of Precidian Investments run what amounts to a lab for designing and patenting new forms of ETFs. Few investors have heard of them, but to mutual fund firms like Fidelity and American Funds, Precidian may well be the messiah of new growth.
Precidian has devised a new structure that would essentially enable old-school mutual fund companies to offer ETF versions of their existing actively managed funds. Despite the growth of indexing, actively managed stock-picking funds still dominate the mutual fund business. Firms like Fidelity, Franklin Templeton, American Funds and Dodge & Cox, and stock pickers like Mario Gabelli, Will Danoff and Ron Baron, have yet to be invited to the ETF party.
What Precidian has figured out (and patented as ActiveShares) is a process that keeps most of the low-cost and tax-efficient benefits of an ETF while disclosing holdings only quarterly, as active managers now do. If ActiveShares' "nontransparent" ETF structure is SEC-approved, you may soon be able to log on to your e-broker any time of day to trade into and out of the portfolios of great managers like Donald Yacktman and Bruce Berkowitz.
"It's clear that funds are ready to leap into the next generation of products," says Precidian CEO Daniel J. McCabe. "Several of the world's largest asset managers have already embraced our structure." McCabe isn't saying who, but SEC filings indicate he is most likely talking about BlackRock BlackRock and State Street State Street.
Precidian's ActiveShares brings several innovations to the ETF world that could attract stock-picking funds. The most important is the publication of intraday indicative values every 15 seconds, a standard for all ETFs but a hurdle for traditional active mutual funds, which publish prices only once a day, after the market closes.
Those values, matched with a fund's benchmark, should give ETF marketmakers enough information to hedge their trading throughout the day in the futures market, a key to keeping the ETF price in line with its net asset value (NAV) and giving all investors the opportunity to buy the fund at a fair price. But portfolio managers would not be required to disclose their holdings daily as most other ETFs are required to do by the SEC.
Another Precidian innovation involves tax efficiency. Its new structure establishes blind trusts for authorized participants, who act as a filter to bring cash into the ETF or receive and liquidate securities on redemption. The tax consequences of this trading are borne by the blind trust, not the investor.
Cracking the code on actively managed ETFs is a big deal because the $6.8 trillion market for managed stock mutual funds dwarfs the index ETF business, whose growth has slowed. SEC approval of "nontransparent" ETFs could open the ETF world to dozens of fund families.
It could also create a big payday for the founders of Precidian, which earns small license fees based on fund expense ratios. Currently most of its revenue comes from the fees it earns on Guggenheim's nine CurrencyShares ETFs ($1.5 billion in assets) and its own $130 million ETF, the Maxis Nikkei 225 Index Fund.
McCabe, 49, and partners J. Stuart Thomas, Paul Kuhnle and Mark Criscitello are veterans of Wall Street trading floors and back offices who specialized in structured products and derivatives operations. All but one is a college dropout. But what they lack in book learning they make up for with deep Wall Street connections, trading experience and, most important, market savvy.
McCabe, who is fond of wearing Prada loafers sans socks in the office, headed up NYSE and Amex trading firm Bear Hunter Structured Products, a subsidiary of specialist firm Bear Wagner, which was owned by Bear Stearns. Kuhnle, 50, studied quantitative analysis at Penn State before dropping out, later landing a Wall Street IT job. He worked with McCabe at Bear Hunter, as did Criscitello, 52, Precidian's finance officer.
The three met Thomas, 47, formerly in equity sales at Morgan Stanley, when he was helping the World Gold Council create the U.S. entity that would become State Street's SPDR Gold Trust, the world's largest gold ETF, with $38 billion in bullion. Most investors know the ubersuccessful ETF by its ticker symbol, GLD.
Launching the firm in 2006 was a midlife gamble for the group. At a time when other Wall Streeters tried to cash in on the ETF boom by launching their own funds, Precidian's partners stuck to product design, in a model similar to that of microchip IP firm ARM Holdings.
"Thinking creatively about building products with protected intellectual property has a different return profile than launching me-too ETFs," says Michael Brown, general partner of Waltham, Mass.' Battery Ventures, which took a stake in Precidian in 2007. The me-too ETF business, he adds dismissively, has simply been a race to the bottom.
Not surprisingly, Precidian isn't the only one trying to create a viable ETF structure for active mutual funds. Eaton Vance, Guggenheim and T. Rowe Price have filed their own SEC applications. Vanguard already has a process for creating ETF share classes of its passive index funds.
As they await an SEC ruling on ActiveShares, the Precidian crew is floating another ETF innovation aimed at the ravenous market for income. According to SEC filings, Precidian is the brains behind a proposed WisdomTree S&P 500 Managed Distribution ETF. Like an annuity, the fund promises a fixed 6% annual payout in all markets, despite the fact the underlying S&P 500 offers only a 2% dividend yield. Precidian's patented formula incorporates the possibility of returning capital as part of the annual payout. Given the recent boom in indexed annuity sales it's likely to be a winner, if approved.
"Precidian brings a level of expertise that provides for their ideas to advance," says William Belden, Guggenheim Funds' head of product development. "They're not just throwing things against the wall."
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