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LEGG MASON INC

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New ETF Model Caters to Stock Pickers -- WSJ

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07/16/2019 | 02:48am EDT

Capital, Legg Mason and JPMorgan plan funds without daily investment disclosure

By Justin Baer 

A new type of exchange-traded fund backed by some of Wall Street's giants will soon debut.

But there is a catch. Investors will have to be fine with less transparency.

Capital Group Cos., Legg Mason Inc. and JPMorgan Chase & Co. are among firms that plan to launch exchange-traded funds that bet on stocks without disclosing investments each day. The ETFs would reveal positions quarterly, as mutual funds do, to prevent front-running of trading ideas. The first of these funds may debut by year-end.

The structure behind the coming wave belongs to a suburban New Jersey upstart, Precidian Investments, which received U.S. regulatory approval for its design in May. Other blueprints, from other managers, aren't far behind. The bet is that this new model will help reverse an outflow of client money from traditional stock pickers.

"This is a game changer for the industry," said Jim Tambone, chief distribution officer at Alger, an investment firm that is considering active ETFs and has held talks with Precidian.

The embrace of a less transparent, actively traded stock ETF represents the latest attempt by more-traditional asset managers to grapple with a sea change in the industry over the last decade. Clients are flocking to cheaper, passively managed products tied to indexes and losing faith in more-expensive managers that try to outperform the market.

No product better embodies this shift than the ETF, which trades on exchanges like stocks but is cheaper, more transparent and more tax-advantageous than mutual funds. There are now more than 2,200 ETFs listed in the U.S., and ETF trading now accounts for roughly 20% of the daily volume in U.S. stock markets each day, according to Nasdaq.

The search for an ETF that stock pickers could use began more than a decade ago, as several firms suggested what it would look like. ETF pioneers Gary Gastineau and Todd Broms first sought regulatory approval in 2005 for a hybrid fund that offered some of the same cost and tax benefits that ETFs provide. Eaton Vance Corp. has since launched funds based on Messrs. Gastineau and Broms's design. Fidelity Investments first submitted a confidential filing on the concept with the Securities and Exchange Commission in 2007 and is among firms that are still seeking the agency's blessing.

Other firms launched actively traded stock ETFs that disclosed their positions daily as passive ETFs do. But the first to win SEC approval for a version that would reveal positions less frequently was Precidian, a firm in Bedminster, N.J., run by four veteran financial engineers who spent most of their careers outside the asset-management industry. Legg Mason bought a minority stake in Precidian in 2016.

"We believe this is a foundational change in the delivery system for active managers," said Precidian Chief Executive Daniel McCabe. It will allow the "active manager to compete on a more level playing field with today's passive ETFs."

Capital Group, Legg Mason and JPMorgan have all agreed to license the Precidian structure.

An advantage of a less-transparent stock ETF is that it will free managers to offer stock-picking strategies while keeping others from front-running their trading ideas.

There are questions, however, beginning with how the new ETFs will trade and whether they will mimic strategies already used by existing mutual funds. Some financial advisers need to be convinced that the new products will benefit their clients and not just help lift stock-picking managers out of their malaise.

"I'm never going to get very enthusiastic about a product designed for the sole purpose of asset gathering," said Leo Kelly III, chief executive at Verdence Capital Advisors, an independent wealth manager in Hunt Valley, Md.

Mr. McCabe and his team were protégés of the late John Mulheren, the larger-than-life trader who befriended Bruce Springsteen and once threatened to kill Ivan Boesky after the speculator testified against Mr. Mulheren in a 1980s stock-manipulation case.

Mr. Mulheren, who was ultimately exonerated after an appeals court reversed a conviction, returned to prominence on Wall Street with Bear Wagner Specialists LLC, a market maker that was partly owned by Bear Stearns.

Mr. McCabe and Precidian principals Mark Criscitello and Paul Kuhnle worked for Mr. Mulheren at Bear Wagner when a small community of Wall Street traders were developing ways to buy and sell all sorts of investment funds on exchanges, and the team created some of these funds. Another Precidian principal, J. Stuart Thomas, previously worked at Morgan Stanley and Merrill Lynch.

As new rules on the stock market's structure upended the business models of market-making firms such as Bear Wagner, and Bear Stearns itself began to buckle under the strain of the coming financial crisis, Mr. McCabe and his partners left to start Precidian with the backing of the venture capitalist Battery Ventures.

Precidian filed its first confidential draft application with the SEC for an actively traded stock ETF in 2009. The firm ultimately revised the plans for its ActiveShares structure seven times before the regulator gave its approval earlier this year. Many of the SEC's questions concerned how the new ETFs would trade and whether their prices could closely track the value of their stockholdings.

In July 2015, Eaton Vance made one of Precidian's SEC denials public when it obtained the firm's communication with the SEC through a Freedom of Information Act request. Eaton Vance executives said they publicized the SEC documents to clear up some confusion over how quickly ETFs powered by Precidian's model would be available.

Eaton Vance has won agreements with several wealth managers, including UBS AG, to sell hybrid funds that have some ETF benefits, but those products have struggled to gain traction with investors. Eaton Vance is now seeking SEC approval on its own active ETF model.

Industry executives said Eaton Vance's hybrid idea may have helped regulators and investors grow more comfortable with the concept -- and paved the way for Precidian and other ETF developers.

"The recent progress in the active ETF space is exciting and important for asset managers and customers alike," said Greg Friedman, Fidelity's head of ETF management and strategy.

Write to Justin Baer at justin.baer@wsj.com

Stocks mentioned in the article
ChangeLast1st jan.
BUCKLE INC 0.51% 17.76 Delayed Quote.-8.64%
EATON CORPORATION PLC 2.35% 79.14 Delayed Quote.15.26%
EATON VANCE CORP 0.76% 40.01 Delayed Quote.13.73%
JP MORGAN CHASE & COMPANY 0.90% 108.69 Delayed Quote.11.34%
LEGG MASON INC 0.90% 36.86 Delayed Quote.44.49%
LEO HOLDINGS CORP 0.53% 10.505 Delayed Quote.0.00%
MORGAN STANLEY 1.08% 40.37 Delayed Quote.1.82%
NASDAQ COMP. 1.35% 8002.812313 Delayed Quote.19.00%
UBS GROUP 1.23% 10.265 Delayed Quote.-17.12%
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Financials (USD)
Sales 2020 2 858 M
EBIT 2020 549 M
Net income 2020 294 M
Debt 2020 932 M
Yield 2020 4,34%
P/E ratio 2020 10,8x
P/E ratio 2021 9,08x
EV / Sales2020 1,45x
EV / Sales2021 1,28x
Capitalization 3 198 M
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Mean consensus OUTPERFORM
Number of Analysts 14
Average target price 40,08  $
Last Close Price 36,86  $
Spread / Highest target 35,6%
Spread / Average Target 8,73%
Spread / Lowest Target -15,9%
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Joseph Andrew Sullivan Chairman, President & Chief Executive Officer
Peter H. Nachtwey Chief Financial Officer & Senior Executive VP
Kurt L. Schmoke Independent Director
Margaret Milner Richardson Independent Director
Robert E. Angelica Independent Director
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