A mere 1% of the exchange-traded fund (ETF) universe is invested in actively managed funds.

As discussed in the 2015 Guide to Exchange-Traded Funds (August 2015 AAII Journal), more than $2.1 trillion is invested in ETFs and exchange-traded notes (ETNs) as of June 30, 2015. Of this large amount, only $20.2 billion is in active exchange-traded funds.

The market share devoted to the overwhelming majority of active exchange-traded funds is even smaller. PIMCO’s Enhanced Short Maturity Active ETF (MINT) and Total Return Active ETF (BOND) account for almost one-third of active ETF assets under management (AUM). Excluding those two funds, active exchange-traded funds control just 0.7% of all ETF dollars.

Clearly, active exchange-traded funds—especially actively managed equity ETFs—have yet to take off as a group.

A big hurdle has been the Investment Company Act of 1940. Known in the financial industry as the ’40 Act, the law governs pooled investment vehicles (e.g., open-end funds such as mutual funds) offered by registered investment companies to the public. A key part of the ’40 Act is the requirement for regular disclosure of the underlying portfolio’s holdings.

Mutual funds are required to disclose their holdings quarterly, with a 30-day lag. ETFs must disclose their holdings on a daily basis. The less-frequent disclosure requirements of mutual funds is preferable for active managers because it allows them to move in and out of positions without tipping off traders to their intended actions. It also makes it harder for competitors to mimic proprietary investment strategies. For these reasons, ETF versions of actively managed funds have mostly not come to fruition.

A New Type of ETF

Eaton Vance subsidiary NextShares has a compromise solution it is trying to bring to the market. It is an exchange-traded managed fund (ETMF), which is designed to be a hybrid of a mutual fund and an exchange-traded fund. The Securities and Exchange Commission has given NextShares an exemption from the ’40 Act’s disclosure requirement for this platform but, as will be discussed momentarily, hurdles remain.

There are two key differences NextShares will have from traditional ETFs. The first is disclosure. Portfolio holdings will only be required to be disclosed quarterly on a lagging 30-day basis, similar to mutual funds. Unlike traditional active ETFs, portfolio holdings will not be disclosed on a daily basis. Participating companies will have the option of disclosing holdings on a more frequent basis. (Mutual fund companies can disclose their holdings more frequently too, if they choose to do so.)

The second difference is net asset value (NAV). This is the underlying value of a fund’s assets. The NAV of NextShares funds will be calculated at the end of each trading day, as mutual funds are. ETFs, conversely, see their NAV fluctuate throughout the trading day. This fluctuation allows authorized participants (APs)—who are large, institutional traders—to take advantage of occurrences when an ETF is trading at a price above (a premium) or below (a discount) its NAV.

To appreciate the potential implications of this, it is important to understand how ETFs trade. Exchange-traded funds are bought and sold throughout the trading day just like stocks are. APs have the option of not only trading on the exchanges, but also transacting in creation units with ETF providers. Creation units are blocks of 50,000 shares, and they can be exchanged for a basket of the underlying securities and cash. The exchange of creation units is enabled by the daily disclosure of an ETF’s holdings. APs can identify what is held by the fund and, based on that information, determine whether or not the ETF’s shares are trading at a premium or discount. This transparency allows ETFs to trade close to their net asset value under normal market conditions.

Conversely, NextShares proposes using NAV-based trading. Authorized participants will have some transparency into how each fund’s portfolio is changing over time, but the full transparency that ETFs provide will not exist. Rather, as stated, the holdings of these funds will only be required to be fully disclosed quarterly with a 30-day lag (just like a mutual fund). NextShares believes APs will be comfortable with the level of disclosure that will be provided.

Individual (and institutional) investors buying and selling NextShares on the open market, just like stocks are currently traded, will transact based on information about the prior day’s NAV. This may mean paying a premium or discount without knowing for sure until after the close of trading.

Contrast this with mutual funds. Like NextShares, the NAVs of mutual funds are reset at the end of each trading day. Unlike NextShares, mutual fund shares are bought and sold only at the end of the trading day. The transactions occur at the closing NAV. In other words, mutual fund transactions always occur at the most currently updated NAV; NextShares transactions, however, will occur at the prevailing intraday market price, which may represent a premium (paying more than a dollar for a dollar’s worth of assets) or a discount (paying less than a dollar for a dollar’s worth of assets).

NextShares is promoting its product as a mutual fund in an ETF wrapper. The company says the structure of its funds will result in lower costs and greater tax efficiency than mutual funds. Representatives of the company predict that investors will save 0.65% annually in expenses compared to mutual funds. They also say that the use of creation units will resolve the problem of embedded capital gains. (Embedded capital gains are the unrealized gains of a mutual fund’s current holdings. When an investors buys shares of a mutual fund, he or she instantly becomes responsible for the tax consequences of transactions made by the fund manager, even if the unrealized profits or losses occurred prior to the investor buying shares of the mutual fund.)

The Hurdles Delaying Launch

It is uncertain when NextShares will be officially launched. Representatives of the company said in June that they are targeting a late 2015/early 2016 date, though it was still early to specify an exact date.

One of the hurdles is technology. The NASDAQ needs to alter its system to handle exchange-traded managed funds, something NextShares expects to be completed this fall. Broker-dealers and other firms also need to build out their systems to support the product. For example, Ben Johnson, the director of passive funds research at Morningstar, said that among the changes data providers will need to make is coding their databases to correctly identify NextShares funds since they will be a unique type of investment product.

Another hurdle is education and compliance. Because this is a new type of product, a large amount of education will be needed beyond simply making market participants aware of the product’s existence. Not only will individual investors need to be informed, but so will financial advisers and institutional investors. Brokers and financial advisory firms also need to consider compliance-related issues and adjust their internal guidelines accordingly.

All these changes will incur costs. At the same time, according to Morningstar’s Johnson, NextShares will not pay 12b-1 or transfer agency fees. This means broker-dealers may not realize the same income they do from mutual funds while being asked to bear the up-front costs of a product whose future is, as of yet, unknown. NextShares’ parent, Eaton Vance, says it will offer some compensation to broker-dealers.

A critical mass of mutual fund companies is also being sought to distribute NextShares funds. NextShares told me at the Morningstar Investor Conference in June 2015 that 13 mutual fund companies have signed preliminary agreements to offer exchange-traded managed funds. Among them are American Beacon, Gabelli Funds, Hartford Funds, Ivy Investment Management and Principal Management. Noticeably absent are the largest mutual fund families.

All ETFs require SEC approval prior to launch. Though an exemption to the disclosure requirement of the ’40 Act has been granted to NextShares, regulatory issues could still effect the launch date.

No Clear Signs of Other Active ETF Platforms

Beyond NextShares, there is no clear sign of a solution to the transparency problem plaguing actively managed ETFs. Beyond PIMCO’s foray, the largest mutual fund companies have been noticeably absent from the active ETF space.

Johnson said that the SEC wants to have alternatives to the NextShares platform; however, it denied a second request from Precidian Investments for a competitive platform this past spring. USAA has reportedly been in talks to license Vanguard’s patented ETF structure. This structure enables ETFs to be offered as a different share class of an existing mutual fund. It is unclear if anything will come from these discussions.

Beyond this, there is chatter and not much more. Some active managers have opted to use so-called smart beta strategies instead of launching fully active ETFs, including J.P. Morgan and Goldman Sachs. Smart beta funds are based on quantitative strategies. These ETFs strike a balance by quantifying an active strategy into an index that can be followed by an exchange-traded fund. Though the ETF’s holdings are disclosed, the specific criteria that the underlying strategy is based on may not be.

Johnson points out that the push for actively managed ETFs is coming from the investment industry and not from individual investors. As such, it remains very uncertain as to when, or if, actively managed funds will become prominent in the ETF marketplace.

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