Looking at Magellan’s MGE structure

Magellan Financial Group has been an unquestionable Australian success in global equities asset management in recent years, the most significant since Kerr Nielsen’s Platinum Asset Management.

Magellan has been proactive in addressing the major Australian retail channels and segments. Its LIC (ASX: MFF), and $8bn of unlisted funds, have been followed in in early March by a new fund replicating its existing Global Fund, featuring a new structure.

The Magellan Global Equities Fund (ASX: MGE) makes use of the AQUA platform used by ETFs to target retail investors who have shown a preference for the ASX as their operating model. But in contrast with LICs, and closer to the ETF providers, it is doing so with an open-ended structure that permits capital raisings on a daily basis – indeed trading to date suggests there are already more than 1,000 unitholders.

MGE combines characteristics of both LICs and ETFs to create an exchange tradable version of the Magellan Global Fund (with comparable underlying holdings and fee structure). But MGE is neither. Rather it is an actively managed trust, quoted on the ASX, with a daily NAV and live pricing. Magellan plays multiple roles:

• Responsible entity (RE)
• Provides liquidity to the ASX by performing the role of market maker
• Unitholder (as seed investor)

To provide underlying liquidity, at the end of each business day Magellan itself may create / cancel units, by applying for / redeeming its net position in units bought and sold on the ASX AQUA market.

There are some genuine advantages here for investors – for example the ability to trade intraday near the NAV is generally going to be a better outcome than the vagaries of premium / discount pricing associated with LICs. There’s also daily settlement via CHESS, like any ASX listed security, providing investors with a familiar operating experience. Anything improving the accessibility of managed funds to retail investors is to be applauded.

That said, a few questions remain for us around the secondary market liquidity and market making.

Intraday liquidity is provided by Magellan as RE – but this is done on MGE’s behalf, and therefore it is the unitholders that benefit from any gains, but also bear any losses associated with market making activities.

An examination of the PDS raises some concerns. MGE is available to purchase units from the market maker (also the RE) at a price which the RE estimates to be the NAV – normally based on yesterday’s share prices, adjusted for live FX. The RE then creates or redeems units in the fund at that estimated NAV at the end of the Australian day.

This sounds like a great deal for investors wanting to get in or out. But there’s a twist. The estimated NAV is just that – an estimate. Global share markets are generally closed when the ASX is open, so it can be hard to know how to price MGE’s equity securities intraday. The use of day-old prices could lead to incorrect estimates in market dislocation scenarios where the market is gapping daily.

Consider this scenario:

• Global equity markets have been falling heavily for days, and an investor buys $1m of units in MGE for $2.50 each at 3:55pm, at a price which reflects yesterday’s global share prices.
• When global equity markets open later in the evening Australian time, they are up 5%.
• Our investor got a great deal, because the real value of those units is more like $2.62. But the fund loses out to the tune of $48,000, as it issues units at what turns out to be a $0.12 discount.

This scenario is not unique to the listed environment. But the opportunity for investors to arbitrage even slightly stale prices – for example by spotting a move in futures – is far greater when there is intraday liquidity.

There is a possible conflict here:

• Magellan (the business, not the RE) wants to keep a tight spread around the MGE price to encourage trading – a key factor in attracting investors. Fair enough.
• However, MGE’s unitholders are taking all the risk.
• All else equal, MGE should seek a spread that provides adequate reward for the market-making risk it is taking. That’s around the level that independent market makers would price it, but current spreads of 1c look keen to us.
• Of course, MGE is rewarded for this risk through the provision of liquidity – but that benefit accrues primarily to investors entering and leaving the fund, not those who are long term holders.

We stress that most of the time this situation is going to be fine, causing minor gains and losses for the fund. It’s in crisis situations when global equity markets are extremely volatile, and liquidity in physical markets dries up, that problems could arise.

The business drivers for active managers to offer their products via direct retail channels such as the ASX AQUA platform are strong, and the MGE structure is a potentially useful innovation for investors. To Magellan’s credit, they have outlined the risks in their PDS.

We’d also like to see Magellan discuss in more detail how they will deal with pricing and liquidity in market stress scenarios. Given that it is the unitholders who are effectively wearing the risk of pricing uncertainties, it’s important that spreads are appropriately wide to ensure long term investors are not disadvantaged – and that the pricing process does not create an opportunity for arbitrageurs.