In this slot four weeks ago, we wrote an introduction to active exchange traded funds (ETFs, which can be read here) and we are returning to the topic due to some interesting related news. The long-standing investment trust Middlefield Canadian Income (MCT) has announced its intention to convert to an actively managed ETF under the HANetf platform. The relevant circular was published on 30 September and, if the relevant resolutions are passed, the first trading date for the new vehicle is anticipated to be 23 October. This could be an extremely interesting test case for the sector.

MCT, established in 2006 and managed by Dean Orrico and Rob Lauzon, is a £150m Jersey-domiciled investment company that invests in large cap Canadian equities. As the name suggests, in doing so it endeavours to provide investors with a good yield, which is currently just over 4%. Overall performance has been mixed. Per its most recent factsheet, the underlying one-year return to 31 August was 13.4% versus 14.5% for its benchmark S&P/TSX Composite High Dividend Index (a benchmark focused on income-paying Canadian equities). The five-year annualised return on net assets was 12.3% against 14.6% for the benchmark, although since inception the data show outperformance, at 7.4% annualised return versus 6.6%.

A persistent issue for MTC, however, has been the discount of the share price to NAV, which has regularly been in double-digits in recent years. Although hardly unique within the investment companies sector, this is something that the board has been conscious of but has struggled to fix. This opened the way for MTC to be one of the UK investment trusts targeted by Saba Capital, an activist US hedge fund, at the turn of the year. In MTC’s case, Saba announced its intention to requisition a general meeting to push for structural change, but then withdrew this threat in order to engage in discussions with the board. These discussions led to the decision to convert to an active ETF. As a result, as the market has anticipated this change, the discount has narrowed substantially to around 2.5%.

MCT is keen to point out that Middlefield, its Toronto-based parent company, has experience of converting funds to actively managed ETFs, with the vehicle being much more established in North America compared to Europe, and the market much larger. However, despite this experience across the pond, this is the first direct move from any UK-listed investment company to convert to an active ETF, so clearly is of great interest.

It is reasonable to assume that the resolutions to make the change will be passed at the class meeting and fund EGM scheduled for 22 October. In contrast to the meetings requisitioned by Saba at the other trusts it targeted, the board of MCT is supporting the change. If the resolutions do pass, shareholders will have the option of rolling into the new vehicle when the existing structure winds up, or receiving their entitlement in cash at “close to net asset value” (NAV). Saba has formally committed to taking the cash option for those shares that it holds directly, which equate to 11.3% of the trust. It also holds a further 18% interest through financial derivatives. Saba has yet to say publicly what it will do with these, although it seems a fair bet that it will again take cash, thereby achieved its aim of exiting the position at close to asset value.

Once launched, the new Middlefield vehicle will be a sub-fund of the HANetf ICAV, an open-ended investment company with variable capital incorporated in Ireland. HANetf is the leading European white-label ETF platform, providing infrastructure and regulatory support to asset managers running ETFs. Dean and Rob are keen to stress that their management of the portfolio will remain unchanged. The focus will still be on income generation, which will be paid out to underlying investors in the same way. The restrictions in place for MCT (minimum 60% investment in Canada, maximum 10% in any one holding, etc) will remain, and liquidity – sometimes a limiting factor with ETFs – should not be an issue, given the focus on large-cap investing. And although direct gearing is not available within an ETF, leverage will still be possible through the use of financial derivative instruments.

So is this conversion a good idea? There are clear advantages. Most importantly, the discount problem will be fixed, with active ETFs ordinarily trading at or very close to NAV. Any investor in MCT that rolls over will therefore have the option of getting out at NAV whenever they choose. In addition, the ETF’s total expense ratio (TER) will be capped at 0.9% versus 1.3-1.35% currently, principally due to costs being spread over a larger base at the ICAV level. From the point of view of the managers, a further advantage will be plugging into the deep marketing reach of HANetf, across the UK and Europe, to potentially grow the fund.

However, there will also be clear disadvantages, and pitfalls, with this change. For one, the lower costs are largely due to the scrapping of the trust’s independent board, which currently represents the interests of the wider shareholder base; investors will clearly have less protection. This is particularly relevant with such a novel development. There also must be a risk that a large proportion of investors will choose to cash out now, or in the future, which would threaten the long-term viability of the fund. A hurdle to overcome will clearly be investor ignorance; the UK wealth management community has not been meaningfully exposed to active ETFs, and in many cases may be unwilling to take a chance, no matter how good the story. There is the sense here – despite their protestations that they are focused on the interests of all shareholders – that Saba want to make their fast buck and leave other investors to their fate.

There are alternative routes that could have been taken, chiefly that the board of MCT could have instigated a robust discount control mechanism. However, clearly that boat has sailed, and we will therefore be left with a very interesting test case, which will be watched closely by investors and other funds which may be contemplating something similar. The success or otherwise of the new vehicle should not be taken as a proxy for the viability of active ETFs as a whole – a €55bn European market, and many times that in the US – conclusively answers that. However, it certainly will give a good indication of whether the active ETF route is a potential one for other trusts to address their long-term discount problem.