Is the mutual fund about to go extinct?

The active versus passive management debate has been raging the last few years.  How easy is it really for a manager to beat his benchmark?  Well, as evidenced by one review, all actively managed U.S. equity funds benchmarked to the S&P 500 Total Return versus the SPDR ETF at rolling 5 year annual returns (1998-2012), only 44% beat the SPDR.  Not great news for the mutual fund industry but a huge source of validation for ETFs. How can mutual funds compete?  By evolving.

To evolve, mutual funds must lower costs, improve performance, and optimize tax efficiency.  ETFs offer a great template for this.  They have no sales loads or imbedded distribution/service fees.  Since they utilize in-kind creation/redemption, they have no flow-related costs.  ETFs are also able to meet outflows in-kind, using securities.  Combine these exchange-traded features with very low operating expenses and you have a vehicle that could reduce mutual fund internal expenses, not all of which is reflected in the expense ratio, by 100-200 basis points a year!  That cost savings can result in 1-2% of performance improvement every year, for every fund.

Why haven’t mutual funds leveraged this new vehicle and shed the mighty headwind of expense and tax burden?  In a word: transparency.  Currently only funds that are willing to publish their actual portfolio every day can utilize the exchange-traded structure.  Thus, only about 1% of ETFs are actively managed.  Very few fund companies want to give up their secret sauce.  They want to get paid for their active management and strategic trading.  Comprising the 1% are mostly fixed income active ETFs that worry little about front-running or having their sometimes illiquid strategies copied.  Even for those, I would wonder about what intellectual capital they are giving up to be an ETF.  Talk to PIMCO, as I recently did, and they seem very happy, as does the industry, with their fully-transparent PIMCO Total Return ETF (BOND).  Of course, we have not seen them launch any equity funds in this structure for probably all the reasons above.

So we have an exchange-traded vehicle that could provide the active management industry a way to level the playing field with ETFs, but precious few active funds are leveraging it.  We need innovation.  There is a proposal before the SEC right now that introduces the Exchange-Traded Managed Fund (ETMF).  It solves the transparency issue.  It provides active management with a low cost, high performing, tax efficient vehicle. What’s the trade-off you might ask for getting your favorite mutual fund delivered this way?  It is a new retail trading process, which essentially combines trading on the secondary market, like an ETF, with waiting for a NAV price until the end of the day, like a mutual fund.  By all accounts, it will deliver more performance and tax efficiency for investors.  Time will tell if the SEC will approve it and the market will adopt it.  As a long-time advocate for the individual investor and their trusted Financial Advisor, here’s hoping for a speedy trial.

It is both fascinating and complex, the world of exchange-traded.  From the consolidated tape, to FINRA requirements, to market making, to asset management and distribution, the expertise at Hobbs|Madison is here to help.  Let’s have a conversation.