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Why ETFs Will Overtake Traditional Mutual Funds

by: Index Universe August 25, 2008 | about stocks: ETB / ETV / ETW / EV / SPY    
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By Jim Wiandt

It's the beginning of the end for grandpa's mutual funds and here's why.

There has been a small but vocal contingent of people in the ETF business that have been saying for years that ETFs would eventually make huge inroads into market share in the mutual fund business. Indeed, the American Stock Exchange, who came up with the ETF, staked their future on the concept. The NYSE bought them before the sea change could get underway, but the signs say they were right.

Arguably still just a blip on the radar with only 1 in 20 mutual fund dollars, ETFs have now woken up the major players by taking often tremendous shares of the new flow coming into the market. And they've done this while attracting many investors who don't fall in the category of old school index investor.

So now that I've thrown that provocative "beginning of the end" subtitle onto my blog, the question is do I actually believe it. There are tremendous obstacles still in the way of ETFs getting into some of the biggest (retirement) asset pools, but you can begin to feel a real push in that direction. And year over year, the taxable money is increasingly going into ETFs, and there's now universal recognition, at least, of ETFs by financial advisors.

Add to all of that the fact that ETFs just are a better mousetrap in terms of cost and trading efficiency (all the more so for active funds though some argue otherwise). The truth is, quality does ultimately drive assets - despite all of our pessimism about obstacles to real competition in the mutual fund business.

So yes, I think the shift is beginning to happen, and is going to happen.

By the way, as a side note to Matt Hougan's blog on Eaton Vance (EV), I did do the math on the $5.5 billion buy-write fund at 1.2% (and this does not even account for the underwriting fee) and came up with an annual $66 million in revenues, which would put that fund at 5th on the list of greatest revenue producing ETFs (just behind SPDRs and its massive $80 billion in assets). Yep, $5.5 billion in assets for $66 million in revenue next to $80 billion in assets for $80 million (still not shabby) in annual revenues.

And Eaton Vance could argue that the buy write is a deal. The ERs on ETFs and ETNs, particularly in that sort of exotic strategy focused or alternative asset space, has moved up. But it's hard to imagine it going much above the 95 bps level that ProShares set for their funds. And frankly, the active guys would have to work to justify it (but they're certainly good at that) in a straight long equity fund. So I see an expanded asset base, and a new baseline for active of less than 100 bps (the good, largest funds of the Fidelities and America Funds are already there). And their investors, Index Publications LLC among them, are smart and will increasingly call for the greater efficiency of ETFs.

And ultimately, the infrastructure (around retirement plans) will catch up to the demand. And the assets will flow...

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This article has 6 comments:

  •  
    Aug 25 10:52 AM
    We're big on ETFs at Contrarian Profits, and think that commodities based ETFs are particularly attractive...

    www.contrarianprofits....
    Reply
  •  
    Aug 26 07:39 AM
    I agree with everything said, but one must be careful of saying (as so many people parrot) that ETFs are low-cost. Many ETFs have expense ratios in excess of .6%, even up to 1%. And many mutual funds, finally wising up, are finally lowering costs, with many below 1%. Vanguard, of course, is best in both categories. It seems to me that mutual funds are best for investors, while ETFs are best for traders.
    Reply
  •  
    Aug 26 09:51 AM
    Well, low expense ratio is really the key factor. While I am locked in by mutual funds (tax considerations if sod), I am putting new funds into ETFs.
    Reply
  •  
    Aug 26 12:24 PM
    In my book it's ETF's and Notes for two big reasons...expenses and trading anytime during the day.
    Reply
  •  
    Aug 26 12:31 PM
    Of the almost 800 ETF funds in existence on July 31, 2008 only 209 had more than $300 million in assets, the level generally thought to be breakeven for a managed fund. Almost 300 of the funds had less than $28 million in assets.

    There is certainly a place for ETFs in the investment universe but I think it is a niche product that has grown too fast and is due for retrenchment.
    Reply
  •  
    Aug 26 12:58 PM
    Discussing ETF's versus mutual funds without describing their distinct functions and advantages is like talking about satellite radio as though it were just radio. Mutual funds originally gave the buyer diversification and simplification of some tax situations, but nowadays most funds are so large that even the themed funds function like just a market index. ETF's allow the buyer to drill down more specifically into certain commodities or to execute short positions with less risk, nice options for the retail buyer. While major pension funds will likely play footsie with big mutual funds for a long time to come, the tide can't be held back forever. There are too many mutual funds today and they're all becoming homogenous index funds, giving the buyer little reason to choose between them and a stronger desire to master one's own fate by buying commodities when they seem cheap or shorting things that seem ready to fall...
    Reply
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