In February, Bowen Asset Management attended the annual “Inside ETFs” conference in Hollywood, Fla. The four-day gathering, which Bloomberg called “the marquee event for exchange-traded funds,” featured appearances by 200 speakers — including Nobel laureate economist Robert Shiller, former NFL quarterback Joe Montana, political strategists and news analysts Michael Steele and Donna Brazile, and author Michael Lewis — and attracted over 2,300 attendees, including many of the top investment advisers in the country. Bowen Asset learned a great deal about the current state of the ETFs industry, which we are putting to work as we strive to stay on the cutting edge.
All well and good, you may say, but — what’s an ETF?
An ETF, or Exchange Traded Fund, is a liquid financial instrument that tracks such things as stock indexes, commodity markets, currencies, bonds, or any bundle of assets. But unlike mutual funds, ETFs trade continuously when the markets are open, and can be margined, lent, or shorted — hence the liquidity. The high level of transparency for ETFs also makes it easier to evaluate potential risks and returns. In modern investment practices, highly focused ETFs can be used to target both broad and narrow thematic investment opportunities in a client’s portfolios just as mutual funds can be focused to invest with particular investment styles or industries.
In short, ETFs are a bucket of investments built around an index with the objective of matching the performance of that defined index. As the index changes, the holdings of the ETF change in lockstep. Mutual funds are portfolios that are generally assembled by a portfolio manager whose primary objective is to outperform the market. The makeup of the portfolio may change at the direction of the portfolio manager in a constant effort to outperform the market. Historically, investors believed that, over the long term, the indexes could not be outperformed and that better results could be obtained by the lowest cost investment, which mimics an index. Mutual fund investors believe that the indexes are only a measuring benchmark and that with investment selection expertise, the portfolio manager can outperform those measuring yardsticks.
Essentially, an ETF combines the trading aspects of common stocks with some of the pooled investment features of a mutual fund. However, there are shortcomings between ETFs and mutual funds, and they are not totally interchangeable investments. Though we might be able to obtain many of the same thematic positions investing in a select group of mutual funds, ETFs provide some low-cost advantages unavailable in traditional mutual funds because of this narrow focus. It is best to think of an ETF as an airplane on autopilot with the computer making all the flying decisions, while a mutual fund relies on the flexibility of human guidance. As with an ETF, as the autopilot becomes better, it mimics the human guidance with an aim to eventually replace that guidance (i.e., the mutual fund portfolio manager).
The differences between an ETF and a mutual fund are narrowing, which puts pressure on the underlying pricing of mutual funds, just as a better autopilot will reduce the need for human guidance. It’s worth looking at the big differences that remain between the two investment vehicles.
Active vs. Passive
Structurally, ETFs have a historically passive management approach, while mutual funds are actively managed. Passive investment management is like the autopilot, a mechanical approach, where investment decisions are made automatically within predetermined selection criteria. For example, in a passive investment S&P 500 fund (e.g. SPY), the ETF will purchase only the proportionally representative holdings of the S&P 500 index and will change holding positions and weighting as the S&P 500 index is redefined. Any changes to the S&P 500 index mean the changes to the underlying SPY holdings will also occur. Thus, trading adjustments to the fund and the underlying index tend to occur less frequently. In addition, there is less expense because changes are dictated by the S&P, not a large staff of researchers and analysts.
Mutual fund managers are generally active managers; they make changes in the portfolio holdings of the fund by buying and selling the underlying stocks and readjusting holdings and position size based on the performance of the individual stocks in the portfolio as well as the skill and aptitude of their investment team. The fund managers are generally afforded substantial latitude in their investment-selection process in an effort to improve the underlying performance of their funds. By investing in an active mutual fund, an investor is relying on the acumen of the fund manager to select the funds underlying investments and outperform the markets.
Passively managed ETFs will typically purchase a basket of securities which mimic, as closely as possible, the underlying index. Adjustments made in the portfolio are for the purpose of maintaining the congruity with the index, not necessarily capturing additional returns. ETF managers typically do not need the extensive research staff required by mutual fund managers, and thus pass through their cost savings to investors in the form of lower management fees charged to investors in their funds.
ETF investors purchase a relatively fixed basket of stocks through the ETF whose holdings are congruent with an index. Superior performance is considered congruent with the index. A mutual fund investor traditionally believes that an active investment portfolio manager can outperform a low cost index over time.
Generally speaking, an ETF resets its positions in a prescribed schedule of intervals as described in the prospectus. These changes can be automatic and often computer-driven, such as a portfolio rebalancing or redefining the shares added to an index. Unless the components of the index change, a traditional ETF does not have to change its positions within the funds.
By contrast, a mutual fund will make changes in its underlying holdings as determined by financial conditions. These changes are decided upon by a portfolio manager. A mutual fund is generally not tied to specific periods of time. As a result, the turnover of a mutual fund can be less than that of an ETF, or greater as determined by the portfolio manager.
Changes in the underlying holdings of the ETF can and often do have a taxable impact for investors that is passed through to shareholders. The difference is that if an ETF has a taxable gain in the fund, the fund is required to pay out to shareholders in the form of a dividend while mutual funds do not have to. A mutual fund can take any gains in the fund, reinvest proceeds, and pass the tax liability of the gains to the shareholders without necessarily having to pay the profits out to the shareholders. In this way, the ETF is more transparent for investors.
For reporting reasons it is important to know when quarterly distributions take place. An investor may he held liable for the taxable liabilities that were incurred by the ETF or mutual fund before the investor owned the fund if the investor purchased the ETF or mutual fund shares before the end of the tax reporting period. If so, the investor can walk into an unforeseen tax liability, owing taxes on gains that they had not participated in or benefitted from.
Blurred lines
Our most recent visit to the “Inside ETFs” Conference this past February pointed clearly to the blurring lines between actively managed mutual funds and more actively managed ETF funds. We are witnessing a plethora of new offerings of manager-driven qualitative approaches in ETFs, heretofore limited to actively managed (with higher management fees) mutual funds. The resulting offerings tend to amplify the pricing pressures on actively managed mutual funds. Also, more of the newer ETFs are becoming actively managed. These new ETF products behave like actively managed funds realigning their underlying holdings in the same manner as an active portfolio manager would.
The growing ETFs market
Currently, U.S. equity mutual funds have around $6.7 trillion, compared with $1.7 trillion for ETFs, according to Morningstar. ETFs, meanwhile, are attracting the majority of new investment dollars. In 2017, the inflows for ETFs hit $464 billion, according to data from State Street Global Advisors. The average 10-year growth rate over ETFs is 16 percent versus the paltry 2 percent for mutual funds according to Morningstar. Many experts, including top-rated financial advisers, believe that ETFs may displace mutual funds within the next 10 to 15 years. As of the most recent reported quarter, ending Dec. 31, 2018, there are more than 2,000 ETFs trading in the U.S. marketplace, which target a wide array of regions, sectors, commodities, bonds, futures, and other asset classes. According to a study done by Charles Schwab, the appetite for ETFs is expected to continue, particularly among millennials, who are making ETFs their investment of choice.
During the sell-off of 2018-19, the growth of ETFs came at the expense of actively managed mutual funds. Morningstar shows that during the fourth quarter 2018 market fall, the outflows from actively managed mutual funds were dwarfed by the outflows from ETFs. Passively managed ETFs saw strong net inflows of $230 billion from September 2018 and January 2019 while passively managed mutual funds (part of the new hybrid funds) saw net inflows of $167 billion. Actively managed traditional mutual funds during the same period saw net outflows of $370 billion. This appears to validate investors’ perception of ETFs as a defensive investment and a lack of understanding of the liquidity risks in ETFs.
The strong in-flows into ETF products demonstrate the increasing attractiveness of those products. As with any investment, it is important to understand a specific product before making the investment. There are places in a portfolio for mutual funds and ETFs. Please consult with your financial adviser before making any investment.
Part Two will look at the structure of ETFs.
Disclaimer
While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.
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