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Have mutual funds become obsolete?

Byline: Rochester Business Journal Staff

Mutual funds are essentially a 1920s innovation. The modern mutual fund dates back to 1924 with the creation of the Massachusetts Investors Trust by the company now known as MFS Investment Management. But the mutual fund's antecedents reach back much further into the late 1700s when a Dutch merchant, Adriann van Ketwich, created the first documented pooled investment trust.

Mr. Van Ketwich created what we now refer to as a "closed-end" fund. The fund issued a fixed number of shares. Once those shares were issued, investors who wanted to participate could only do so by buying shares from an existing shareholder. The initial fund was called "Eendragt Maakt Magt," which means "unity creates strength." It was a brilliant insight then, but one that seems obvious today: create a portfolio of diversified investments to reduce risk and allow even small investors with minimal capital to participate. That first fund was a global fund holding investments across Europe and the American colonies. Not bad for 1774.

The Massachusetts Investors Trust in 1924 represented the next phase of innovation in pooled investment vehicles in the United States by creating an "open-end" fund, commonly referred to as a mutual fund. Unlike the closed-end fund which issues a fixed number of shares, a mutual fund can issue an unlimited number of shares, thereby continuing to meet demand from new investors.

Fast forward to 2018 and mutual funds are now the primary investment vehicle for most individual investors. Individual investors hold approximately 90 percent of the $19 trillion in mutual fund assets. Closed-end funds are still around, but total assets are less than $300 billion. The up-and-comer to watch is the exchange-traded fund (ETF), a type of pooled investment vehicle first used in 1992 but which has become an increasingly popular option over the past 10 years.

Total assets in ETFs, currently about $3.4 trillion, are a fraction of the mutual fund market. Also, most ETFs are held by institutional investorsbut that is changing quickly. Over the past several years, the share of ETFs owned by institutional investors has been trending down and share owned by individual investors has been rising. A recent survey of investors reports that the overwhelming majority of millennial investors view ETFs as their primary investment vehicle.

Does the future to belong to the ETF? Is there still a role for the traditional mutual fund in the portfolio of individual investors? Let's consider the question by examining several basic features of both investment vehicles.

1. Trading and pricing. The primary difference between mutual funds and ETFs relates to how they are traded and priced. Mutual funds are not listed on an exchange. They are traded either directly with the mutual fund company or through a financial adviser or a broker-dealer. Trades are processed only once a day, and the investor gets the price determined after the market closes, typically 4 p.m. This practice is known as "forward pricing," because the investor will not know the price at which a purchase or sale will execute until after the close of the market.

By contrast, ETFs can be traded throughout the day while the market is open. This is known as "intra-day trading." The relative ease and flexibility of intra-day trading is touted as a major advantage of ETFs. Investors should consider, however, whether that advantage is theoretical real. Over a long-term holding period, how much will it matter whether your trade was executed at 9:05 a.m. or after 4 p.m.?

2. Complexity. The greater trading flexibility of ETFs comes at the cost of additional complexities for the investor. All mutual fund purchases, for example, are executed at the public offering price which is based upon the "net asset value" (NAV). The NAV is determined daily after the market closes. The price paid or received always reflects the value of the underlying securities. Not so with ETFs.

ETF shares generally trade at a premium or discount to the net asset value of the underlying securities. If, for example, you buy an ETF at a premium, the amount paid in excess of net asset value is an additional cost. Likewise, if you sell an ETF at a discount, the difference between the discounted price and the net asset value represents value lost. Investors trading in ETFs need to take account of the implicit costs associated with premiums and discounts.

Another implicit cost with ETFs is the bid-ask spread. The price at which an investor buys an ETF (the "ask") is generally higher than the price at which an investor could sell that ETF (the "bid"). ETFs trading at a very narrow bid-ask spread (a penny, for example) are not a problem, but ETFs trading at wide spreads can mean higher costs for investors.

Mutual fund investors do not have to deal with premiums or discounts or with a bid-ask spread. However, mutual fund investors often need to deal with share class selection, an issue discussed in previous articles, and a decision with which ETF investors generally do not have to contend.

3. Explicit costs. Another advantage claimed for ETFs is that the explicit costthe annual expense ratiois generally less than for comparable mutual funds. This is largely true if comparing ETFs with most actively managed mutual funds. The average actively managed mutual fund still has an annual expense ratio close to 1 percent, whereas the expense ratio for most ETFs is typically a fraction of that and in some cases is close to zero. If, however, the comparison is between an index tracking mutual fund and an index tracking ETF, the ETF is not necessarily the lowest cost option. These days, many index-tracking mutual funds compete head-to-head with ETFs on pricing. Many broad market index mutual funds and ETFs are available with annual expense ratios well under .10 percent. Moreover, unlike mutual funds, ETFs carry the additional implicit costs associated with trading at a premium or discount and the bid-ask spread.

4. Transparency. Most ETFs give investors daily disclosure of the fund's holdings. Mutual fund holdings are required to disclose only quarterly. The less frequent disclosure of mutual fund holdings helps to mask the well-documented tendency of many mutual funds to drift from their allocation targets. This can make it harder for investors to accurately track their portfolio allocations. More timely information is generally an advantage for investors, but the frequency of disclosure is less significant with index funds, whether they are mutual funds or ETFs.

5. Taxes. ETFs may present their strongest case on the issue of tax efficiency. Most ETFs are index funds with very low portfolio turnover and, therefore, very little in realized capital gains. In this respect they are much like index mutual funds which also realize little, if any, capital gains in most years. However, ETFs have another tax advantage. If a mutual fund investor wants to sell, the mutual fund must sell securities to raise cash. Especially during times when many investors want out, those forced sales can incur substantial capital gains that will be distributed among all the fund's shareholders.

By contrast, when an ETF investor wants to sell, he simply sells his position to another investor. There is no sale of the underlying securities and no capital gains exposure for the fund's other investors. In practice, many broad market index mutual funds have provided the same tax efficiency as their comparable ETF peers.

ETFs are unlikely to entirely supplant mutual funds as the preferred investment vehicle for individual investors. The strongest case for their use is probably when dealing with taxable investment accounts where tax efficiency is a top priority. In retirement accounts and other tax-deferred accounts where tax efficiency is not an issue, the added complexities associated with how ETFs are priced and traded may not be worth the trouble, especially for "do-it-yourself" investors. Mutual funds are likely to persist as a popular investment vehicle for many years. They are more user-friendly and easier to trade, and most index mutual funds compare favorably with ETFs on cost.

Properly understood, ETFs and mutual funds defy simplistic characterizations such as good/bad or superior/inferior. They are different tools in the tool box of the informed investor. Each has its place.

David Peartree JD, CFP is a registered investment advisor offering fee-only investment and financial planning advice. This column is a collaborative work by David Peartree and Patricia Foster, Esq Patricia Foster is a securities law attorney who represents clients in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. The information in this article is provided for educationalpurposes and does not constitute legal or investment advice.

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Publication:Rochester Business Journal
Geographic Code:1USA
Date:Oct 17, 2018
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