Journal of Financial Planning: August 2014
Matt Hougan is president of ETF Analytics and global head of editorial for ETF.com (formerly IndexUniverse), where he oversees content and spearheads its efforts to reshape the way investors analyze ETFs.
Exchange-traded funds have been stealing market share from mutual funds for the past decade. With $1.8 trillion in assets under management, ETFs currently have about 11 percent of all assets invested in the mutual fund space. That number grows by about 1 to 2 percent a year.
The trend is unmistakable and probably irreversible. For the five years ending in 2013, ETFs received $775 billion in net inflows, while mutual funds experienced $81 billion in net outflows.
The latest death knell came in early June, when Jeff Gundlach, the rock star founder and portfolio manager of DoubleLine—one of the only mutual fund companies attracting any inflows recently—announced plans to partner with State Street Global Advisors to launch an ETF. If a firm that pulled in $1.6 billion in inflows into its mutual funds in the first five months of the year feels it’s necessary to launch an ETF, you know we’ve reached the tipping point.
Want more proof?
- ETF assets are growing 4.5 times faster than mutual fund assets on Charles Schwab’s platform.
- Eaton Vance, Janus, Prudential, Legg Mason, T. Rowe Price, and a dozen other firms have recently filed papers to enter the ETF space.
- ETFs now account for more than 25 percent of all trading on the New York Stock Exchange.
What Does That Mean For You?
ETFs are winning market share because they are inherently cheaper and more tax-efficient than traditional mutual funds. The average large-cap equity mutual fund charges 1.35 percent in fees, according to FINRA, while the average large-cap equity ETF charges just 0.44 percent. You can do much better than that, of course: the Schwab U.S. Broad Market ETF (SCHB), for instance, charges just 0.04 percent in fees. You can own SCHB for 37 years and pay the same amount you would pay to hold the Growth Fund of America (AGTHX) for one year. (By the way, AGTHX underperformed SCHB significantly over the past few years.)
Unlike mutual funds, ETFs almost never pay capital gains distributions, shielding clients from unwanted taxes.
Think about those facts as you compete for clients. In today’s fee-only advisory world, there will be advisers offering well-diversified ETF portfolios with total expense ratios below 0.20 percent. How are you going to compete with mutual funds charging 1 percent more?
This becomes all the more important if you believe future market returns will trail historical averages. If we are looking at 6 percent or 7 percent returns going forward (not 9 percent or 10 percent), a 1 percent difference in fees is enormous.
What Are the Risks?
If you’re transitioning from a mutual fund portfolio to an ETF portfolio, you’re taking on major new risks and operational challenges that you should approach carefully.
Beyond the issues of choosing the right ETF, which my team focuses on every day, the biggest place I see people stumble is with trading. The ability to trade intraday is one of the hallmarks of ETFs, but it’s actually one of their less useful attributes. Few among us can tell which way the market is heading in the next few hours, so being able to trade it is not really a big deal.
More importantly, however, the operational challenges and costs involved in trading ETFs well can be significant. With mutual funds, you submit your orders and get priced at net asset value. You can always buy; you can always sell; and you always get a fair price.
With ETFs, who knows? Some ETFs trade at penny-wide spreads; others trade at spreads larger than a dollar. Your ability to execute orders at tight spreads varies by the time of day and by your skill and contacts. A slip-up can cost you clients.
For large advisers, fairly parsing out ETF trades that clear on different platforms can be an enormous headache. I’ve seen advisers with multi-billion dollar books of business limit the ETFs they use because they didn’t invest in the operational expertise to trade other funds well.
Whether you’re building low-cost portfolios or dynamically allocating between this and that, ETFs can bring tremendous value. But if you don’t think about the challenges—selecting ETFs, trading ETFs, etc.—the advantages can be lost.