Investor's Business Daily, March 6th, 2007
Are the days of the traditional mutual fund numbered?
Mutual funds have been a strong force in the investment world, with their assets mushrooming from $135 billion at the end of 1980 to $10 trillion at year-end 2006.
But investors have been stuffing a noticeably greater amount of cash into exchange traded funds, hedge funds and managed accounts that feature such alternative assets as commodities and private equity.
Will recent trends continue? Will the newfangled investment vehicles replace mutual funds the way iPods and MP3 players elbowed out CDs?
Evidence suggest ETFs are winning some assets that otherwise might go to mutual funds, but the industry is unlikely to suffer a fatal blow. Hedge funds, managed accounts and private equity funds have grown too. But they appeal to more sophisticated investors. Each may be richer than the average fund investor, but average investors combined have more clout.
Mutual funds' success in recent years stems largely from the rise of the 401(k) retirement plans. By the end of 2005, 401(k) plans and individual retirement accounts made up 32% of the $8.9 trillion then in mutual funds, according to the Investment Company Institute. That percentage has only gone up over the last year, says Chris Wloszczyna of the ICI.
What makes ETFs so popular? The broad-market index ETFs are seen as cheap alternatives to passively managed index funds. They're also recapturing the assets of fund traders who have been given the cold shoulder by funds.
Inflows for actively managed funds have varied from as much as $272 billion in 2000 to net outflows of $16 billion in 2002. But in the years since, they have stayed high, reaching nearly $150 billion in 2006 thanks largely to automatic-investing features of many retirement plans.
Increasing Flow
Meanwhile, ETF inflow went up from only $7 billion in 2000 -- a scant 2% of fund inflow -- to $60 billion in 2006, or 40% of fund inflow, according Strategic Insight data.
ETF assets ballooned from $65 billion at the end of 2000 to $422.4 billion in 2006 as the number of ETFs grew from 80 to 357. More are planned as firms such as Rydex Investments, which introduced a Japan currency ETF in February, move to fill market niches.
ETFs are bought through brokers, and so carry sales commissions, or loads. But their recurring expenses are lower than mutual funds'. And they can be traded like individual securities.
Most fund investors prefer no-load funds. In 2004, investors put $136 billion into no-load funds vs. $38 billion in load funds. Fund investors can choose between actively managed portfolios and index portfolios.
Actively managed funds have expert money managers tracking investments. They can move assets to protect capital from market or sector slumps. Their fees tend to be up to 100 basis points higher than ETFs'.
Mutual funds also are priced just once a day, making them less appealing to traders. Many also carry redemption fees that penalize traders.
Largely because of commission and active-management issues, the party for funds is far from over.
Debate rages over whether actively managed funds' higher fees pay for superior performance, whether measured by gains or stability.
Jack Bogle, founder and former chairman of Vanguard Group, argues that ETFs get part of the equation for superior performance right: low fees. But they stumble over their commissions and their appeal to frequent trading. This can pull novice investors away from long-term investing in the broad market. The results are often ruinous.
But for ETFs to become a real threat to funds' dominance, somebody will have to invent an actively managed ETF and get 401(k) plans to buy them, says Edward Bernard, vice chairman of T. Rowe Price. "We're studying that, and so is everybody else," he said.
The obstacle to an actively managed ETF a trait that endears them to investors: transparency. Active ETFs that reveal too much about strategy would risk losing performance to rivals and opportunists.
Issuers will also have to convince 401(k) plans that ETFs are a good alternative to funds. Thus far that hasn't happened, T. Rowe's Bernard says.
Fidelity Investments spokeswoman Sophie Launay says the firm is unconcerned about ETFs replacing actively managed funds because of its long history of providing better returns with its managers.
David Connelly, director of retail investment product management at MFS Investment Management, says the future is probably actively managed funds supplemented by ETFs that offer basic market exposure. The funds would provide additional return.
Copyright 2007 Investor's Business Daily, Inc.
