Exchange-traded funds gain on traditional mutual funds

In the early 1990s, executives of the now-defunct American Stock Exchange hatched a revolutionary idea: a hybrid mutual fund-type investment that would trade like a stock.

But in an era when hot-handed mutual fund managers had rock-star status, the concept of the “exchange-traded fund,” or ETF — low-cost, pre-programmed portfolios designed to simply replicate a broad or narrow swath of the market — didn’t get a lot of people’s hearts pounding.

Twenty years later, however, exchange-traded funds have ballooned into a $1.4-trillion industry in the U.S. and $2 trillion worldwide. Asset growth has surged since 2007 as the number of ETFs has soared past 1,400, covering every corner of stock, bond and commodity markets.

And although conventional U.S. mutual funds still hold more than seven times the assets of ETFs, an increasing number of professional and small investors now see traditional funds as lumbering dinosaurs, doomed to be outmaneuvered and eventually overcome by more efficient and focused ETFs.


“I don’t see any justification for traditional mutual funds” to go on, said David Kotok, who manages $2.2 billion at Cumberland Advisors in Sarasota, Fla. He has been using ETFs exclusively to build client portfolios since 2000.

Don Gimpel, an 84-year-old investor in Beverly Hills, estimates that his portfolio now is 70% in conventional mutual funds and 30% in ETFs. But as he looks for new areas of investment, he sees ETFs as “the wave of the future. You can center your whole portfolio around them.”

Extinction, if it happens, won’t come quickly for traditional funds. They still dominate in key markets, including 401(k) retirement plans.

But ETFs’ ascent is a warning to owners of traditional funds to be vigilant: If other investors are leaving your fund for ETFs or other alternative investments, the drain could cost you dearly by forcing the fund to raise cash by dumping assets.

ETF advantages

ETFs have blossomed as investors have responded to the funds’ advantages over traditional mutual funds and other portfolio options.

Most ETFs are passive investments, meaning they are designed to replicate returns of specific market slices — say, U.S. mid-size stocks, blue-chip drug stocks, gold bullion or the Turkish stock market.

The ETF boom has provided investors with a vast menu of options to diversify their portfolios using the funds as building blocks. ETFs “give you more of a sense of control” than conventional funds, said Chris Binkley, a 38-year-old Harrisburg, Pa., investor.


Unlike mutual funds, which must be purchased directly from fund companies, ETFs trade on stock exchanges. That means they can be bought and sold any minute of the day. Most conventional funds, by contrast, can be bought or sold only once a day, at the fund’s closing price for that day.

Most ETFs also offer the crucial advantage of very low portfolio management expenses, a byproduct of how they are constructed. Some take as little as 0.04% of assets a year to cover expenses, compared with the 1% to 2% that many conventional funds take.

Less for Wall Street means more for investors. Over time, the savings can be gigantic.

Although investors must pay standard brokerage commissions to buy or sell ETFs, online trades at discount brokerages typically cost less than $10. And some brokerages have been waiving all commissions, part of an ETF price war that has raged in recent months among fund titans, including BlackRock Inc., Vanguard Group Inc., Charles Schwab Corp. and Fidelity Investments.


But what has driven much of the boom in ETFs is the same basic attraction that has boosted their cousins, “index” mutual funds: ETF investors choose to own a broad swath of the market, or a specific piece of it, and accept whatever return it generates — instead of taking a chance on a fund manager to beat the market returns via savvy stock-picking.

Binkley has accumulated a portfolio that includes a number of conventional mutual funds. But in the case of U.S. large-capitalization stocks and mid-size shares, “I don’t use mutual funds anymore,” he said. “Finding a manager who’s going to beat the [market] index is really hard.”

Indeed, the last five years have been dismal for so-called active fund managers in the U.S. stock market’s core sectors.

Just 25% of managers of large-capitalization (i.e., blue-chip) stock funds beat the benchmark Standard & Poor’s 500 index in the five years through 2012, S&P; Dow Jones data show.


Managers of funds that own mid-size shares fared even worse: Just 10% beat the return on the S&P; 400 mid-cap index in the five years.

Binkley said he now uses the Vanguard Mid-Cap ETF (ticker symbol VO) as a core long-term portfolio holding. The fund’s annual expenses amount to 0.10% of assets, cheaper than the 0.24% standard fee of Vanguard’s conventional Mid-Cap Index fund.

Vanguard, which pioneered low-cost passive mutual funds in the 1970s, has long preached about the futility of trying to beat the market’s return over time.

What brought that idea home for many investors was the market crash of 2008-09, when so many active managers failed to protect their funds from devastating losses.


“That’s part of why investors have lost faith in the mutual fund business,” said Tom Lydon, founder of ETF Trends in Newport Beach.

The turn in sentiment shows in the money drain from conventional funds.

U.S. and foreign stock mutual funds available to American investors suffered combined net cash outflows of $9 billion in 2010, $82 billion in 2011 and nearly $103 billion in 2012, according to Morningstar Inc.

Outflows mean new purchases of the funds were exceeded by the sums investors were cashing out.


By contrast, U.S. and foreign stock ETFs had combined net inflows of $261 billion in those same three years.

This year, investors were net buyers of domestic stock mutual funds in January, but the inflows turned to outflows once again in February. ETFs, however, continued to pull in cash.

Pros push change

A sea change in the financial services business is likely to keep pushing dollars toward ETFs, said Joel Dickson, senior investment strategist at Vanguard in Valley Forge, Pa.


“There has been a huge shift in the financial community in the last decade away from commissions and to fee-based advice,” Dickson said.

In 2000, only about 20% of assets overseen by professional financial advisors were fee-based, meaning the advisor charged clients a set annual fee — often a percentage of total assets managed — rather than taking hefty commissions on specific investments.

Now, about 60% of assets managed by advisors are fee-based, Dickson said. Without favored commission-paying products to sell, advisors naturally gravitate toward low-cost investment tools. “And those low-cost options are predominantly on the ETF side,” Dickson said.

Aging baby boomers who have substantial nest eggs in 401(k) accounts usually don’t have ETFs available to them in those accounts. But that can change at retirement if boomers roll over their 401(k) assets to self-directed accounts that they manage themselves or turn over to an advisor.


Gene Marino, a Princess Cruises executive who lives in Canyon Country, said he’s considering using ETFs to build a portfolio outside his retirement nest egg.

He hasn’t invested in ETFs because he didn’t know much about them until recently, Marino said. “But the more I’m looking at them, the more I think they’re appealing,” he said.

Some financial pros note, however, that the idea of “passive” investing via ETFs can become a misnomer. If the nature of ETFs encourages long-term investors to become more inclined to trade the markets, that may defeat the main purpose of passive, buy-and-hold investing.

Likewise, mutual-fund industry executives point out that financial advisors who use passive ETFs to create client portfolios are employing active-management techniques if they’re favoring some stock market sectors over others.


Those are judgment calls, which, as with individual stock-picking by active mutual fund managers, may or may not make money.

“At the advisor level, it’s active management bundled on top of ETFs,” said Sean Collins, senior director of industry analysis at the Investment Company Institute, the trade group for the mutual fund industry. “The question is what degree of active management you want.”

The passive-versus-active debate has been further blurred by the debut of a relative handful of actively managed ETFs. Instead of passively tracking a market index, active ETFs compete with other actively managed funds by attempting to beat the market.

Newport Beach bond fund giant Pimco operates one of the highest-profile active ETFs, a version of its behemoth Pimco Total Return bond fund. The ETF (ticker symbol BOND) was launched a year ago. Many other fund firms have announced plans to develop active ETFs, though most remain on the drawing board.


Don Phillips, head of Morningstar’s investment research unit in Chicago, worries that ETF developers have created too many niche ETFs that will prove toxic to investors who don’t understand the risk of loss in narrow market sectors.

One popular niche product line for traders are ETFs that use borrowed money to magnify by two or three times any move, up or down, in an underlying stock index.

Phillips decried what he called the “arms dealer mentality” among some ETF firms — the idea that “we just make them, we can’t control what people do with them.”

Still, he said, the overall effect of ETFs’ growing popularity has been to help put downward pressure on investment fees.


ETFs also have provided individual investors the ability to diversify their portfolios in ways that were impossible even a decade ago, Phillips said.

“You have an investing toolbox your grandfather could only dream of,” he said.