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ETFs and Mutual Funds—It’s Not an Either/or Decision

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ETFs and Mutual Funds—It's Not an Either/or Decision

Written by: By Adam Patti, CEO, IndexIQ | New York Life

When the first exchange-traded fund (ETF) launched in 1993, it was anything but clear that these funds would take off, and at first they didn’t. By 2003, there were about 100 ETFs in the marketplace and while there were a few ETF evangelists out there singing the products’ praises, the momentum had yet to develop. Fast forward to 2016 and we now find ourselves in an environment where flows to ETFs have frequently been topping those to active mutual funds, and where investors and advisors currently have about 1,800 exchange-traded products (ETPs) to choose from.

One can point to a number of factors when trying to explain the rise of ETFs, from a general marketplace trend toward lower-cost passive strategies, the inherent tax efficiency found in most ETFs, intraday liquidity, and more. Recently, the new rules from the Department of Labor establishing a fiduciary standard for retirement plan advisors has also been highlighted as a factor that may spur the movement of more assets into ETFs. One can also point to a number of pundits ringing the death knell for the actively management mutual fund world, and a common trope in fund industry coverage in recent years has been that ETFs are winning what is an “us versus them” struggle against the mutual fund category.

It’s worth noting, however, that traditional open-end mutual funds haven’t gone away, and for good reason. In fact, these funds held about $16 trillion in assets at year-end 2014, compared to around $2 trillion at that point for ETFs, according to the Investment Company Institute, though ETFs were growing faster.

Why the continued resilience of mutual funds?

For one, not every market, asset class, or investing style can be effectively captured in an index, the key to building an ETF. Some markets may be too inefficient and some strategies may be too customized or demand a level of portfolio concentration that doesn’t synch up well with the benefits of indexing.

There are thinly traded markets and asset classes where shares in the ETF may trade more frequently than shares of the underlying securities. In some segments of the market—and some parts of the world—good active management can clearly add value. Bond ETFs can also offer particular challenges, as the indexes often include hundreds of issues, many of which trade infrequently. Having an effective pricing mechanism is critical to avoid tracking issues.

Nonetheless, there’s clearly strong momentum behind the movement to ETFs. Most large-asset management firms now offer both ETFs and mutual funds, or will soon as institutions, advisors, and retail investors push for more options. While the value of introducing a host of “me-too” products just to have them is questionable, most fund companies will have existing mutual funds that would lend themselves to the ETF structure. This does not mean that those mutual funds will go away, but rather that an ETF version of a manager’s given strategy can be created as well, providing the marketplace with more choices and giving managers more ways to reach different key investor constituencies. The key is finding those funds where the strategy can be captured efficiently in an index and the market opportunity is judged to be significant enough to justify the effort.

For investors and their advisors, the question isn’t ETF or mutual fund; it’s what are the best vehicles for achieving my objectives?

For many, the answer will include both indexed and actively managed approaches. For example, ETFs can be used by those seeking to manage market volatility, or to get exposure to an asset class like real estate or a major geography like Canada; while on the mutual fund side, you may want to take advantage of a portfolio manager’s sector expertise, the ability to access smaller, nondomestic markets in Africa, Asia, or South America, or a strategy that doesn’t easily lend itself to an indexed solution. These funds can be combined in a portfolio to diversify and manage risk.

The fund world offers something for almost everybody, and new products continue to be added to the mix. Some of these are innovative and provide value, while others just contribute to the clutter. To put the number of ETFs in perspective, since there has been some handwringing lately about ETF product proliferation, there were nearly 8,000 mutual funds available at the end of 2014, according to the Investment Company Institute, compared to 1,800 as of the end of 2015 for ETPs.

But there’s no reason to let this embarrassment of riches overwhelm you. When you know why you’re investing—and what you want to achieve—the sorting process can move along quickly and efficiently. As you move forward you’re likely to find that the question of ETF or mutual fund is not a matter of either/or, but of how to best put the attributes of both to work in various portfolios.

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