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Investors are Leaving Mutual Funds in Droves — and Turning Passive

In the first nine months of 2015, Charles Schwab clients pulled $1.6 billion of net assets out of mutual funds, while adding $23 billion to ETFs. While this isconsistent with broader industry trends, favoring ETFs, we think a closer look at Charles Schwab and peer Fidelity's own fund flows is enlightening.

Unlike mutual funds, ETFs trade intraday on an exchange and incur trading costs much like a stock. Schwab and Fidelity are not the only platforms to allow clients to trade certain ETFs commission free, TD Ameritrade and E*Trade do so as well, but the former two are distinct in offering their own products that sit side-by-side with other ETFs from other more dedicated ETF managers.

Besides offering commission free trades on its platform for certain products from Guggenheim, PowerShares, and WisdomTree, Charles Schwab also runs 17 equity ETFs and 4 bond ETFs and we think these products have among the more popular on Schwab's One Source platform. Most of these Schwab ETFs are ranked favorably from our performance, risk and cost factor perspective. The largest, Schwab US Broad Market, has $5 billion in assets, a 0.04% net expense ratio and trades for a $0.03 bid/ask spread. It provides exposure to large-, mid- and small-cap stocks, while seeking to replicate a market-cap weighted S&P Dow Jones index. The ETF ranks favorably in part for its low-risk holdings.

In August 2013, Schwab launched five ETFs constructed and rebalanced annually based on factors such as sales and cash flow. One of them is Schwab Fundamental US Broad Market Index, which has $205 million in assets and tracks a FTSE Russell index. FNDB has a higher 0.32% expense ratio than SCHB and trades with a wider bid/ask spread. Relative to SCHB, FNDB has less exposure to financials and more to consumer staples stocks.

Through September, investors put $8.2 billion into Schwab's equity ETFs, much higher than the $881 million that went into Schwab's own equity mutual funds. Before you question the data given the outflows most mutual funds have experienced this year, note that six of Schwab's largest equity mutual funds are index based.

According to Morningstar's fund flows, investors pulled $150 billion out of active mutual funds and ETFs in the 12 months ended September and added $461 billion to passive products.

Schwab's passive mutual fund lineup is led by Schwab S&P 500 Index Fund, which has $20 billion in assets and has a 0.09% expense ratio. Meanwhile, Schwab 1000 Index Fund has $6 billion in assets and replicates a proprietary index.

While Schwab's decision six years ago to add a broad array of low-cost ETFs has helped make it the seventh largest ETF provider at the end of September with $34 billion in assets according to etf.com, just ahead of Guggenheim, discount brokerage peer Fidelity was just outside the top-20 with $2.8 billion in assets.

Fidelity has more than $162 billion in ETF assets under administration and provides its brokerage customers access to many ETFs, including 70 iShares, that they can buy commission-free online.

Fidelity has a 12-year-old Fidelity NSDAQ Composite Tracking Index ETF, but in October 2013 we think Fidelity made its ETF presence notable with the launch of ten passive U.S sector ETFs. These products include Fidelity MSCI Health Care and Fidelity MSCI Information Technology. With approximately $670 million in assets, FHLC is the largest of those ten. It has a modest 0.12% expense ratio and trades with a $0.01 bid/ask spread.

Since then, Fidelity added three actively managed bond ETFs in October 2014 and a 11th sector ETF offering sole exposure to REITs in February 2015. We think Fidelity's bond ETFs remain small, in part because of how they performed versus cheaper passive alternatives during their short history.

Fidelity Total Bond ETF is the largest of these ETFs with $118 million in assets. FBND rose 0.6% in the one past year, but it lagged the 2.2% gain for the passively managed and popular iShares Core Aggregate Bond.

FBND trades side-by-side with AGG on Fidelity's platform commission free, but its 0.45% expense ratio is more than five times higher.

According to Lipper, Fidelity's equity and bond ETFs gathered $58 million and $112 million, respectively, in the first nine months of 2015.

In contrast, Fidelity's equity mutual funds lost $12 billion in assets in the same period. According to Fidelity, the majority of this is due to retirement plans converting assets to collective investment trusts (CITs). CITs tend to have lower costs than mutual fund versions of the same portfolio but are not part of Lipper fund flows data.

However, we think Fidelity's base is also impacted by investors rotating away from actively managed funds. Fidelity has 19 mutual fund share classes with greater than $10 billion in assets, 15 of which are active mutual funds.

Fidelity Contrafund, with $73 billion is the largest such fund, focused on large-cap growth equities. While the fund has outperformed its peers on a one- three- and five year total return basis through September, the fund lagged the S&P 500 Growth index in the latter two periods.

Meanwhile, Fidelity's bond mutual funds gathered $9.3 billion in assets in the first nine months of 2015 and this business is similarly made of investors seeking to outperform an index. The seven largest bond fund classes are active led by Fidelity Strategic Advisers Core Income (FPCIX 11 ***). This is fund of funds offering that includes strategies from DoubleLine, JP Morgan, Metropolitan West, PIMCO and others.

S&P Capital IQ has rankings of nearly 1,100 equity and fixed income ETFs and 17,000 such mutual funds. Rankings are based on performance, risk and cost factors, including holdings analysis. Commissions are not factored in our research.