Are Mutual Funds Becoming Obsolete?

Ivanna Hampton: Welcome to Investing Insights. I am your host, Ivanna Hampton. We are recording this episode live at the Morningstar Investment Conference here at Chicago’s Navy Pier. And the topic at this table is how newer choices are waging what appears to be a successful battle against the legendary mutual fund. So, does the original vehicle for retail investors still have a purpose? Two Morningstar specialists are here to explain why exchange-traded funds and collective investment trusts, or CITs, are challenging mutual funds. Joining me is Bryan Armour, who is the director of ETF and passive strategy research for North America, and sitting next to him is Dan Sotiroff, who is the associate director of US passive strategies research. Welcome to the podcast studio, guys.

Bryan Armour: Thanks for having us.

Dan Sotiroff: Thanks for having us.

Hampton: Well, let’s start with an explainer. How are exchange-traded funds and mutual funds alike and different?

Armour: It’s just a different wrapper. So these go around an investment strategy. They can even be around the same investment strategy. Really, the big difference is how investors trade in them. So, with mutual funds, they trade at the net asset value at the end of the day directly with the fund. The fund portfolio managers then take that money and go put it to work, or they use cash or sell assets to meet redemptions. Whereas in ETFs, most investors are trading with each other or trading with market makers on stock exchanges throughout the day. So, the entire trading session, it’s open for trading. They’re trading with each other. It’s not affecting the ETF itself, at least not directly. And then authorized participants can trade with the ETF itself at the net asset value end of day. And what that does is it really just opens up, I guess for the ETF trading, less of an impact on the ETF itself when investors are trading with one another.

But also with the authorized participants, you can do in- kind creations or in- kind redemptions, where you’re basically trading securities for ETF shares, which is a bit different from mutual funds, where it’s all cash.

Hampton: Dan, let’s bring you into the conversation.

Sotiroff: I think a simple way to think of it, everything Bryan said is absolutely true. The bigger thing is just to think of the history of where these have gone over time, specifically the ETF. It started out as a unit investment trust with a lot of exemptions to the 40 Act. Today, they’re actually probably more similar than they’ve ever been. And I think a really simple way of thinking about an ETF is just a mutual fund that has some provisions that allow it to trade throughout the day on an exchange. That’s a really, really simple way of thinking about it, I think that most people can wrap their head around. A lot of the rules are very similar in the treatment and diversification requirements and whatnot that the SEC is looking for. More and more of those two worlds are actually colliding, and they’re becoming more similar, and they’re more similar today than they’ve ever been in the 33 years that we’ve had ETFs.

Hampton: But between ETFs and mutual funds, which do investors prefer?

Sotiroff: Hands down, it’s ETFs. I don’t think the numbers lie. It’s a statement of the obvious right there. If you want to put some numbers to it, we were putting these together earlier. In the past five years, we’ve seen around $2.2 trillion blow out of mutual funds. We’ve seen a little more than twice that, around $4.5 trillion move into ETFs. So I think there is some money coming out of mutual funds going into ETFs, but net new money that’s just coming into investments in general is going toward ETFs overwhelmingly. I think it’s fairly safe to say. So it’s hands down. I mean, we see it all the time. You can pick out certain ETFs. And we just had Vanguard 500. The ETF share class of that fund just surpassed a trillion dollars last week. You’ve seen all these random signs come up, all these various numbers you can throw out there.

There’s a ton of them. The numbers are just getting bigger and bigger and bigger in favor of ETFs. The other sign, I think a good one to quote here, is at the end of the year, if you look at the market share between mutual funds and ETFs, I think it was around 37% ETF. The balance, which would be what, 63% would be mutual funds. That’s probably closer to 60/40 today, roughly speaking. And that trend is only moving in one direction. That’s only continuing to favor ETFs.

Hampton: Bryan, why do you think this is happening?

Armour: I would say three things. So number one, cost. ETFs tend to be cheaper. There are no sales loads, typically no 12b-1 fees, or any of the add-on costs that come with it. There’s also greater tax efficiency. The reason why I explained the in- kind redemption at the top was because when you move securities out of the portfolio in kind, you aren’t realizing capital gains, and therefore the ETF itself, the fund itself, is not going to be distributing capital gains, which would then be taxed. And so it reduces tax drag. It’s more tax-efficient. So, cost, tax efficiency, and then the changing shape of advice. This is probably the biggest reason. We’ve moved from commission-based advice to fee-based advice. Advisors are taking a percentage of assets, which I think better aligns them with the investors at the end of the day than commissions, but you should think about the total cost of advice and your funds’ expense ratios together to get a more apples-to-apples comparison between the old model and the new.

Hampton: Dan, what cases would it or could it be beneficial to own a mutual fund instead of an ETF?

Sotiroff: Preference plays a big role here. Excuse me, tripping over my words a little bit. And there are situations where a mutual fund still works very, very well. So the primary one being if you’re in a 401(k) plan, ETFs are not really set up very well to do partial shares. If you have, let’s say, I put $100 in, and the ETF share class costs $76. Well, I can buy one share, but that $24, what do we do with it? In a mutual fund, you can just put the entire $100 into the mutual fund, you’ll get the equivalent shares back. So you can do fractional shares very, very well in a mutual fund. It’s very easy, not that difficult to do. So, they work very, very well in a 401(k) plan. I’m trying to get my phone back up here. The other thing is, especially when we get into active management, and we’re seeing a big move from active managers moving from mutual funds to get into the more in- demand ETF vehicle, one of the things they have to contend with is capacity management.

Certain strategies can only manage so much money before they run into natural limits where they start to erode the edge that they have or that they’re claiming to have of the market. In those cases, the prudent thing to do is to close your fund off to new money, to continue managing the money you have, but maybe be selective about taking in new money. ETFs can’t really do that very well. Once you’re trading, you’re trading. I guess you could close down an ETF in that way, but you would end up with a closed-end fund, and that runs into a whole new set of problems. Mutual funds are just set up very, very easily to do that. And so that’s another case where I think that it makes sense to stick with a mutual fund. But those are kind of the two overriding scenarios, I think, where you’re going to really see mutual funds kind of coexist.

The other one you could throw in there, and we’re kind of working through the early experimental stages of this, is the ETF mutual fund share class. That would be more of like, OK, somebody’s already in a mutual fund, it gets an ETF share class. Maybe there’s some motivation to get into the ETF if you really want it, but theoretically, you’ve got the ETF bolted on, and it’s giving you the tax efficiency. So, maybe there’s a little less motivation there to actually move your money out of the mutual fund and into the ETF. We’re going to see how that plays out in the coming years as more of those start to actually trade. But that’s sort of an edge case, I think that’s kind of a toss-up in all of this.

Armour: The one thing I want to add for 401(k)s, I think where mutual funds are catching heat is not ETFs, because you’d have to upend the whole system to make it work for ETFs. You don’t get the tax advantage in a tax-sheltered account. So, why would you spend the time and money doing that? But CITs, collective investment trusts, are the mutual fund’s enemy in 401(k)s and retirement plans because CITs have grown; they’re over, I believe they just surpassed half of 401(k) assets, which is a huge deal, and it’s really just around the fact that they can negotiate different prices. They’re typically going to come in lower than mutual funds, almost certainly going to be the same strategies available in mutual funds. It’s really just an easy win for investors there.

Hampton: I’m going to stay with you.

Armour: OK.

Hampton: ETFs used to be synonymous with passive investing. One, is that still the case, and then two, how’s it changing?

Armour: Once upon a time, it was an oxymoron. Active ETF was an oxymoron, but now I think the first ETF launch in 1993 was the State Street SPDR S&P 500 ETF; the first active ETF didn’t launch until 2008. And it was really sort of a niche area of the ETF market. Ultrashort bonds were big, for example, but didn’t really catch on until the ETF rule passed in 2019. And the main reason for that is because, number one, it made it easier to create new products, but number two, those creation/redemption baskets used to be pro rata. So, if you wanted to buy an ETF share as an authorized participant, you’d have to get in the correct proportion, the entire S&P 500, send it over, get the ETF shares back. Now you can come up with custom creation/redemption baskets, making it easier for market makers to trade the ETF in and out to make tighter bid-ask spreads.

But also as an active manager, now you have a new portfolio management tool. Also, if you owned Nvidia for the last few years and have a huge capital gain, you can use the redemption process to get rid of it without realizing those gains. One thing real quick to just throw out is when I say tax efficiency, it’s for the fund, the distributions won’t come out, you pay taxes, put it back in, but the investor will still have to pay taxes at the end. So, any gains, they still pay. It’s a tax deferral tool. You don’t avoid taxes completely.

Sotiroff: Put kind of an asterisk on that. It’s tax-deferral, not tax-avoidance. That gets messed up in the media sometimes, so let’s be clear.

Armour: Since 2021, we had Dimensional convert mutual funds into ETFs, ARK Innovation ETF ARKK was blowing up, and it just changed the shape of active ETFs all of a sudden. So, many different asset managers are jumping into the market. J.P. Morgan was hugely successful, and Capital Group jumped in, some of the legacy mutual fund managers. So now it’s over 10%, I believe it’s 14% of ETFs’ assets are in active ETFs now. We had 90% of new launches last year were active ETFs. And now active ETFs actually outnumber passive ones as of last year.

Hampton: Well, I’m going to ask you about that. Actively managed ETFs provide a path for active managers to compete against passive investments. Who are the notable names, big and small, behind these launches?

Sotiroff: It’s a good question. And maybe to just pick up where he left off, yes, the number of active ETFs has certainly outnumbered the number, but when you unpack that, it’s not what most people think. The headlines aren’t really reporting that story quite accurately. Yes, there are some big active managers in the space. So, the big ones are the big low-cost systematic asset managers. Dimensional and Avantis are probably the biggest in that camp. You’ve got some traditional fundamental active managers as well. So, I think of Capital Group. T. Rowe Price, Fidelity also have some pretty big lineups in there. J.P. Morgan has a huge active ETF lineup right now, really big in fixed income. Those are kind of the giants in the space right now, and you want to think of this in like a power laws sort of way or the 80/20 rule, whatever you want to call it, you have relatively few at the top of the mountain, and then there’s like this long tail of the other ones.

The other ones that you get into, yes, there’s some fundamental active managers out there that are trying to be successful in that space, but the competition’s just really, really steep. They’re finding some success, but they’re not going to blow up and be like a J.P. Morgan or something like that. And then you have this very, very long tail of stuff that is technically quote, unquote active, but it’s not really active in the sense that you have like a shrewd manager who’s picking stocks and bonds and trying to build this long-term portfolio for you. It’s things like the single-stock ETFs that are levered and inverse. It’s the covered-call ETFs. And there are all sorts of variations and flavors of this stuff out there. It’s active because it’s not following an index, but it’s not really active in the sense that you’re picking stocks and bonds like you think a traditional active manager would.

So, there’s a big caveat around that number of all these new active ETFs out there that you should be aware of. But it is a growing space. We’re seeing more and more people get into it. I think when we start to see more of the plumbing get sorted out with the ETF share class, I think that’s going to be another big gateway for a lot of them to get into the ETF world. We’re going to wait and see on that. There are still some things that are being sorted out in the background operationally, but it’s moving in the right direction, and I think they’re going to see a lot more of that coming out in the near future.

Hampton: So, we’re going to have some more to talk about, is what you’re saying.

Sotiroff: Yes, absolutely.

Hampton: Bryan, if active management is expanding in ETFs, are mutual funds an endangered species?

Armour: Endangered is maybe a little harsh, but perhaps. The one thing I would say is extinction’s not around the corner, though. There’s a lot of inertia for various reasons people aren’t looking to change, but you could also be sort of held captive by capital gains. It would be, even if ETFs are the better solution, if you were to add new money today, it might be less efficient to sell your mutual fund, pay taxes, and then reinvest in an ETF. So, it’s not going to change overnight. And then to the same point, even despite the outflows, net assets are still growing because the underlying assets are growing. Stocks and bonds have done fantastically well over the past several years, especially stocks, so assets are growing. It’s going to continue to be a big part of financial markets. But at the end of the day, the only thing I’ll say is it’s important for investors to be aware of this because net new money, you want to select the right wrapper, but really strategy-first, like what are the objectives?

Do the objectives make sense in an ETF or mutual fund format? And if an ETF is available, that’s a better way to go, but that doesn’t mean you change your existing portfolio.

Hampton: Dan, what’s the takeaway as mutual funds wage a multifront battle against ETFs and CITs?

Sotiroff: I think the reason you see a lot of these trends emerging is it’s just investors are kind of waking up to the fact that the ETF is just a better vehicle. Regardless of whether this is a passive or active strategy that’s underlying it, the vehicle is just more tax-efficient. Like Bryan started out saying, it’s also lower-cost. It’s a little bit easier to get in and out of, in some cases. Mutual funds still have their place. And I think what we’re going to see, at least in the near future and maybe for years to come, is that they’re probably going to coexist in some way, and that’s where the ETF share class kind of comes into play. And you’re seeing this now with some of those systematic active managers where they’re offering both, and they’re letting investors choose.

The fees are equivalent. You can pick what share class you want for whatever purpose you want. So, I think for at least the foreseeable future, they’re going to kind of coexist in some way, shape, or form, but the ETF is clearly just the better vehicle in a lot of ways, and that’s why it’s winning. It’s more tax-efficient, and it’s cheaper at the end of the day.

Hampton: Sounds promising. Coexisting.

Sotiroff: Coexisting.

Hampton: Well, Bryan and Dan, thank you for coming to this special table at the Morningstar Investment Conference. Well, that wraps up this episode at the Morningstar Investment Conference. Excuse me. I need to look down at my notes because I have a lot of people to thank. I want to thank senior video producer Jake VanKersen, lead technical producer Scott Halver, senior audio engineer and producer George Cassidy, and, of course, associate multimedia editor Jess Bebel. I thank you. I appreciate you for listening and watching in the space out there and in the box around me. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.