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Are Mutual Funds Doomed?

Though ETFs have more to recommend and are growing at a faster clip, mutual funds can still play a valuable role for advisors.

Financial advisors adore Dimensional Fund Advisors (DFA). The firm’s slate of mutual funds, which can only be bought by advisors and not retail clients, now holds more than $600 billion in assets. Strong returns and low fees have been an easy sell for advisors—and their clients. 

Yet DFA runs the risk of falling behind the times as client assets steadily migrate towards the lower fee structures found in exchange-traded funds (ETFs). The firm surely sees the writing on the wall, having lowered its fees in 2015, 2017 and again in 2019. Another set of fee reductions are slated to kick in next month. 

In fact, there has been growing industry chatter that DFA may soon enter the ETF market as well, joining a growing roster of mutual fund firms including Franklin Templeton, Legg Mason, JPMorgan and Goldman Sachs that have all launched ETF fund families in the past few years, according to Todd Rosenbluth, director of ETF and mutual fund research at CFRA.

“Five years ago, mutual fund firms didn’t have any sort of plan of how to respond to the growing appeal of ETFs,” says Rosenbluth, adding that “they now have come to see it’s not just a passing fad and is here to stay.”

The steady industry migration makes ample sense in an increasingly cost-sensitive marketplace. That’s because mutual funds have a built-in disadvantage. Each fund must support the salaries of managers and their research teams, have extensive administrative costs in order to comply with the Investment Company Act of 1940, as well as built-in transfer-agent costs and distribution costs.

Even Fidelity Investments, which runs one of the largest mutual fund platforms in the country, concedes that it’s an unfair fight. As part of its marketing communications, the firm notes that “mutual funds charge a combination of transparent and not-so-transparent costs that add up,” and while ETFs also have various fees, “there are simply fewer of them, and they cost less.”

Lower costs help explain why advisors are showing a growing predilection for ETFs. A recent survey by Broadridge Financial found that 83% of financial advisors increased their asset allocation to ETFs over the past two years. Fully 49% of respondents said that the shift is being driven by the lower costs for ETFs, while another 17% cited greater tax efficiency for the (mostly) static ETF portfolios. (Index composition changes will always lead to some portfolio turnover.) 

The report also noted that ETF adoption is greater among RIAs than broker/dealers, which shouldn’t come as a surprise. Fee-only (fiduciary) advisors don’t receive commissions or compensation from outside parties. In contrast, wirehouses and independent broker/dealers can arrange for kickbacks from mutual funds (known as “trailer fees”) to be rebated back to the advisory firm, a sort of hidden tax on clients that regulators are beginning to more closely scrutinize these days. 

The SEC has begun to more actively enforce its “Share Class Selection Disclosure Initiative,” which requires advisors to make full disclosures concerning mutual fund share class selection. And as clients are better informed about mutual fund expenses, they may question why advisors don’t simply invest their assets in lower-cost ETFs.

Despite the higher fee structures in place, mutual funds still dominate the market. Here in the U.S., open-end mutual funds contained $20.8 trillion in assets as of November 2019, according to the Investment Company Institute (ICI). The five-year growth rate through the end of 2018 was 4.8%. While assets within domestic ETFs stood at a smaller $4.2 trillion. Yet that figure rose at a 14.9% yearly clip in the five years ended 2018, or more than triple the growth rate of mutual funds.

Even as ETFs grow in popularity among both retail investors and advisors, mutual funds still have a role to play, including among advisors that are highly sensitive about fees. Scott Bishop, a financial planner with Houston-based STA Wealth Management, had been using ETFs for clients almost exclusively throughout the current bull market. Now, with the bull market already into its second decade and perhaps getting long-winded, Bishop sees a growing role for mutual funds.

“We’re at the point where not all stocks in a major index like the S&P 500 will fare well in a market downturn, so this is a good time to deploy actively-managed funds that take a much more selective approach than a passive index,” he says.

Bishop adds that his firm “owes it to our clients to do a lot of due diligence around the fund managers we select. We want to see that the fund managers have a deep research bench, maintain a clear discipline in their approach, have personal stakes in the funds they run, and have strong track records throughout down cycles in the market as well.”

By maintaining a blend of ETFs and mutual funds in client accounts, Bishop’s firm can keep costs in check. “Our average portfolio has around 24 basis points in fees,” he says.

Jennifer Weber, a financial planner with Lake Success, NY-based Weber Asset Management, also remains a firm supporter of mutual funds and is squarely focused on the lineup of Fidelity Select Portfolios funds. 

“We like to invest with managers that are focused on industry disruptors in areas like technology and healthcare,” she says. The Fidelity Select Technology fund (ticker: FSPTX), as an example, has beaten the broader technology fund category by two percentage points annually, on average, over the past 10 years. The Fidelity Select Health Care (FSPHX) has garnered a 300 basis-point annual edge over its category in that time, according to Morningstar.

Still, most mutual funds fail to deliver sustainable gains. In the 15 years ended June 2019, fully 88% of domestic mutual funds underperformed their benchmarks, according to S&P Dow Jones Indices.

Over the past few years, the lowest-cost ETFs have been snaring the vast bulk of new fund flows. Yet advisors need to dig a little further when selecting the right ETF for clients. Rosenbluth cautions that a low-cost fund can fail to deliver the targeted exposure being sought.

He cites the Vanguard Small-Cap ETF (VB) and the iShares Core S&P Small-Cap ETF (IJR) as examples. The Vanguard fund owns firms with a median market value of $4.7 billion, which is really more of a mid-cap valuation, while the iShares fund owns companies with a median market value of around $2 billion. Owning a fund that fails to meet your target benchmarks can lead to results that stray from target allocation projections. In this example, if you’re looking for true small cap exposure in a balanced portfolio, then the Vanguard portfolio is poorly served to meet your needs. 

Advisors also need to take heed of fund liquidity and trading spreads. The smaller the base of assets, the greater the bid/ask spreads will be in place, which could serve as a sort of stealth transaction tax. 

Eventually, the distinction between mutual fund firms and ETF providers is bound to blur. With the recent move by the Securities and Exchange Commission to approve non-transparent ETFs, firms such as T. Rowe Price are moving quickly to offer their actively-managed approach in an ETF wrapper. Such funds aren’t built to deliver rock-bottom expense ratios but can at least pass on the structural savings inherent in the ETF format. 

Whether advisors and retail investors will embrace them is an open question. Yet it’s increasingly clear that the era of high-cost mutual funds, and their attendant fee kickbacks to brokers may be on a glide path towards extinction.

David Sterman, CFP, is President of New Paltz, NY-based Huguenot Financial Planning

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