NYT: The Low-Cost Power of Exchange-Traded Funds

April 9, 2010

By CONRAD de AENLLE

TWO trends in fund investment have progressed side by side for several years: strong flows of money into exchange-traded funds and into portfolios that track the movements of a stock index.

The coincidence is no coincidence. Nearly all E.T.F.’s — so far — are index funds, so as each type attracts investment, so does the other.

The trends indicate a broadening realization that the lower expenses of running and owning both kinds of funds give them an edge in performance that’s hard to overcome over the long term. Index fund managers have no research to conduct or buy, make no visits to companies and trade relatively few securities. E.T.F.’s, including the handful of actively managed ones, have additional cost advantages.

The widespread view of portfolio managers and other investment professionals is that the migration of assets will continue, affecting performance, costs and the types of products available. “This is a very dynamic time in the asset management space,” said Christian Magoon, chief executive of Magoon Capital, a consultancy that advises fund issuers. “E.T.F.’s are a disruptive technology similar to the digitalization of music. E.T.F.’s are disrupting mutual fund vehicles.”

What’s so disruptive is that E.T.F.’s trade throughout the day, unlike mutual funds; that makes E.T.F.’s useful for professional investors, including mutual fund managers. Even more disruptive, maybe, is that E.T.F.’s can often replicate mutual fund portfolios, actively or passively managed, at considerably less cost.

Total expenses, including management fees and costs for marketing, trading and legal and regulatory compliance, are 1.26 percent for the average actively managed mutual fund, according to Morningstar. For index mutual funds, the corresponding figure is 0.99 percent, while the average E.T.F. is run for just 0.57 percent of assets.

That helps to explain why E.T.F.’s have grown at a faster pace of late. Assets rose 67 percent in the 12 months through February, data from Morningstar show, compared with 49 percent for mutual fund assets.

The growth of E.T.F.’s seems to be coming at the expense of actively managed mutual funds rather than index funds, which are more than holding their own. Assets in index funds totaled $1.7 trillion at the end of last year, triple the amount at the end of 2000.

There is another cost advantage to E.T.F.’s that leads analysts to predict continuing expansion: taxation is less severe.

“E.T.F.’s are substantially more tax-efficient” than mutual funds, said Harold R. Evensky, president of Evensky & Katz, a financial planning firm. That is especially true when the portfolio follows indexes dominated by large companies like those of the Standard & Poor’s 500 or the Russell 3000.

The reason is arcane and comes down to differences in the way E.T.F.’s and mutual funds create or eliminate shares to meet investor demand. A rule generally allows E.T.F.’s to do so without triggering taxable transactions.

“If you’re invested in an S.& P. or Russell 3000 E.T.F., there is no tax consequence until you sell,” Mr. Evensky said. In an equivalent mutual fund, he added, “you may have tax consequences if you just sit there and hold it and haven’t done anything.”

“An E.T.F. is almost like having money in a retirement account.”

The various ways to enhance returns through E.T.F.’s have not been lost on investors — or on portfolio managers. Scott Burns, director of E.T.F. analysis at Morningstar, said that several large firms, notably Legg Mason, Pimco, Goldman Sachs, T. Rowe Price and Eaton Vance, have taken steps to introduce actively managed E.T.F.’s.

Mr. Burns has called active management “one of the hottest areas in the E.T.F. market,” although it still comprises just 0.2 percent of E.T.F. assets. He also noted that firms like Charles Schwab and Fidelity had begun offering some E.T.F.’s for little or no commission.

Active E.T.F.’s are likely to be more expensive to run than index E.T.F.’s, although more economical and tax-efficient than equivalent mutual funds. Mr. Magoon, the fund consultant, expects the cost gap between active E.T.F.’s and active mutual funds eventually to be anywhere from 0.4 to 1.5 percentage points annually. Such a discrepancy is “going to be hard to ignore,” he said, and mutual fund managers will come under increasing pressure to cut expenses and fees.

Some firms will convert their products to E.T.F.’s or run identical portfolios using each structure, Mr. Magoon predicted. Others will see their best and brightest managers go off to run hedge funds or something else with high potential rewards.

Active E.T.F.’s are most likely to grow at the expense of active mutual funds, not passive E.T.F.’s, investment advisers say. The trend toward indexing is likely to continue, and it may cause problems, in theory, for the markets and investors. There could be such a thing as too much indexing.

“If everyone’s an indexer, then they’re not investing on fundamentals, just buying the biggest stocks in the index,” said Jeremy DeGroot, chief investment officer of Litman/Gregory, a company that creates portfolios using multiple active managers. That could create a pattern in which the big index components are bought, become bigger, then are bought some more, no matter the price, until a violent reality check brings valuations back in line.

He considers that a long shot, because an overwhelming majority of assets is still actively managed. But he pointed out that something similar has already happened. In the late 1990s, Internet stocks soared and portfolio managers kept buying to keep from underperforming the benchmark indexes that the small group of stocks increasingly dominated. What became a few enormous companies — mega-capitalization stocks became “mega-cappier,” as Mr. DeGroot put it — kept soaring until they crashed in 2000.

OTHER, more subtle effects are expected as indexing proliferates. Mr. Burns, at Morningstar, suggested that as outperformance by active mutual fund managers becomes harder to achieve, some will be tempted to “swing for the fences,” taking on more risk in the hope of beating their peers. Finding winners among actively managed funds is not easy now and would become harder as the number of consistently strong performers dwindled. That’s why fewer investors seem to be making the attempt.

“What you’re seeing is more advisers embracing lower-cost asset-allocation strategies and embracing E.T.F.’s,” Mr. Burns said. “They’re throwing up their hands and saying, ‘I don’t want to beat the index; I want to get the index.’ ”