Mutual funds fight for flows against ETFs

Mon Apr 9, 2012 11:45am EDT

A man grabs his briefcase as he waits in line to speak with employers at the UJA-Federation Connect to Care job fair in New York, March 21, 2012. REUTERS/Shannon Stapleton

A man grabs his briefcase as he waits in line to speak with employers at the UJA-Federation Connect to Care job fair in New York, March 21, 2012.

Credit: Reuters/Shannon Stapleton

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NEW YORK, April 9 Reuters - A funny thing happened on the way to the death of the traditional mutual fund, foretold by some analysts. It hasn't happened.

Instead, in the last two months, flows into equity exchange-traded funds (ETFs) have slowed, while flows into equity mutual funds have picked up. Just last December, the spread between the two was a whopping $46 billion in favor of ETFs; by March the advantage had shrunk to $5 billion, and equity mutual funds were seeing positive inflows for the first time since last April.

So what's going on? One reason for the turnaround: In a volatile world, many investors prefer having an active manager shifting holdings and sidestepping the carnage in a particular sector or region.

"Mutual funds are more nimble in navigating the investing landscape," said Loren Fox, senior analyst for fund research firm Strategic Insight. "If you're locked into a tight box with an ETF, and your box is going down the tubes, then low costs aren't your first concern. It's the fact that you're losing a lot of money."

This is a momentum shift from fund flows in recent years, when ETFs looked to have mutual funds on the ropes. With their built-in advantages like lower fees and intra-day trading, ETFs became something of an investor craze: Since the beginning of 2010, equity ETFs have sucked up more than $142 billion in assets, according to fund research firm Lipper, a Thomson Reuters company. At the same time, equity mutual funds saw more than $86 billion in outflows.

The trend was so powerful that sometimes it looked as if ETFs were going to eventually eclipse their more traditional counterparts. ETFs have grown to more than $1 trillion in assets, up almost 15 percent in 12 months, according to the Investment Company Institute - impressive, during a time of high market volatility and investor skittishness. One recent headline from Josh Brown, an investment adviser who runs the popular blog The Reformed Broker, read: "The Day the Mutual Fund Died." (link.reuters.com/mah57s)

"Investors and advisers are attracted to ETFs for their low expense ratios, tax efficiency, transparency and ability to be traded throughout the day," said Erik Liik, CEO of FocusShares, which offers a menu of ETFs that track Morningstar indexes. "They've democratized investing by bringing virtually all types of investments to all types of investors."

But take a step back, because traditional mutual funds still have a commanding position in the marketplace. That's in part because the presence of ETFs in 401(k) plans - the nation's premier vehicle for individual retirement saving - is still relatively rare. And the notion of actively managed ETFs, which could open a new front in the battle for fund flows, hasn't taken off yet: There are fewer than 50 ETFs on the market with active management, a tiny sliver of the overall total.

There are also concerns that ETFs might not be a terrific solution for all investing woes. Indeed, the relative advantages of ETFs can also be major handicaps.

Facilitating investments into tiny market niches, for instance, "serves to slice and dice asset classes into ever-smaller micro-classes," said Rick Ashburn, chief investment officer of California financial advisers Creekside Partners.

Allowing frequent trading isn't always a positive because it means more investor costs that can hobble returns. A research paper from fund giant Vanguard Group found that investors tend to lag fund returns, and that's because they're "persistently unable to effectively time the market."

Also a trouble-spot: While a few ETFs are gargantuan, like the S&P 500 SPDR with almost $100 billion in assets, 42 percent of the more than 1,400 U.S.-registered ETFs have less than $25 million in assets, according to Lipper. There's even a chance your ETF could be liquidated entirely if it doesn't attract enough interest.

"There are so many ETFs in existence that the average daily trading volumes on many ETFs are pathetically low," said Kirk Chisholm, principal of Portland, Maine money managers NUA Advisors. "If you try to sell the shares, there may not be a buyer within a reasonable spread, and it could cost you more than you expected to sell the position."

Looking ahead, Strategic Insight's Fox thinks it's likely that neither strategy will win a knockout and that ETFs and traditional mutual funds will manage to co-exist. Cost-conscious index investors will continue to gravitate to ETFs, largely because of the appealingly low fees. Meanwhile, active investors will keep on paying mutual fund managers a little more to try to beat the market. Because, in the immortal words of the New York Lottery: Hey, you never know.

(The author is a Reuters contributor. The opinions expressed are his own.)

(Editing by Beth Pinsker Gladstone, Jilian Mincer and John Wallace)

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