ETFs vs. mutual funds: Investment vehicles get ready to rumble
Is there a battle royal brewing in the world of investment funds? Exchange-traded funds are suiting up in the locker room, preparing to challenge mutual funds' dominance. A recent report from Deloitte, Exchange-Traded Funds: Challenging the Dominance of Mutual Funds? says that ETFs could in time bulk up with some of the serious monetary muscle we call market share.
ETFs have become popular with investors due to their fee structure, tax efficiency and level of transparency, says Craig Stier, U.S. leader of Deloitte Asset Management Services Practice and author of the paper. They have also made it easier for retail investors to invest in individual commodities like oil and gold. "These are some reasons perhaps why ETFs have weathered the sharp slowdown in markets better than mutual funds," says Stier.
As a result, ETF net assets are nearly $500 billion, and there is a high likelihood that the asset growth slope they have displayed in recent years will return once markets stabilize. Based on current industry trends, Stier foresees the following:
- Over the next two to three years, total ETF assets in the U.S. will likely exceed $1 trillion;
- Actively managed ETFs are unlikely to become as popular as index-based ETFs;
- More closed-end funds will reorganize and become ETFs;
- ETFs will predominantly focus on commodities, emerging markets, fixed income and currencies.
Why? Several reasons:
- New SEC rules that will make it easier to launch ETFs;
- New disclosure rules that will make ETFs more popular with retail investors;
- More 401(k) plan money that will be invested in ETFs;
- Greater tax efficiency of ETFs;
- Lower costs, liquidity; market-exposure diversification;
- Greater transparency;
- And an increasing number of mutual fund complexes that enter the ETF business.
While mutual funds have a 69-year head start and are much larger than ETFs, retail and institutional investors and advisors are ensuring that ETFs will be one of the fastest-growing investment products of the future, says Stier. But in order to move from lady in waiting to potential champ, ETFs will have to expand their investor friendly attributes beyond transparency and low costs, he says.
The way Stier sees it, there are tactical moves that could enhance ETFs position. Among the ideas has in mind are:
Link to less exotic indices. "Some of the best performing ETFs are linked to less exotic indices such as commodities and equities," says Stier. The data shows that exotic funds on average have not performed as well as regular ETFs. This is not to say exotic funds have not performed well, but exotic ETFs are difficult for average investors to understand. Simpler is better, and simpler betas are cheaper than their more exotic counterparts.
Think long-term. ETFs should focus on indices with long-term appeal. There are a number of ETFs that have been launched to benefit from a current market situation. Inverse financial sector ETFs, for example, profit from the ailing financial sector. However, most investors recognize that these ETFs have a limited shelf life. Being linked to an index with a long-term appeal is usually more attractive to investors, particularly retail investors.
Go after the 401(k) crowd. One barrier to 401(k) funds investing in ETFs is their higher costs compared to index mutual funds. Given that 401(k) assets will probably reach $7.5 trillion to $8.5 trillion in 2015, ETF sponsors should make themselves 401(k) friendly, allowing them to tap into this huge pool of assets, which for now primarily invests in mutual funds.
At some point, Stier says he foresees ETFs possibly crossing over into the hedge fund arena.
With half of all ETFs falling short of the $50 million in minimum assets required to maximize profitability, attracting capital will be key to remaining competitive. For now though, clearly "it's on."