Should Your Mutual Fund Own ETFs?

Exchange-traded funds have turned the money management industry upside down. In stark contrast to the old paradigm of the actively managed mutual fund, where investors essentially trusted fund managers to make all the investment decisions, ETFs have given investors a lot more power to choose their own investment strategies. With that power comes the responsibility of wielding it wisely, of course, but many investors are more than up to that challenge.

Historically, actively managed mutual funds have gotten a lot of criticism because their returns often lag a passive index investing strategy. But now, money managers are coming under fire for another reason: They've started to use ETFs themselves. That isn't necessarily a bad thing for investors, but professional investors should recognize that by using ETFs, they're decreasing the value they provide to fund shareholders.

What's good enough for hedge funds is good enough for you
Yesterday's article from Fool contributor Michael Lewis shined some light on how high-priced hedge fund managers are incorporating ETFs into their investment portfolios. With billions of dollars in assets, you might think that big hedge-fund players like John Paulson and Bridgewater Associates would be able to find special ways to get simple, general exposure to broad asset classes like the U.S. stock market or the price of gold. But Paulson has long used the SPDR Gold Trust (NYS: GLD) as a primary method for gaining gold exposure, with each share having a value of just less than a tenth of an ounce of gold. And Bridgewater uses the SPDR S&P 500 as a major element of its market allocation.

Now, regular mutual funds are jumping on the bandwagon. MarketWatch reported last week that active mutual fund managers have started including ETFs as top holdings of their portfolios.

What's the big deal?
On one hand, using ETFs makes a lot of sense for hedge funds and mutual funds. Rather than getting stuck in a bunch of relatively small positions in hundreds of different stocks, an ETF lets you get into or out of a broad investment class quickly and efficiently. Fund companies argue that it allows their funds to reduce cash levels without risking not having enough liquidity to pay off redeeming fund shareholders in the event of a rash of selling.

But these methods create additional expenses for fund investors. Paulson's 21.8 million share ownership of SPDR Gold is worth more $3.5 billion at current prices, and with an expense ratio of 0.4% annually, Paulson's fund would pay $14 million in fees every year on those holdings. Bridgewater's portfolio is even more ETF-heavy, with SPDR S&P 500, Vanguard Emerging Markets Stock (NYS: VWO) , and two international iShares ETFs making up close to 80% of the fund's total assets. The SPDR and Vanguard funds are both cheaper than SPDR Gold, but nevertheless, investors lose millions to additional fees that stem from hedge-funds' use of ETFs.

With hedge funds at least, managers have a partial incentive to cut fees. With 2-and-20 compensation tied in part to performance, any drag from high ETF fees falls through to managers' bottom line.

Paying twice
Active mutual fund investors, however, suffer because mutual fund managers don't have the same direct incentive to cut the fees they pass through to shareholders. Sure, funds are judged on performance, but without a direct financial hit to fund managers' profits, it's hard to see them changing their behavior.

The fairer answer would be to allow mutual funds to use ETFs as investments, but only if they reduce their share of the fees they already collect from shareholders to cover the cost. Subcontracting out part of their investing responsibility is perfectly fine, but fund shareholders should end up footing a double-sized bill as a result.

Don't hold your breath
Of course, you shouldn't expect fund companies to do that anytime soon. Given the highly competitive nature of the industry, fund companies need every edge they can get. With assets fleeing from active funds to ETFs, even profitable managers Janus Capital (NYS: JNS) and Franklin Resources (NYS: BEN) are struggling to stand up to SPDR manager State Street (NYS: STT) and other major players in the ETF industry.

What you can do, though, is to track the ETFs that big fund managers use and then just buy them yourself. Unless you think your fund is using ETFs as a timing bet -- something you'd expect from hedge funds but not necessarily from mutual funds -- you could well do better just cutting out the middleman and buying the ETFs for your own portfolio.

ETFs aren't the only smart way to invest. The right stocks can be valuable as well. Learn about the stocks that The Motley Fool's special report on long-term investing picked as stocks that can help you retire rich. It won't cost you a cent, so be sure to pick up your copy today.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

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Fool contributor Dan Caplinger doesn't believe in double-dipping. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy tells you what we own.

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