The open-end mutual fund structure has been around since the 18th century thanks to a Dutch merchant. Mutual funds were introduced to the United States in the 1890s, and they gained popularity in the 1920s. The modern mutual fund has forgone additional changes to satisfy regulation. Currently, around 85% of all retail assets are managed in open-end mutual funds, and slightly over 10% in exchange traded products. Not too long ago ETFs we merely 1-2 percent of the market share but have been gaining ground quickly. There are multiple reasons why mutual funds have been losing assets to ETFs, some of which are rational and some are not. Let’s explore the main mutual fund disadvantages compared to ETFs:
- Capital Gains Tax Efficiency (applies mainly to US investors). Equity mutual funds are less tax-efficient than comparable ETFs. The lower tax-efficiency is due to how the operations of the two vehicles differ and how investors purchase the products. There are three fundamental differences of how ETFs handle subscription and redemptions compare to mutual funds and how this translates into better tax efficiency.
- ETF investors trade directly with one another on an exchange approximately 90% of the time. The direct exchange of ETF shares amongst investors means that the ETF managers do not need to sell any securities in the portfolio to raise cash for the selling investors. This helps avoid the disposition of securities with ingrain capital gains. On the other-hand, mutual fund shares do not trade on an exchange, and investors have to transfer their cash to the mutual fund company to participate in the fund. When someone wants to sell out of a mutual fund, if the portfolio manager doesn’t have the available cash, he will need to sell securities. If those securities are sold at a capital gain, the remaining investors in the mutual fund as of the capital distribution record date will have to bear the tax burden.
- For the other 10% of the time, when the supply and demand are not offsetting, equity ETFs use in-kind transactions, not forcing the manager to sell any securities with embedded capital gains. To elaborate, ETF shares may only be created and redeemed by what’s called the Authorized Participants (for short APs), who are also known as market makers. If more investors are trying to sell ETF shares on the exchange compared to available demand, the ETF price will begin to trade below NAV. When this happens, the APs will start delivering the oversupply of ETF shares to the ETF provider (portfolio manager) in exchange receiving an equivalent value basket of securities from the ETF’s portfolio. In turn, the APs will sell the basket of securities and deliver the cash to the selling investors, helping the ETF manager avoid the need to sell any securities with embedded cap gains.
- ETF managers can deliver any securities held in the portfolio to the APs. Again, when the secondary (the exchange) market is unable to clear the trades because there are more sellers than buyers, the authorized participants will begin to redeem ETF share with the ETF manager. The ETF manager has full discretion which securities will be delivered to the APs. The manager does not have to give the APs any particular basket of securities, just one that is equivalent in market value to the ETF shares being sold. That means that he can pick and choose the securities with the current highest embedded capital gain, which helps to avoid further future capital gains.
Below is a tax efficiency table for index mutual funds against index ETFs:
Note, equity ETFs almost never distribute capital gains. The same cannot be said for fixed income ETFs since in-kind transactions are usually not available due to the large variations of bond securities and their lack of liquidity. Also, ETFs do not avoid paying taxes on things like dividend and interest income.
- Flow related expenses. Long-term mutual fund investors subsidize liquidity for short-term investors. When mutual fund investors move in and out of the fund, they generate transaction costs. The manager has to either buy securities with the newly provided cash or sell securities to raise cash for the leaving investors. The trading activity generates expenses that reduce fund performance, hurting the remaining investors. ETFs deal in-kind, passing the transaction costs to the frequent traders (via the spread) and not affecting the performance of the long-term ETF investors. In a research paper, Roger Edelen quantified the adverse effect of shareholder entry and exit costs on fund performance(Edelen 1999). He found that mutual trading costs accounted for an average net reduction in annual investor return of 1.44 percent, while 30% of those cost are attributed to the liquidity offered to entering and exiting shareholders, hence flow related trading cost can be anywhere in the region of 20-50 bps. One thing to keep in mind is that the flow related turnover expense will fluctuate depending on the liquidity of the securities in the fund (for example, small cap vs. large cap) and the size of the fund (larger fund trades will have the larger market impact). Also note, pricing decimalization and scandals in the early 2000s which caused many mutual funds to adopt investor protection mechanisms such as redemption fees have helped mitigate but not eliminate some of the flow related costs. Nevertheless, these costs are significant and are paid by the long-term mutual fund investors. Equity ETFs through the in-kind process externalize and pass the trading costs to whom they belong, the traders.
- Uninvested cash(cash drag). Mutual funds have to hold more cash to handle incoming redemptions. Since ETF perform redemption in-kind, they do not need to carry high amounts of cash. The uninvested cash position further drags mutual fund performance lower. White paper by NextShares estimates that this decreases investor returns by approximately 20 basis points per year.
- Mutual funds are slightly more expensive to operate. ETFs managers do not have to keep track of shareholders since they trade on an exchange. Mutual funds have the additional expense of transfer agency, reporting, and marketing materials. These costs can range from an additional 1 to 10 basis points depending on the size of the fund.
To summarize, most mutual fund disadvantages stem from the use of cash redemptions. On the occasions that ETFs experiences outflows, the ETF manager can hand over a basket of the fund’s underlying securities instead of cash. It can also pick which securities to give to the Authorized Participants, ridding itself of tax lots with the greatest embedded capital gains. Mutual funds are not required by law to use cash for all flow transaction, but for practical reasons they do.
Also, don’t assume ETF investors pay less in costs or don’t have their inefficiencies. ETFs are not less expensive than mutual funds for the average investor, but with a better understanding of ETF costs, they can be. To gain a better understanding of ETF costs and inefficiencies, please read the following post Hidden costs of ETFs.
Edelen, Roger M. 1999. “Investor Flows and the Assessed Performance of Open-End Mutual Funds.” Journal of Financial Economics, vol. 53, no. 3 (September):439–466.
NextShares 2014. “Avoidable Structural Costs of Actively Managed Mutual Funds”