Financial advisers will likely be drawn to the allure of exchange traded funds in 2009, thanks to an anticipated rise in open-end mutual fund expenses, according to industry experts.
"I definitely expect to see average mutual fund expenses going up," said Jeff Tjornehoj, a Denver-based senior analyst at Lipper Inc. of New York.
For example, Capital Research and Management Co. of Los Angeles, adviser to American Funds, sent out a letter to investors in December announcing that, despite negative returns, it was discontinuing fee waivers as of Jan. 1.
It's a trend that would only serve to widen the advantage ETFs have over mutual funds when it comes to expenses.
A look at ETFs and open-end mutual fund share classes in the large-blend category — one of the largest categories followed by Morningstar Inc. of Chicago — illustrates the point.
The average equal-weighted expense ratio of ETFs in that category was 0.48%, compared to 1.27% for open-end fund share classes, according to the most recent data.
The average asset-weighted expense ratio of ETFs in that category was 0.15%, compared to 0.58% for open-end fund share classes.
"One reason ETFs are becoming so popular is that the expenses of ETFs are so much lower than mutual funds," said Scott Kays, president of Kays Financial Advisory Corp., an Atlanta-based firm with $125 million under management. "A rise in mutual fund expenses will drive more assets to the ETF side."
A rise in fund expenses seems unavoidable because breakpoints — discounts on front-end sales charges or loads — that lowered expenses as fund assets increased, will work in reverse as fund assets decrease.
ETFs don't offer breakpoints, which works in the favor of investors during a time of falling assets.
Mutual fund assets stood at $9.35 trillion in November, down from a high of $12.356 trillion in October 2007, according to the most recent data from the Investment Company Institute, the Washington-based trade group for the investment management industry.
ETF assets stood at $478.06 billion in November, down from a high of $610.31 billion in May 2008.
The decline in ETF assets, however, has been due largely to market depreciation. ETFs have continued to attract new money, while investors have been pulling money out of mutual funds.
For example, ETFs saw $2.6 billion of new money in October and $26.1 billion in November, according to Morningstar.
Open-end mutual funds saw outflows of $115.8 billion in October and $40.7 billion in November.
If mutual fund expenses go up as expected, that trend will continue.
Breakpoints that once allowed fund providers to offer funds at a discount will be the primary culprit for rising fund prices, but there are other possibilities, such as Capital Research and Management dropping its fee waiver.
"Within the last year, our assets under management have fallen roughly 40%," said Chuck Freadhoff, a spokesman for the American Funds.
As a result, the company dropped its fee waivers because it wants to continue to strengthen its investment capabilities, he said.
That response angered Andrew Horowitz, president of Horowitz & Co. Inc., a Weston, Fla.-based firm with $65 million under management.
"In the end mutual fund companies should suck it up," he said.
If they don't, ETFs will continue to get more fund business, Mr. Horowitz said.
"The answer is, yes, rising prices would encourage ETF use relative to mutual funds," said Lloyd D. Raines, a first vice president based in Stamford, Conn., for RBC Capital Markets Corp. of New York. But he said there's more to it than that.
ETFs — because they generally follow an index — offer investors greater transparency than funds, Mr Raines said.
"At a time when people are nervous, they are more comfortable knowing what they are buying," he said.
There is another issue: Actively managed mutual funds have failed to prove they can add much value in a down market, said Mark Balasa, a financial adviser and co-president of Balasa Dinverno & Foltz LLC of Itasca, Ill., which manages $1.5 billion in assets.
"The argument was that active funds can do better in a down market because they can pick their battles," he said. "That's hasn't really played out."
It's for those reasons, not an increase in the difference in price, that Bradley Kay, an ETF analyst with Morningstar, believes ETFs will continue to win out over mutual funds in 2009.
"There has always been a big price difference between ETFs and funds," he said.
An increase in fund prices may help, but Mr. Kay said he doesn't think it will be the main driver of assets moving towards ETFs in 2009.
ETFs continue to represent a great story, but some financial advisers said that despite perceived advantages they will stick with mutual funds.
"I know there has been a trend to ETFs, but I still think there will always be a place for mutual funds," said Jeffrey Feldman, president of Rochester Financial Services, a Pittsford, N.Y., firm that manages $100 million in assets.
There is a case to be made for actively managed funds — that a good manager can add value, he said.
Although ETFs are generally cheaper than mutual funds, that's not always the case when commissions for buying and selling ETFs are taken into account, said Richard Schroeder, executive vice president of Schroeder Braxton & Vogt Inc., an Amherst, N.Y., financial advisory firm with $220 million in assets under management.
"In some cases, the transaction costs cancel out the advantage of the lower expense level of the ETF," he said.
E-mail David Hoffman at [email protected].
