It soon may become easier for mutual funds to invest in exchange traded funds, but industry experts are divided as to whether funds will rush to invest in a product that is sometimes depicted as a competitor.
The Securities and Exchange Commission proposed a rule earlier this month to allow investment companies such as mutual funds to make larger investments in ETFs than is permitted under the Investment Company Act of 1940, which now limits one investment company to acquiring no more than 3% of another investment company's shares.
The rule, which was proposed along with a rule that will make it easier to bring ETFs to market, has the support of the ETF industry and is expected to become reality soon after a 60-day comment period, said Tom Conner, a partner in the financial services practice at the Washington-based law firm Sutherland Asbill & Brennan LLP.
"It is a big deal because it gives ETFs kind of a new kind of market," even though mutual funds already invest in ETFs, he said.
About 114 stock mutual funds have more than 5% of their assets invested in ETFs, according to the most recent data from Morningstar Inc. of Chicago.
EXEMPTION ADVANTAGE
But the playing field is currently tilted toward established ETF participants who have been able to get exemptions that allow mutual funds to hold more than 3% of their ETFs. Companies like
Barclays Global Investors of San Francisco and
State Street Global Advisors of Boston have a competitive advantage be-cause they have already secured the exemption for their ETFs, but new entrants that haven't already done so must go through that onerous process.
"This [the proposed rule] is something that will really improve the competitive situation," Mr. Conner said.
That may be true at least among traditional, index-based ETFs, said James Pacetti, president of ETF International Associates Inc., an industry consulting firm in New York.
"I do not see a lot of these new enhanced ETFs benefiting from this," he said, referring to new and proposed actively managed ETFs, and ETFs that claim to be pegged to an index, but where the index has certain elements that resemble active management.
That's because mutual fund managers like to understand what they are holding, and only ETFs that follow a transparent index give them that ability, Mr. Pacetti said.
It's hard to believe the SEC rule proposal will result in a mutual fund manager rushing to invest in ETFs of any kind, said Jeff Ptak, an analyst with Morningstar.
"In terms of what the proposed rule might mean for the future, it's a net positive for ETFs," he said. But at the same time, ETFs "won't see billions of dollars pouring forth" from mutual funds, Mr. Ptak said.
ETFs can help mutual fund managers fill "gaps" in a portfolio, he said, meaning that ETFs can be used to temporarily park cash.
But fund managers will be leery of using ETFs to any greater degree, because big investments in the passively managed vehicles raise questions about what the fund manager is doing to earn his or her money, Mr. Ptak said.
"If they go whole hog into an ETF and ask investors to pay upwards of 100 basis points, that will rankle," he said.
Yet there are still mutual fund managers that invest heavily in ETFs.
The AdvisorOne Funds is a group of five mutual funds advised by CLS Investment Firm LLC of Omaha, Neb., all of which invest heavily in ETFs. The group, which has assets totaling $1.24 billion, uses its focus on ETFs to market its funds as a way for investors to access
portfolio management available to institutional investors.
"The principles of asset allocation used to manage [the AdvisorOne funds] are the same principles used by some of the largest pension funds in the United States," according to the group's website.
Including the funds' underlying expenses, the total expense ratio of the AdvisorOne funds ranges from 1.41% to 1.47%, according to Morningstar. The average expense ratio of all stock funds is 1.42%.
The FundX Upgrader Funds, advised by Dal Investment Co. LLC of San Francisco, is another example of a fund group with funds that invest heavily in ETFs.
At the end of last year, 44.42% of its flagship $815 million FundX Upgrader Fund was invested in 26 ETFs, according to Morningstar.
Including the fund's underlying expenses, its expense ratio is 2.13%, according to Morningstar.
E-mail David Hoffman at [email protected].
