ETFs bust the mutual fund manager myth

Two major forces are behind the dramatic growth in popularity of exchange traded funds: the wide-spread adoption of fee-based advice and the prolonged 10-year bear market’s effect of destroying the “mutual fund manager” myth.

ETFs have been steadily taking market share from traditional mutual funds. This trend accelerated in 2008. The dramatic shift in net new flows between ETFs and mutual funds was so great that even the most ardent mutual fund proponents were forced to take notice.

In 2008, ETFs had net inflows of $177 billion while mutual funds had net outflows of $224 billion (see graph).

According to a recent report published by State Street Global Advisors of Boston, the total number of ETFs increased from 629 to 747, in 2008. Over the next several years, the number of ETFs should easily surpass 1,000.

How have ETFs gone from virtually non-existent to challenging mutual funds as the investment tool of choice in less than 20 years?

The threat ETFs pose to mutual funds was apparent at the Investment Company Institute’s 50th Annual General Membership Meeting in May 2008. At the meeting, American Century Investments’ president Jonathan Thomas said, “ETFs have cannibalized the actively managed space,” referring to the rapid growth of ETFs and their effect on traditional, actively managed mutual funds. The ICI is based in Washington, and the American Century Investments is based in Kansas City, Mo.

There was a time when investment professionals had few choices when it came to pricing their servicers. Access not only to information but also to investment vehicles was controlled by large Wall Street brokerage firms, and the primary way investors paid for investment advice was in the form of a commission on the product they purchased. Clearly, such a system tremendously increased the potential problems and conflicts.

By the late 1980s and early 1990s, fee-based financial advisers started to make inroads. They were typically independent of the large brokerage firms and offered clients an alternative. Instead of commissions based on purchases, they charged an asset-based fee on the amount of money managed. In fact, by the mid 1990s the trend was sufficient enough that most brokerage firms began offering all-inclusive, fee-based accounts.

MANAGER MYTH
For years, Wall Street promoted mutual fund managers as mythical characters who can find winning stocks and beat the market. Every month the latest reports and financial magazines showed the latest and greatest new managers. The focus was on mutual fund manager selection and indirectly individual stock selection. But over the last 10 years, the notion that fund managers add value has been diminished.

Where combined with a fee-based account, ETFs are the best way to serve investors, allowing the adviser to focus on the truly important question of asset allocation (stocks, bonds and cash) using a low-cost vehicle that will track the asset classes.

With ETFs the value of the adviser is not in picking fund managers but in managing the allocation mix and rebalancing strategy that is best suited to the client.

There is no question that ETFs have changed the way portfolio management is delivered. They have commoditized equity and fixed income returns and moved the control to the advisor, not the fund manager or investment firm. Advisors have embraced this new approach. In the fall of 2003, I founded my company as an all-ETF portfolio manager. At that time, there were few other all-ETF advisors out there. Today, our numbers are growing. The trend will continue and eventually ETFs will play a dominate role in the portfolio of most investors.