Watch Out Mutual Funds!

Distributors and platforms play an important role in vehicle usage, according to a recent Cerulli Report: “Product Development in an Evolving Portfolio Construction Environment.’ Their ability—and willingness – to support different product vehicles and structures directly impacts asset managers’ ability to raise assets in the retail third-party distribution channel. Technology hurdles are often to blame when certain vehicles are not adopted. “For example, ETFs have not yet made a meaningful mark in the DC marketplace because of technology constraints and other issues but this is changing,’ says Cindy Zarker, Director and lead of author of the report.

While ETF usage in portfolio construction is “dwarfed’ when compared to mutual funds, the report notes that, in the competition for assets in the various components of investors’ portfolios, ETFs are a potential threat to those mutual funds. It notes that advisors are using ETFs in multiple ways in both the core and satellite allocations, as well as in the active and passive slices of investors’ portfolios.

The report notes as an example that some advisors are tapping diversified U.S. equity ETFs – such as the S&P 500 SPDR, as “cheap beta.’ However, asset allocation also plays a role in the usage of ETFs in portfolio construction—both from the perspective of asset managers’ competency as asset allocation specialists and financial advisors’ approach to asset allocation, according to Cerulli. Advisers who are strategic asset allocators are likely more interested
in ETFs for their lower fees and long-term investment themes, whereas advisers who employ a
tactical asset allocation approach in their clients’ portfolios may use ETFs because they offer continuous liquidity and access to commodities and other markets where they want to make a concentrated bet.

Product Developments

However, one issue confronting ETFs, according to the report, lies in the area of product development. “Unlike mutual funds where the product development has not only facilitated innovation but also spawned many “me too’ products (the report notes that there are now almost 700 large-cap blend portfolios), it is less viable for firms to replicate index-tracking vehicles.’ As a result, the report claims that, after exhausting the pool of mainstream indexes, and then the supply of more discreet benchmarks, “…ETF architects are slicing and dicing the universe of investable securities, as well as commodities, into new indexes from which to construct ETFs.’

Mutual fund assemblers have jumped on the ETF product development bandwagon launching mutual funds that invest in ETFs. The report notes that one of the challenges to ETF “wanabees’ has been to identify unique indexes. “Unlike mutual funds, the ability to develop copycat products has been constrained by the need to obtain rights on an index or to create a new index.’ Additionally, the report notes that ETFs based on traditional broad-based indexes justify very low fees that require the ETF to garner substantial assets in order to be profitable.

According to the study’s authors, many asset managers that have not yet entered the ETF marketplace are concerned about the competitive threat of actively managed ETFs, and some asset management executives see that the need for transparency places trading limitations on active ETFs. The report notes that “…many insist that the higher fees associated with active ETFs, particularly equity ETFs, will negate one of the biggest advantages—low fees.’ However, ETF manufacturers counter that the benefit isn’t related to cost as much as tax efficiency and transparency.

“Some asset managers that were once steadfast in their belief that ETFs did not pose a threat to mutual funds are now reconsidering this position. At this juncture, with the future of active ETFs just now beginning to be written, asset managers must determine their position via a well defined product strategy. It is too soon to tell how investors, and their advisors, as well as platforms, will weigh the trading, tax efficiency and other advantages of ETFs relative to the strengths of mutual funds,’ says Zarker.