ETF Transition Could Support Mutual Fund Industry Growth

At the end of January, there was $6.93 trillion in US-listed exchange traded products. Under any circumstances, that’s a staggering sum and it’s even more so when considering the domestic exchange traded funds industry is just over 30 years old.

As has been widely documented, much of the growth of ETFs has come at the expense of actively managed mutual funds. Measured by number of products and assets under management, mutual funds are still the king of the hill, but ETFs and passive index funds will eventually wear that crown. Consider this: Of the 15 largest mutual funds in the U.S., none are actually mutual funds. They’re all passive ETFs or index funds. The largest active mutual is the Fidelity Contrafund in the sixteenth spot.

This transition, which is ongoing with more room for growth, isn’t surprising. As advisors know, active management has its shortcomings. Not to mention active mutual funds are less tax efficient and come with higher fees than ETF counterparts – facts that cannot be ignored at a time when more clients are increasingly conscious of the benefits of tax-advantaged investments and low expense ratios.

In a sign of “if you can’t beat ‘em, join ‘em,” more well-known mutual fund issuers with rich traditions in active management are joining the ETF industry – a move that could mark a new dawn for the mutual fund business.

For Mutual Fund Issuers, a Smart, Needed Move

Around mid-2015, mutual fund flows did the then unthinkable: They turned negative. Worse yet, they remained negative through the end of last year and over that period, the industry bled $2 trillion with plenty of that capital matriculating to passive ETFs.

“By comparison, ETFs have continued to consistently haul in new money, with almost all of those flows going into index-tracking ETFs. At least part of the reason rests with the advantages the ETF structure has over mutual funds. All else equal, ETFs typically cost less and make fewer capital gains distributions. Not only are they cheaper, but they’re also more tax-efficient,” notes Morningstar analyst Daniel Sotiroff.

Add it all up and active mutual fund issuers have compelling reasons to enter the ETF industry and some are doing just that. Those include Avantis, Capital Group (American Funds), Dimensional Fund Advisors (DFA) and T. Rowe Price, among others. In fact, Avantis, Capital Group and DFA were among the more prolific gatherers of ETF assets in 2022, leveraging familiar mutual funds turned ETFs to lure capital from advisors and investors.

“In many instances, the fees tied to the latest breed of actively managed ETFs are now lower than their mutual fund predecessors, and they possess the same tax efficiency as their index-tracking counterparts, inching them closer to the standard set by index ETFs,” adds Sotiroff. “In doing so, the lower fees and taxes tied to ETFs are becoming less of the differentiators that they were in the past, meaning the underlying investment process and the people tasked with overseeing it have become more important in selecting great ETFs for the long haul.”

DFA Leading the Way

At this juncture, it’s not a stretch to say more active mutual fund issuers will enter the ETF arena and those that already have will likely convert more mutual funds to ETF structure. The success of DFA serves as inspiration and as a template.

“It launched 23 new ETFs and converted an additional seven tax-managed mutual funds to ETFs over the past three years. Dimensional’s ETFs pulled in more than $26 billion of new money in 2022 alone, largely offsetting the money that left its mutual funds,” concludes Sotiroff.

At the end of the day, fund companies know that advisors and clients like familiar brands and funds, but they don’t like paying up for those perks. Put simply, that will stoke more mutual fund to ETF conversions.

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