(Bloomberg) The arms race between mutual funds and their exchange-traded brethren turned into a beat-down in 2020.
Roughly $427 billion has poured into U.S. exchange-traded funds this year, divided almost evenly between equity and fixed-income funds, according to Bloomberg Intelligence data. Meanwhile, mutual funds have bled roughly $469 billion of assets in 2020, on track for the worst year on record in Investment Company Institute data going back to 1990.
The stark divergence in fortunes is part of a tectonic shift that’s seen investors favor ETFs over mutual funds for nine consecutive years, lured by the industry’s ultra-low fees and tax advantages. That trend was accelerated further in 2020, thanks to a well-timed rule from the Securities and Exchange Commission and the Federal Reserve’s first foray into the $5.3 trillion U.S. ETF market. Combined with another rocky performance from active managers, it’s clear why ETFs are winning out, according to State Street Global Advisors.
“The investor experience isn’t that great. You’re paying high fees for a less tax-efficient vehicle that also underperformed its benchmark,” said Matt Bartolini, head of SPDR Americas Research. “So, not surprisingly, you’ve seen significant outflows, since investors aren’t willing to pay that fee to then get saddled with a tax bill that they didn’t force because someone else redeemed out of the fund.”
Part of the groundwork for 2020’s shift was laid a year ago, when the SEC implemented a long-awaited overhaul of the rules governing the funds. The so-called ETF rule effectively streamlined the approval process for new funds and lowered disclosure requirements. That ushered in scores of first-time issuers, including quant giant Dimensional Fund Advisors, which oversees $527 billion in assets.
“While we had been planning on how we might do this for over a year, the ETF rule that the SEC came out with allowed us to do it,” said Joel Schneider, Dimensional’s deputy head of portfolio management, North America. “How do you decide when to buy and sell? How do you bring that active implementation into the ETF structure? It’s now much easier for us to do.”
Additionally, a record year for fixed-income ETFs bolstered 2020’s flows, thanks largely to an implicit endorsement from the Fed. After the coronavirus upended markets in March and effectively froze trading, the central bank announced it would buy bond ETFs to help restore market functioning. Billions poured into debt funds as a result.
‘Exclamation Point’
The fact that ETFs kept trading as a liquidity crunch gripped cash bonds helped showcase their value as a portfolio tool to fund managers, according to Morningstar Inc.’s Ben Johnson. Even with trading all but halted in the underlying bonds, investors were able to shed their fixed-income exposure via ETFs at the height of March’s turmoil.
“ETFs have, in the bond market, stepped in as being one of the primary mechanisms via which investors seek liquidity in their fixed-income exposures,” Johnson, director of global ETF research, said by phone. He added that the trend really took hold in the wake of the global financial crisis, and then “had an exclamation point put on it this year, when you saw the Fed sort of step into support in the corporate credit markets and use ETFs as one of their tools.”
Despite a banner year, ETFs have a long way to go before overtaking the $17.5 trillion mutual fund market. One huge hurdle rests in the U.S. retirement system and 401(k)s, which are largely designed to integrate mutual funds, which price once per day when trading closes. That operational hurdle is one that ETFs “can’t really overcome right away,” according to Bartolini.
Another consideration is the fact that plenty of investors don’t necessarily need or want to trade intraday -- a key feature of ETFs.
“The majority of clients don’t wake up and think, ‘Gee, I wish I had a different wrapper in my portfolio,’” said Greg Trinks, head of investment management research, Americas at UBS. “There’s a cohort that’s not interested in putting in that kind of labor to manage investments through the ETF wrapper and they’re always going to have a degree of comfort around the pricing mechanisms a mutual fund affords.”
Still, the tides are turning in favor of ETFs. Vanguard, the second-largest ETF issuer, has shifted roughly $37 billion of its mutual-fund clients to lower-cost ETF shares, according to spokesman Freddy Martino. Meanwhile, anticipation is building behind the industry’s first mutual fund-to-ETF conversion. That process is expected to further expedite the flood into ETFs, with giants such as Dimensional planning its own fund conversions.
“The direction of travel is very clearly towards the ETF format because it’s more cost efficient, more tax efficient, more easily accessible for a larger number of investors than mutual funds ever can be,” Morningstar’s Johnson said.
