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Worth noting, though, is that if it were possible to create a pooled, unitized account that could be offered to the masses using ETFs that was cheaper than a mutual fund, mutual fund companies would likely be taking this route. Therefore, the idea that creating these large pooled ETF accounts that can somehow be cheaper than a large pooled mutual fund is somewhat faulty reasoning from the start. Even though a small price discrepancy between an ETF and mutual fund may exist, there are likely reasons for this, especially when they are being offered by the same sponsoring organization. Take for example Vanguard, the company whose investments were used as the case study for this paper. Vanguard offers both mutual funds and ETFs that are based on the same underlying index methodology (MSCI), and in fact, are share classes of the same funds. The ETFs are typically less expensive than their respective Investor-share class mutual funds. These differences reflect the different record-keeping and administrative costs associated with the two strategies. While it’s certainly possible that someone could do it cheaper than the 800-pound gorilla (Vanguard has over $1 trillion of assets under management), these authors would be highly skeptical of such a claim after all the costs are considered.
A Word On Revenue Share
A common criticism of mutual funds is the payments (known as revenue sharing) made to retirement plan providers. These types of payments can come in a variety of forms (12(b)-1s, subtransfer agent fees, investment manager rebates, etc., and exist for a variety of purposes, such as a method to pay for distribution (12(b)-1s) and record keeping (subtransfer agent fees). It is important to note, though, that despite the negative press associated with revenue share, revenue share dollars are not necessarily a bad thing. From a practical perspective, if a retirement plan provider is going to charge 1 percent for its services, the nature of its compensation (e.g., through revenue share generated from a higher expense ratio or from an explicit fee billed to clients) is not going to change the total net cost billed to the plan.
If the revenue share monies from mutual funds are returned to the plan to offset fees (based upon the Frost Model, or DOL Advisory Opinion 97-15A), revenue share can actually decrease the total net cost of the mutual fund. In some cases, this can make an index mutual fund that has a higher expense ratio than an ETF actually be less expensive than the ETF. For example, say a mutual fund has an expense ratio of 15 bps and the ETF has an expense ratio of 10 bps. Ignoring the costs associated with pooling, the ETF is clearly less expensive; however, if the mutual fund offers 10 bps of revenue share that is returned to the plan to offset expenses, the net cost of the mutual fund would actually be 5 bps. Therefore, for this example, the mutual fund is actually net cheaper than the ETF, even though it has a higher expense ratio. While a mutual fund with a net expense ratio of 5 bps may seem too good to be true, we are aware of at least two different mutual fund organizations that have index funds available with net costs lower than 5 bps.
Beware Of Backtesting
Something to be aware of with ETFs, which isn’t an issue for other investments, is that ETFs can use "backtested" or hypothetical returns. This is because ETFs are passive strategies and the hypothetical performance represents the performance of the underlying strategy the ETF is following. Therefore, it is possible for a new ETF to show five- or 10-year performance history in its marketing materials, despite the fact it’s brand new, although noting the fact the returns are "hypothetical" somewhere in the small print. This creates the "what might have happened had you bought into this strategy 10 years ago" situation, which is also something known as hindsight bias.
As an example of the potential problems associated with ETFs using hypothetical performance, let’s assume that stocks with names that begin with the letters G, W and K dramatically outperformed all other stocks over the last 10 years. An astute analyst may contrive some reason for this to have occurred, and why it is likely to continue to occur, and then create an ETF that follows such a strategy. The marketing materials would show strong relative performance against similar indexed or active strategies despite the fact few people (if any) would have been likely to invest in this strategy 10 years ago.
While the previous example may seem extreme, ETF strategies are becoming increasingly esoteric. Therefore, it is important to ensure that the underlying methodology is sound when selecting an ETF, not just the hypothetical historical performance.
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