Why would a mutual fund manager add ETFs to a portfolio? It makes more sense than you think.

On Thursday, SmartMoney’s Ian Salisbury wrote about something that may be surprising to some: mutual fund managers buying ETFs for their portfolios.

He points to the Columbia Small Cap Core fund (SSCEX), an equity mutual fund with $900 million in assets that recently cited its top position as the iShares Russell 2000 ETF (NYSEArca: IWM) instead of a single-stock holding.

Other funds have bought the ETF recently as well: Salisbury cites both the $1.8 billion American Century Small Cap Value fund (ASVIX) and the $860 million Invesco Van Kampen Small Cap Growth (VASCX) as mutual funds with significant positions in the iShares ETF.

IWM tracks the Russell 2000 index of small-cap stocks, so it’s not like the ETF didn’t belong in these portfolios. But it does raise a question: Why pay a mutual fund manager to own an ETF?

The concern comes down to fees. Shareholders of a mutual fund pay fees for their slice of the pie: transaction costs, advisory fees, marketing and distribution expenses—all on top of the fees paid to the fund manager herself.

These fees add up, and they’re one of the several reasons why many advisors are moving to lower-cost exchange-traded funds.

But ETFs aren’t without fees. Even though most are far cheaper than their mutual fund equivalents, fund issuers still charge expense ratios to maintain the funds.

If mutual fund managers buy IWM, they have to pay that expense ratio. And the costs, so the concern goes, will get passed down to the shareholder.

But before you pick up the phone and lash out at your mutual fund manager, it’s important to remember the benefits of ETFs in your fund’s portfolio. Because in truth, not only is this a legitimate tactic, it’s actually good money management.

Imagine you're the manager of an equity mutual fund. One day, you walk into the office and discover you suddenly have $4 million in new inflows. Hey, congratulations! But now you have to spend those flows. What do you do?

You could sit on the cash, of course. But that would cause your portfolio to trail a rising market, and you really don’t want a 1-to-1 drag on your portfolio.

You could buy stocks, but there might not be anything particularly attractive in the markets right now, no matter how cheap Facebook gets.

Plus, buying stocks in a hurry means poor execution or buying stuff just to buy stuff, not because you believe in it.

Or you could buy an index product that will at least track the market you're focused on. Which option sounds right to you?

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