ETFs In Mutual Funds? Sure!
August 24, 2012
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?
Mutual funds have to equitize cash, either from inflows or dividends, or just because they sell something and don't see anything in the market they want to buy. They used to buy futures, where margins could climb sky high; now they use ETFs. It allows them to get quick, cheap exposure to the market.
You put the money to work in an index product, and then when you get a better idea, you buy some stocks and sell off that index position. It's the best way to handle "cash management."
And here’s the dirty secret: Everyone does it. In fact, you’ll notice it frequently happens around the last day of the quarter, depending on what inflows, outflows and dividends different mutual funds receive.
The fact that reporters are starting to notice is actually a good sign.
“But what about the extra fees?” you may ask.
In the grand scheme of things, shareholders shouldn’t notice much of a difference. In IWM’s case, the annual expense ratio comes to 23 basis points. That’s not free, but it’s a pretty low fee.
I’d be concerned if a mutual fund only held ETFs, something that’s happened in a few extreme cases in the past. But to my knowledge, these funds don’t exist anymore—likely because investors wised up to what seems to me to be a pretty blatant rip-off.
Mutual funds are still a huge business: $12.17 trillion of the market compared with the $1.2 trillion in ETFs.
And even as more investors move toward ETFs, mutual funds aren’t going anywhere. If anything, this trend of ETF holdings in mutual funds is a good sign: Managers should use every tool available to grow their clients' money, and ETFs are one of the most efficient tools in their belts.
Cory Banks is the managing editor of ETF Report from IndexUniverse. He can be reached at email@example.com.