On March 1, Bill Gross, co-founder of the Pacific Investment Management Company, officially crossed the line and fired his opening salvo in the exchange-traded fund business.

The bond guru decided to take the active management he used to make PIMCO's Total Return Fund the largest mutual fund extant and apply it, with some variation, to bonds that could be traded at any time in an exchange-traded fund.

Should mutual fund managers who must compete with Total Return Fund and its $250 billion in assets as well as the Total Return ETF, now two weeks old, be worried enough to lower their fees to compete - or follow suit and launch ETF versions of their own open-ended mutual funds?

Not so fast, say industry executives. Gross' latest move-bringing active management to a field that has built itself up on the basis of investing passively in indexes as their benchmarks-should attract plenty of attention from other fund managers.

But active open-ended funds have plenty of redeeming qualities not found among ETFs, they say, ranging from track records to risk management.

Raking in the Dough

ETFs experienced net cash inflow of a record $42.7 billion in the first two months of 2012, according to data from the ETF Industry Association. That compares to total estimated inflows to long-term mutual funds of $5.51 billion for the week ended February 29, according to the Investment Company Institute.

Clearly, ETFs are hot. Assets under management in ETF products, including both ETFs and exchange-traded notes, stood at $1.2 trillion as of Feb. 29th, a 14 percent increase over February 2011. By contrast, mutual funds grew 3.8 percent, to $12.06 trillion in January, from $11.8 trillion in December 2011, according to ICI figures.

Gross's new fund may lead to some competition in net fees and expenses, according to Tom Roseen, Head of Research Services at Lipper. And fund managers may look at ETFs as a new distribution channel opportunity.

"However, not everybody should be in ETFs, which are not good for small, recurring investments," Roseen says. Recurring investments come with transaction fees, which can build up because ETFs are traded like stocks via brokerages. By contrast, many mutual funds waive fees for recurring investments.

Also, Roseen says that ETFs are also not as tax efficient as advertised because some fixed income or real estate funds have the same tax inefficiencies as their open-end counterparts.

"So there is a time and place for ETFs and open-end funds."

And while most ETFs are cheap by comparison to mutual funds, Gross' new offering sports an annual expense ratio of 55 basis points, which is 30 basis points less than the retail version of the mutual fund but is still more expensive than the institutional version of the mutual fund, Pimco Total Return Institutional Fund, which charges 46 basis points.

Cutting Fees

In addition, Roseen offers that some fund families are cutting their fees to make them that much more competitive among investors.

"Also, active managers can point out how they did in certain markets, specifically in stock picker's markets," he says.

Dan Culloton, associate director of fund analysis at Morningstar, adds that ETFS and traditional index funds have put a lot of downward pressure on expenses across the board.

For example, while the average fund reportedly charges 150 bps, Direxion, purveyor of alternative mutual funds and ETFs, recently launched its Direxion Indexed Managed Futures Strategy Fund at 145 basis points for A Shares.

That "makes it the lowest cost mutual fund with the lowest minimum necessary to get involved," says John Cadigan, national sales manager at the firm. "We've woefully undercut the only other competing futures index, which is 2%."

What's the Alternative?

Culloton also says that a lot of mutual fund firms are trying to launch alternative strategies, particularly in the fixed income area, to market their own products as actively managed products.

"Firms that do not currently offer ETFs are offering strategies that would give people more reason to pay higher fees for their services. But ETFs are just mutual funds distributed in a different way,'' he says.

Vanguard's ETF share classes are essentially separate share classes of its mutual funds. Most individual investors don't need to trade ETFs all day everyday, he contends.

Culloton also notes that passively ETFs are growing robustly whereas active mutual fund flows have been consistently weak, particularly actively managed equity funds.

According to ICI data, domestic equity funds had estimated outflows of $322 million for the week of Feb. 29.

"ETFs are great innovations if you like low-cost, tax efficient, passive investing. But like a great circular saw, you can make a house with it or chop off a limb," he says.

Hung Tran writes for Money Management Executive.



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