Why advisors should scrutinize mutual funds that hold ETFs

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Over the past several years, the love affair between advisors and ETFs has blossomed. But they’re not the only ones who have become enamored with passive investments. Numerous mutual fund managers have also taken a shine to ETFs, with institutional and retail managers buying about $150 billion worth of ETFs in 2017 alone, according to Goldman Sachs.

While that may be welcome news for ETF providers, it might not be a fully positive development for advisors and their clients. New research, published in January by a trio of academics, found that actively managed mutual funds that hold, on average, 12.8% of their assets in passive investments underperform actively managed mutual funds that hold only stocks and bonds, by between 0.41% and 1.63%.

Large ETF positions are associated with large underperformance.

“Large ETF positions are associated with large underperformance,” wrote Sara Shirley, D. Eli Sherrill and Jeffrey Stark, the authors of the report published by social science research publisher SSRN. Shirley is assistant finance professor at Roger Williams University in Bristol, Rhode Island; Sherrill is assistant finance professor at Illinois State University in Normal, Illinois and Stark is assistant finance professor at Bridgewater State University, in Bridgewater, Massachusetts.

The findings might come as a surprise to those advisors who pay more attention to a fund's stock holdings than its ETF assets.

Todd Rosenbluth, director of ETF and mutual fund research at New York-based CFRA Research, an independent investment research company, did indeed find the findings surprising. He hoped managers were using ETFs to bring down costs and be more targeted in certain areas of the market.

At the same time, Rosenbluth says he can see why these funds might underperform. Typically, portfolio managers use ETFs to make tactical moves in their fund. If a manager thinks the financial sector will get a boost from reduced regulation under a Donald Trump presidency, for example, they might buy a financial sector ETF.

ETFs are also used by managers who can only have a certain percentage of assets in cash and might use ETFs as placeholders until a better stock idea comes along. This can lead to managers making bets on the market – and there’s plenty of research to show that timing the market is a fool’s errand – and more active trading.

ETFs also come with fees the manager must pay. Even if it is, say, 50 basis points, add in the mutual fund’s management expense ratio, and after-fee returns have to be even higher than they otherwise would.

“The higher the expense ratio of the mutual fund, the harder it is to keep up with peers,” Rosenbluth says.

The study didn’t attribute the decline to anything specific – the authors are continuing to study why these ETF-holding funds underperform – but the authors hypothesize that more-frequent trading and additional sector bets are contributing to lackluster returns.

Interestingly, this doesn't apply to funds that hold a small number of ETFs. Any underperformance in funds that have, on average, 0.7% of assets in ETFs can be attributed purely to poor-performing stocks, say the authors.

Mike Geri, managing director of wealth management at RBC Wealth Management, has some reservations about putting the blame on the ETFs themselves. It’s the more frequent trading, or the attempt to time the market, that’s resulting in the weaker performance, and not the ETFs themselves, he says. Stock-trading managers may see similar results.

The study's authors hypothesize that more-frequent trading and additional sector bets are contributing to lackluster returns.

“People who trade too much make large negative contributions to long-term investment performance,” he says. “That’s what’s happening here.”

Still, there may be something about the nature of ETFs that causes managers to use them differently than other investments.

What does this mean for advisors? More due diligence, says Gary Gordon, president of Pacific Park Financial, based in Ladera Ranch, California. Advisors should pay even more attention than they do to costs, and possibly reconsider funds that have a higher fee due to holding a larger percentage of assets in ETFs, he says. As an advisor, that’s his main concern.

However, he won’t go as far as saying advisors shouldn’t buy funds that hold ETFs. In some cases, ETFs can make sense. He doesn’t mind if managers use funds to rotate in and out of sectors or geographies, but it only works if their overall fee is low enough.

“I am not entirely opposed, but any rotations need to be done at a reasonable cost,” he says.

Ultimately, advisors need to be mindful of what’s in the mutual funds they’re holding, and they may want to think hard about whether they want to own funds that hold high percentages of ETFs. And if they’re not thinking about these issues now, they should start.

“As mutual funds become more involved in the ETF market, it will be important for [clients] to be aware of the role that ETF positions play in the overall performance of the fund,” say the authors of the study. “They’ll want to ensure both [clients] and advisors are comfortable with the mutual fund’s portfolio creation process.”

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