More than 100 mutual funds have 80% of their assets in ETFs, which are cheaper and more efficient to trade. So why are the mutual funds that invest in them more expensive?


Mutual Funds Use ETFs as a Shortcut


ETFs have become increasingly popular with all sorts of investors—including mutual fund managers. More than 100 mutual funds have 80% of their assets in ETFs, which are cheaper and more efficient to trade. So why are the mutual funds that invest in them more expensive?

File under: If you can’t beat ’em, join ’em. The popularity of the $1.5 trillion exchange-traded-fund industry is indisputable. But what’s surprising is how popular ETFs have become with mutual-fund managers. In fact, the past five years have seen the launch of about 100 funds that hold at least 80% of their assets in ETFs, according to Morningstar. And it’s becoming more and more common for managers of conventional mutual funds to use ETFs here and there for “tactical” purposes.Of the funds where ETFs are the primary investment vehicle, most are asset-allocation funds. Asset-allocation funds are designed to serve as a complete investment portfolio; their managers choose and combine investments with the aim of meeting specific investment goals.

Historically, asset-allocation funds have invested in other mutual funds. But a growing number are using ETFs, citing their low costs, liquidity, and tax efficiency.

So if that’s the case, why are mutual funds of ETFs more expensive, on average, than their traditional counterparts—funds of mutual funds? The average portfolio net expense ratio of all the mutual funds of ETFs is 1.55%, according to Morningstar. The combined average for all of the corresponding categories of mutual funds is just 1.39%.

The difference appears small at first, but it can have an impact over time. On a $50,000 investment that earns 6% a year, you’ll pay an additional $1,250 in fees over 10 years. And that doesn’t factor in opportunity cost: That $1,250 doesn’t have the opportunity to compound on your behalf.

The differences are even more stark in some categories. World allocation funds that invest in ETFs are 28 basis points (0.28%) more expensive than funds of mutual funds, and moderate-allocation funds of ETFs are 19 basis points more expensive than their mutual-fund-driven counterparts.

Some ETF-oriented funds are cheaper, though—as they should be. “Aggressive allocation” funds of ETFs, for example, are 18 basis points cheaper on average than the universe of aggressive allocation funds. Target-date funds of ETFs are also less expensive than their category averages by 22 basis points.

IF COSTS AND STRATEGIES SEEM ALL over the map, perhaps it’s because the purveyors of these funds are also all over the map. There are virtually no fund-industry marquee names offering funds of ETFs. That lack of big-time competition may explain why costs are what they are, says Matt Hougan, executive vice president at IndexUniverse. “When the big guys jump in, it will drive prices down,” he predicts.

Many of the funds of ETFs were hatched when investment advisors figured out that they could package and sell their in-house ETF strategies to a broader market in mutual-fund form. That’s the case with CLS Investments, in Omaha, Neb. CLS started out managing money for its own clients, but in the 1990s it transitioned to an investment provider to other advisors, says Rusty Vanneman, manager of the firm’s AdvisorOne Amerigofund (ticker: CLSAX). CLS switched to ETF portfolios about a decade ago because of their lower costs, ease of trading, and style purity, he says.

Meanwhile, more traditional stock-picking mutual-fund manager are starting to use ETFs. During the recent Japan rally, for example, a number of managers of go-anywhere funds used ETFs to gain exposure to a part of the market they didn’t have a lot of expertise in, notes Hougan, adding, “I think you’ll see more of that happening.”

Stadion Money Management, in Watkinsville, Ga., uses ETFs as an inexpensive tool for making cheap, quick adjustments in its six funds. Tactical managers rack up higher costs because they’re more active, but using ETFs rather than mutual funds can make a difference of as much as 1% in a fund’s expense ratio, said Brad Thompson, Stadion’s chief investment officer. Even more important, he says, is the liquidity of ETFs: When the market’s tanking, getting out in the morning rather than the end of the day can have a huge impact on performance.

Sometimes an ETF is used more administratively, says Morningstar analyst Andrew Gogerty: Many fund managers use ETFs to park their excess cash on a short-term basis.

SO WHAT SHOULD INVESTORS MAKE of mutual funds that invest in ETFs? In theory, ETFs have the ability to help funds perform better, and perhaps even less expensively. In reality, investors should exercise caution. Most of the asset-allocation funds that use ETFs, for instance, come with red flags: not just their cost in some cases, but also the fact that they’re relatively young and are largely offered by small, lesser-known managers. In addition, many have yet to be tested by a bear market.

Actively managed funds that use ETFs to get in and out of an area quickly are another story. It’s fine for a manager to add a little extra exposure quickly and cheaply by, say, adding a Japan ETF. But you should be clear about the extent to which the manager is making those kinds of opportunistic moves, and whether they’re appropriate for the fund’s stated strategy. And if an ostensibly stock-picking fund manager turns to ETFs too often, of course, you might well ask why he deserves his salary.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: