businessman holding scale Active ETFs vs. mutual funds: Let’s compare.

While mutual funds may still dominate the U.S. market, ETFs are gaining traction quickly. According to the 2019 Investment Company Institute Factbook, at the end of 2018, the U.S. domestic mutual funds market amounted to $17.7 trillion in total net assets. At the end of 2018, US domestic ETFs had $3.4 trillion in total net assets, which is double the assets in ETFs from just five years ago. Index domestic equity ETFs are attracting one and a half times the net inflows of index domestic equity mutual funds since 2009. Clearly, ETFs have become very popular investments in a rather short period of time and are continuing to grow.

Most ETFs today are indexed ETFs where there is no real active investment management, but rather where the fund is merely tracking some index. ETFs are fully transparent, meaning the holdings and positions are published daily, as opposed to mutual funds that are only required to disclose holdings quarterly. This full transparency has kept many investment managers from creating actively managed ETFs, as this would be revealing their secret sauce — their investment strategy — and allow front running by investors. There are a few actively managed ETFs, but most of these are from smaller, relatively unknown investment managers. Out of a universe of around 2,300 ETFs today, only 300 or so are considered actively managed, which constitute around $62 billion of the $3.4 trillion in ETFs.

Game Changer for Active ETFs

Now along comes what is called the nontransparent ETF, also known as semi-transparent, concealed ETFs or next-gen ETFs. These could be a game changer. For the first time, it will now be possible for investment managers to put actively managed funds inside an ETF wrapper and not have to worry about revealing their investment strategy. Precidian Investments has at long last received approval from the Securities and Exchange Commission for its actively managed ETF strategy, called ActiveShares.

ActiveShares, which will operate similarly to a blind trust, will only hold securities traded on U.S. exchanges, according to filings. The ActiveShares structure introduces a new middleman to the mix, known as an “authorized participant representative,” which will know the daily holdings information and work with authorized participants to create and destroy shares. Beyond that, portfolio holdings will be publicly available on a quarterly basis. So investors are left with a situation akin to investing in an actively managed mutual fund.

An indicator of how popular actively managed ETFs may become, the following fund companies have already licensed ActiveShares from Precidian: Legg Mason, BlackRock, Capital Group, JPMorgan, Nationwide, Gabelli, Columbia and Nuveen.

Advantages, Disadvantages of the Active ETF

It is a well-known fact that ETFs enjoy better performance over a comparable mutual fund, all things else being equal. Two of the main reasons for this disparity are (1) the fact that the fund manager of an ETF does not have to sit on cash to cover redemptions like a 40 Act fund, thus does not have that drag on performance and (2) the filing costs and administration of a 40 Act fund are greater than running the same fund as an ETF. For example, there are no transfer agent fees with an ETF like there are with mutual funds. When actively managed, nontransparent ETFs start showing up, don’t expect the same low expense ratios of an indexed ETF. It does cost more to run an actively managed fund, whether it be an ETF or a mutual fund.

But if an investment manager can replicate the same strategy with the non-transparency of a mutual fund but get better performance because of the lower costs by using an ETF chassis, why ever use a 40 Act mutual fund chassis? The short answer to that is one size does not fit all.

In other words, depending on who the investor is, there are pros and cons to owning ETFs just like there are with owning a mutual fund. These pros and cons need to be broken out between the two major types of account holders to better understand the pros and cons of investing in an ETF. Those two major types of account holders would be those invested in tax-deferred retirement accounts, like a 401(k) plan, and those holding investments in some type of taxable retail brokerage account. Let’s look at each one.

Tax-Deferred Accounts

ETFs are not the best investments for retirement accounts for a number of reasons. Retirement plans have been very slow adopting ETFs due to the complexity in recordkeeping and trading as they act very similar to employer stock, which any recordkeeper will tell you is a pain. ETFs can trade anytime during trading hours, but that is not so easy to accommodate in retirement record keeping systems. Most 401(k) recordkeeping systems are designed for an end-of-day valuation with trades placed after hours based on the end-of-day Net Asset Value (NAV). These recordkeeping systems are not designed to accommodate intraday trading very well.

Another issue in accounting for ETFs in 401(k) recordkeeping systems is that ETFs must trade in whole shares whereas mutual funds can be traded in fractional shares. Most transactions in a 401(k) recordkeeping system have fractional shares. A $100 payroll contribution allocated across four funds will result in four trades and they will all have fractional shares — you can bank on that.

And finally, a lot of the trading within a 401(k) plan is from participants moving from one investment to another. With mutual funds, a participant can sell shares from one fund and buy into another fund with both funds settling on T+1 and thus resulting in a zero net settlement. Since ETFs settle on T+2, a participant could not sell from an ETF and a buy into a mutual fund and settle both trades on the same day. The participant would be out of the market for one day waiting for settlement of the ETF before they could buy into the mutual fund.

One of the advantages of the ETF in a taxable account is that the pass-through of capital gains is much rarer than with a mutual fund, but since 401(k) plans are tax-deferred, the pass-through of income has no taxable impact on the participant, so one of the benefits of owning an ETF goes away when held in a tax-deferred retirement account. However, most ETFs to date have been index funds and thus the amount of realized capital gains has been minimal. An actively managed ETF could result in more realized capital gains than an indexed ETF, somewhat reducing this traditional benefit of ETF ownership.

The bottom line is that the lower cost structure of an ETF will have a difficult time overcoming the various obstacles of recordkeeping and trading ETFs in retirement plans. So, expect mutual funds to continue their reign as the dominant investment in retirement plans.

Retail or Taxable Accounts

Brokerage accounts do not have the same recordkeeping or trading issues around ETFs that are found in 401(k) plans, so brokerage accounts are a great place to hold ETFs. In addition, taxable accounts are very much concerned with the tax consequences of pass-through dividends and capital gains, so ETFs have the advantage over mutual funds when it comes to managing income taxes. As noted above, though, an actively managed ETF will most likely generate more realized gains than an indexed ETF, but not having to deal with redemptions like a fund should keep realized gains to a minimum.

Another advantage of ETFs over mutual funds is around rapid trading. Many funds do not allow rapid trading and may require a 30- or 60-day holding period before selling to discourage market timing in a fund. There would be no such restrictions on ETFs. Keep in mind, however, that the 30-day wash sale rule applies to ETFs, so if you sell for a loss and then buy the same ETF back within 30 days, you cannot claim the loss at that time.

Now, there are some negatives with owning ETFs in a brokerage account. There are trading costs when buying or selling shares of an ETF, similar to buying or selling any security. For smaller investment amounts, a no-load, no transaction fee mutual fund may be a better option than buying an ETF. Another possible negative, at least for the foreseeable future, is that the SEC-approved Precidian model only allows trading in investments on U.S. exchanges. So, if you are looking for exposure to foreign markets, mutual funds would still be your best bet.

Conclusion

Nontransparent, actively managed ETFs will be an attractive, low-cost investment for many individuals. Due to the issues with recordkeeping and trading ETFs in retirement plans, it would appear that the real market opportunity will be with investors in retail brokerage accounts. Will they supplant the traditional 40 Act mutual fund? Probably not, but they will attract a lot of money that would have previously gone into mutual funds, which means it’s something we should be following closely over the next few years.


Burton KellerBurton Keller is a co-founder and executive vice president of Delta Data.