2. Economists are quite fond of saying that more is better and less is worse,
however much like the other nuanced focuses of the endeavor the dismal science
leads to more crammed synapses than a koan. In the fast paced worlds of investing
and finance, sometimes less is better and leads to more. An interesting case would
be the fees charged on funds, specifically Exchange Traded Funds and Mutual
Funds. The 40-Act Fund also known as the Mutual Fund has been the choice of
investment vehicle for investors looking for diversified, risk adjusted returns.
Transparency and Values were stringent, blacklined, and paid for with fees
reducing returns to investors.
The Exchange Traded Fund, a younger contender has shown significant
momentum in challenging the long established constituent of the financial
landscape. The smaller fees associated with ETFs has shown to be a significant
threat to the industry as a whole, the transfer of funds from areas of higher
concentrations of fees to lowers concentrations of fees saw dramatic
“cannibalization” of funds with similar profiles as the ETF. The same structure as a
Mutual Fund is reconstructed and run for a significant discount of the cost. The
industry has felt it with “the average large cap equity mutual fund charges 1.35
percent in fees...the ETF charges just 0.44 percent.1”
While this may seem to be a significant benefit for investors, it may do so at
the harm of less sophisticated investors. With a larger portion of employers
allowing employees the opportunity to play a significant role in their retirement
allocations and are encouraged to monitor their own future endeavors an Exchange
1
"Mutual Funds Are Dead: Here’s How to Adapt." 2014. 19 Nov. 2014
<http://connection.ebscohost.com/c/articles/97363811/mutual-funds-are-dead-here-s-how-adapt>
3. Traded Fund offers significant benefits to an individual who wants to take
advantage of Intra-day arbitrage opportunities, protecthimself from falling
markets, or more broadly have access to larger level of liquidity. An increased
access to the “lubricant” of an economy in a Hayekian sense2.
While this may look enticing to some, Richard Cookin “How Complex
Systems Fail” reminds us about the innate flaws of the various systems humanity
has built to insulate themselves. It is important to remember that “all Practitioner
actions are gambles, that is acts that take place in face of uncertain outcomes3”
which implies that imperfect knowledge on behalf of a participant can alter the
entire system. Is there a significant threat to an investor in controlof their future by
offering them the opportunity to liquidate their assets at once? Will Exchange
Traded Funds outpace Mutual Funds in the desirable vehicle for future
consumption? It's hard to say which castle in the sky the crowds will build
Mutual Funds were born out of the catastrophe that was the Great
Depression. The focus and fervor of reformers at the time was to protect
individuals who would be far and away from the types of benefits felt by monetary
policy injections. While Quantitative Easing was still an innocuous idea at the
time, the years after the Depression saw a clearly defined blossoming of the
Securities Industry and the Regulatory Institutions that would shape the board in
which we will all attempt to play “bythe rules of the game”. The Securities
2
Steele, GR. "The Money Economy." American Journal of Economics and Sociology 57.4 (1998): 485-
498.
3
Cook, Richard. "How complex systems fail." Cognitive Technologies Laboratory, University of Chicago.
Chicago IL (1998).
4. Exchange Act of 19344 and The Investment Company Act of 19405 have been the
skeletal frameworks in which regulations, capital requirements, and liquidity ratios
have been based off of. The acts clearly state the types of fees, sometimes referred
to as “loads” for the fund to charge investors and which portion of the fund has to
be allocated to suchfiduciary responsibilities such as prospectus and annual report
dissemination. Other investment vehicles exist and ETF’s can take the same
organization structure as an Open-End Fund, a Closed-End Fund, and a Unit
Investment Trust.
Mutual Funds have to be purchased through an intermediary, they do not list
on stockexchanges and the only method to obtain shares is to purchase them
through the fund company, a financial advisor, a broker-dealer, or other registered
representative. The closestmost individuals come to this is the off chance they
rebalance their portfolio in a company sponsored 401k plan. The Net Asset Value
of the fund is calculated at the close of the trading day, this is the price in which
the investor is allocated shares. At this point in the process, the investors is offered
all of the benefits of the Securities and Exchange Commission enforceable acts.
Funds have to allocate money to deliver that individual the propermaterial
necessary to make them an educated investor. While this opens up the opportunity
for companies to form from the outsourcing of this task, it detracts from the
investor’s total return. Mutual Funds must pass through realized capital gains,
raising their tax burden. As an investor redeems shares, cashmoves out as the
manager sells underlying securities, the number of shares decreases and long term
4
"Securities Exchange Act of 1934 - Securities and Exchange ..." 2011. 19 Nov. 2014
<https://www.sec.gov/about/laws/sea34.pdf>
5
"Investment Company Act of 1940 - Securities and Exchange ..." 2011. 19 Nov. 2014
<https://www.sec.gov/about/laws/ica40.pdf>
5. investors will feel the impact of the realized capital gains for the redemption of
shares.
The metrics used to track Mutual Fund performance may vary. With
rebranding constantly offering “smart alpha”, the search for yield is at the core of
the problem is the tracking error, how well the manager was able to track the
broader index the fund replicates assuming a passive strategy. In a struggling
market “the criteria for selecting funds has shifted to expense ratios, tax efficiency,
and management turnover.6” The Tech Bubbles has changed the landscape of the
investment community with fewer managers outperforming their major
benchmarks, predictions about who would be able to waned, and expense ratios of
funds did not adequately correlate with performance. Investors had “becomeway
of actively managed funds.”
Exchange Traded Funds had come around much later in the game, the 1990s
had been an interesting era and it was going to leave many marks on the
investment landscape. Much subtler than the “stateless capital” that was kicked
around or the debasement of regulatory authorities, the rise of the ETF would be a
lasting contribution as “the average investor benefits from the lower fund expense.
“The ETF would usurp the king of the mountain with its ability for “Redemption in
Kind.” status.
ETFs are formed by depositing securities into a fund, these allow for
creation units representing a fixed amount of ETF Shares to be traded on an
6
"Increasing After-Tax Return with Exchange-Traded Funds." 2012. 19 Nov. 2014
<http://connection.ebscohost.com/c/articles/17543881/increasing-after-tax-return-exchange-traded-
funds>
6. exchange. They are as diverse as the the fish in the sea, funds have attractive
names and perilous sounding investment profiles, such as Double Levered , Short
Vix, and Russia Bull 3x. The most popular replicate the major Indices, Markets,
Commodities, and Consumption Sectors. They are traded daily on exchanges and
offer the investor the opportunity to liquidate at the market price.
Trading strategies for Stocks, Bonds, and Futures can apply- ETF’s can be
shorted, they can be levered up, and this trading allows the price to fluctuate from
the Net Asset Value of the Fund. Arbitrageurs can step into the situation and buy
components of the ETF and short the fund or vice versa. Divergence outside of
regulated parameters forces funds to adjust, either buying or selling securities to
create or redeem shares. Opportunities are small, and with the commission costs
and tax burdens these strategies may prove too complex or cumbersome for
investors. Lower turnover has been linked to lower tax burdens from capital gains,
these benefits can be combined with hedging strategies to help offset portfolio
components that entail significant headwinds.
ETFs have evolved from many different forms, rudimentary vehicles existed
on the Toronto StockExchange in the 1980s. In the 1990s ETF assets started to
gain the attention they deserved “net assets comprised only 0.03 percent of total
investment companies worth...the end of 2010 ETF net assets represented 6.39
percent of total investment companies net assets.7” Sharifzadeh and Simin(2012)
attempt to ascertain is the investors who prefer ETFs do so because of the return
characteristics or productfeatures offered in comparison to Mutual Funds.
7
Sharifzadeh, Mohammad, and Simin Hojat. "An analytical performance comparison of exchange-traded
funds with index funds: 2002–2010." Journal of Asset Management 13.3 (2012): 196-209.
7. The methodology behind the study looked at Mutual Funds and ETFs that
share the same investment philosophy in order to compare them. Various other
studies have attempted to ascertain differences between benchmark and fund
performance with focuses being active vs passive, segmentation/integration vs
foreign index returns effects on tracking error8, and the significance of fees and
efficiency from an investor’s point of view9. Sharifzadeh and Simin use the Sharpe
Ratio to measure fund performance taking into account the return and volatility of
the fund. ETFs outperformed index mutual funds 134 times in terms of Sharpe
Ratio...showed no statistically significant difference between ETFs and Index Fund
performance. ETFs outperformed index mutual funds 125 times in terms of risk
adjusted buy and hold returns...showed no statistically significant different
between ETFs and index fund performances. Their results indicated that product
features are more competitive than performance.
Poterba and Shoven(2002) test the tax efficiency claims of ETFs against
mutual funds10. They compare pretax and after tax returns of large ETFs and their
benchmark funds, they find that the total pretax return for a SPDR trust investor
was 16 or 17 basis points. Below the return on the Vanguard Index 500. This Index
...was six basis points lower than the return on the S&P500 Index. They explain the
difference between the returns on the S&P 500 and the ETFs by focusing on the
difference in the ETF expense ratios and the non-interest bearing cashaccounts
ETFs hold cash in prior to distributing it to investors. This dividend reinvestment
delay will cause the return to fall below the index, increasing tracking error. The
8
Johnson, William F. "Tracking errors of exchange traded funds." Journal of Asset Management 10.4
(2009): 253-262.
9
Kostovetsky, Leonard. "Index mutual funds and exchange-traded funds." The Journal of Portfolio
Management 29.4 (2003): 80-92.
10
Poterba, James M, and John B Shoven. "Exchange traded funds: A new investment option for taxable
investors." 14 Feb. 2002.
8. higher tax burden associated with the greater capital gain distributions on the Index
500 fund, relative to the SPDR ETF, do not reduce the after-tax return by enough
to outweigh the pretax return advantage of the index fund. While ignoring the
effect of transaction costs, the study waves this off by holding over longer periods.
Cannibalization of a fund can be a threat to a company trying to maintain a
traditional Mutual Fund Industry while trying to adapt to the ever changing
environment that markets provide. The two products may offer benefits to different
types of investor. Rather than a one vehicle fits all, investors are free to chooseif
they want to be frequent participants in the market of if they would like to be
traditional buy and hold investors in the more known sense. Studies of funds
eating the assets can show positive spillover effects as investors chooseto be the
type of market agent that participates in the world in actively seeking arbitrage.
Agapova(2010) find that instead of being substitutes, Vanguard’s ETFs and their
corresponding conventional index mutual funds are complements, with ETF flows
having a larger effect on conventional index mutual fund shareholders’ flows than
the other way around. The spillover effects resulting from ETF tax efficiency
might be an explanation for the complementary effect between the two rival
products offered by Vanguard.11
The complementary nature of the Vanguard funds alludes to industry as a
whole. While funds that focus on certain investment vehicle types may attract the
type of large scale investor that requires the lower fee and has the sophistication to
manage their portfolio on their own. Sang and Seasholes (2005) find the well-
documented disposition effect in detail and come to a number of conclusions: (i)
Neither sophistication nor trading experience alone eliminates biases – in this case,
11
Agapova, Anna. "Are Vanguard’s ETFs Cannibalizing the Firm’s Index Funds?." The Journal of Index
Investing 1.1 (2010): 73-82.
9. the disposition effect; (ii) Together, sophistication and trading experience eliminate
the reluctance of investors to realize losses;(iii) There is an asymmetry with
regards to trading behavior.12
While behavioral factors may inhibit investor’s abilities to realize maximum
gains, the benefits of low fee in lieu of higher fees are notable. The division
between the types of investors can be the key significant component. An investors
that trades often will encounter larger commission fees and larger opportunities for
market timing and arbitrage failures. This type of exposure to risk may be a
deterrent to other investors who want to take less of an active role and focus on
their day to day activities. Financial literature is dense and time consuming causing
the fee to be seen as a costof doing business. Fund cannibalization is always a
possibility, however research shows that funds can be complementary to each other
as investment houses take advantage of the spillover effects by creating Spliced
Index Funds.13 Investors and Markets can benefits from the increase in choices, but
need to be aware of the risks associated.
The data collected came from Investment Company Institute’s statistical
website. The data was imported using Excels built in tool. From there it was
transformed in pivots tables and calculated as a Percent of Column Total. Analysis
of the data as a Percent of Row Total would show changes from year to year, this
was left out because of the data format needing to be transformed a 2nd time with
the results being evident already. For the time period of September 2013 to August
2014 the Exchange Traded Fund Industry increased in the amount of Bond funds
12
Feng, Lei, and Mark S Seasholes. "Do investor sophistication and trading experience eliminate
behavioral biases in financial markets?." Review of Finance 9.3 (2005): 305-351.
13
"VGSIX Vanguard REIT Index Inv Fund VGSIX Quote Price ..." 2013. 20 Nov. 2014
<http://quotes.morningstar.com/fund/VGSIX/f?t=VGSIX>
10. and Global/International Equity, Hybrid funds while decreasing the amount of
Domestic and Domestic Equity Funds. Mutual Funds had increased in Domestic
Equity, Municipal Bond, Equity, Taxable and Tax Exempt Money Market funds
while decreasing exposures in Bond, World Equity, and Taxable Bond Funds.
Assets under Management for Exchange Traded Funds Net Issuance was
0.0038% lower in 2014 than in 2013 with $121,094.00 vs. $121,312.00,
respectively. These assets represented larger portions of Domestic Broad Based
funds and large exposure to Global/International Equity than previously. Mutual
Fund Assets saw inflows of 16.7% total from September 2013 to August of 2014
with $59,365.40 and %59,407.00 millions of dollars, respectively. The shifting of
power from Mutual Funds to Exchange Traded Funds does not seem so
cataclysmic after such a deep dive, with both vehicles offering substituibable
products.
11. Assets of Exchange-Traded Funds
by Type % of Total AUM
Sum of Aug-14 Sum of Sep-13
Domestic (Broad-Based) 830,919.00$ 664,482.00$
Domestic (Sector/Industry) 311,030.00$ 259,227.00$
All 1,880,659.00$ 1,541,878.00$
Bond 281,512.00$ 248,985.00$
Global/International Equity 454,536.00$ 367,835.00$
Hybrid 2,662.00$ 1,349.00$
Total Domestic Equity 1,141,949.00$ 923,709.00$
Grand Total 4903267 4007465
AUM of Mutual Funds Sum of Sep-13 Sum of Aug-14
Domestic equity 5,243.00$ 6,175.60$
Municipal bond 518.80$ 546.60$
Taxable bond 2,780.20$ 2,941.20$
World equity 1,889.10$ 2,216.50$
Bond 3,299.00$ 3,487.80$
Equity 7,132.10$ 8,392.10$
Hybrid 1,201.40$ 1,380.90$
Taxable money market 2,415.30$ 2,325.70$
Tax-exempt money market 263.70$ 255.80$
Total 14,311.40$ 15,842.40$
Total long-term 11,632.50$ 13,260.90$
Total money market 2,678.90$ 2,581.50$
Grand Total 53,365.40$ 59,407.00$
12. Number of Mutual Funds Sum of Sep-13 Sum of Aug-14
Domestic equity 10.81% 10.70%
Municipal bond 1.90% 1.83%
Taxable bond 4.84% 4.98%
World equity 4.50% 4.56%
Bond 6.74% 6.81%
Equity 15.32% 15.26%
Hybrid 2.01% 2.11%
Taxable money market 1.32% 1.22%
Tax-exempt money market 0.59% 0.57%
Total 25.98% 25.98%
Total long-term 24.07% 24.18%
Total money market 1.92% 1.80%
Grand Total 100.00% 100.00%
% of Exchange-Traded Funds by
Type Sum of Aug-14 Sum of Sep-13
Domestic (Broad-Based) 9.14% 9.26%
Domestic (Sector/Industry) 9.32% 9.71%
All 40.77% 40.52%
Bond 7.53% 7.24%
Global/International Equity 14.21% 13.84%
Hybrid 0.56% 0.48%
Total Domestic Equity 18.46% 18.96%
Grand Total 100.00% 100.00%
