The Battle Between Mutual Funds and ETFs

The battle between mutual funds and exchange traded funds has taken a new turn. Recently, Pimco, the world’s largest bond fund, launched a cloned and actively managed ETF designed to mimic the performance of its massive $250 billion Total Return mutual fund. If the ETF clone is successful in replicating or beating the performance of its parent fund, it could deliver a big blow to the mutual fund business.

Say what?

To understand why this is potentially a big deal in the investment world, it is important to understand the differences between the two fund types.

What is a mutual fund?

Mutual funds are actively managed pools of capital that invest large sums of cash on behalf of their customers across a diverse set of investments, like stocks, bonds and commodities. They allow investors the ability to gain exposure to a wide array of investment products without the need to make separate purchases ortrades. But since mutual funds are actively managed and are heavily marketed by brokers, they charge customers management fees, which can reduce an investor’s capital gains.

What is an ETF?

Exchange traded funds were developed in the mid-1990s. ETFs are able to charge lower management fees because they mostly run on autopilot, meaning there is no one actively changing the composition of the fund in an effort to beat the market. The majority of ETFs just passively trade against an already established index, commodity, or investment pool.

Some investors are drawn to ETFs because they have daily transparency, meaning that an investor knows what the ETF owns at the end of each trading day, as opposed to at the end of each quarter with a mutual fund. In addition, ETFs don’t charge customers a special marketing fee, known as a 12-b1, which is used by some mutual funds to compensate brokers.

ETFs have been growing at a rate of around 40% a year for the past decade. That compares with mutual funds, which grew at an average rate of around just 5% a year over the same time period. But despite its meteoric growth rate, ETFs are still small fries compared with mutual funds with just $1.2 trillion in assets under management, versus around $25 trillion invested in mutual funds. But that could soon be turned on its head, thanks to a new investment trend that blends the tradability of ETFs with the active management of a mutual fund.

The rise of the active clones

The actively managed ETF business is set to get its biggest boost ever with the launch of Pimco’s Total Return ETF. The cloned fund will start out with a fraction of the assets in its daddy mutual fund, but it will be able to draw in more cash if it posts healthy returns. The clone will also carry a higher management fee than the daddy mutual fund at a rate of 0.55% vs 0.46%, respectfully. While the management fee is a bit higher with the ETF, the transaction fee associated with getting in and out of a mutual fund immediately flips the equation. For example, on a $10,000 investment, the difference in fees is only around $9. Meanwhile, brokerage firms charge around $8 to trade an ETF and a whopping $35 to trade a mutual fund, a difference of $26 per transaction.

Factoring in just one transaction cost bumps the first year management fee for the mutual fund to 0.72%. Other asset managers will be watching the Pimco clone intently. If it is able to produce a return that is as strong as or stronger than the mutual fund, net of fees, then prepare for a swarm of actively managed ETFs to hit the scene. State Street, the third largest ETF distributor has already said it is gearing up to create clones of its big ETFs. Legg Mason, another large asset manager, announced that it is starting up its first active ETF product as well.

Begun, the Clone War has

So will this new trend in investment management turn mainstream? Active ETFs seem to have most of the characteristics of mutual funds, except that they are cheaper and more transparent. Mutual funds still have their place, however –especially if an investor wants to hold their position for several years. You should examine your options carefully or consult with a financial professional before making a final decision.

Nevertheless, it is still too early to tell what will happen. Funds typically are judged on their performance after a year in service, so there is a while to go before we know anything. Meanwhile, mutual funds may fight back by cutting their fees to keep investors from fleeing to ETFs, especially passive long term investors with tons of cash.

So to quote Yoda from Star Wars: “Begun, the Clone War has!”

Cyrus Sanati is a frelance financial journalist whose work has appeared in dozens of leading publications, including The New York Times, BreakingViews.com, and WSJ.com. Follow Cyrus on Twitter @csanati