Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Like an ageing boxer who is still on top but starting to lose some of their pace and power, the mutual fund is slowly but surely being supplanted by a newer, brasher invention: the exchange traded fund.
Before dwelling on why, it is important to acknowledge what a phenomenal invention the open-ended mutual fund has been — arguably one of the greatest in financial history, whether ranked by success, longevity or social usefulness.
Globally, there are more than 70,000 mutual funds with combined assets of almost $40tn, according to Morningstar. The combined private equity and hedge fund industries can muster maybe a fifth of that, and with a more controversial social impact. Despite a decade of rampant growth, there is still just $9tn in ETFs globally. Yet the era of the ETF is dawning.
The latest sign of a baton being passed came last week, when JPMorgan Asset Management said it would convert four actively managed mutual funds with $10bn of assets into ETFs. This followed Dimensional Fund Advisors earlier this summer turning $29bn worth of mutual funds into ETFs. Many more conversions are in the works. Bloomberg Intelligence’s ETF analysts reckon that more than $1tn of mutual funds could be transformed into ETFs in the coming decade.
But even excluding conversions, the ETF is ascendant. In the first six months of the year there were 109 new mutual funds launched in the US, but 199 ETFs, according to Morningstar. Nowadays, even Capital Group — long hostile to the idea of ETFs — is planning to enter the field. Why the shift?
In the US, tax efficiency is one big reason. Unlike mutual funds, the ETF structure means investors typically do not have to pay capital gains tax until they actually sell.
Yet ETFs are now a global phenomenon. Their success cannot be written off as simple tax arbitrage.
For one thing, the tradability of ETFs makes distribution much simpler. Anyone can buy an ETF listed on any major stock exchange, often without paying any commission.
The biggest advantage, however, is its flexibility. Because of its genesis as an index tracker, the ETF is widely associated with cheap, passive investment strategies. The vast majority of the industry’s $9tn of assets are indeed in such vehicles. Yet this obscures the fact that the ETF has evolved into much more than just a next-generation passive fund.
In reality, the ETF is an adaptable wrapper for all sorts of investment strategies, and able to package up virtually any market into tradeable, Lego-like blocks of risk, whether offshore Chinese equities, bank loans, stock market volatility or carbon credits. Nowadays, almost everything can be and is being put in an ETF structure, from Cathie Wood’s hyper growth-oriented stock picking strategies at Ark Invest, to Tuttle Capital’s launch of an “anti-Ark” ETF that will allow people to short Wood’s flagship fund.
Not everyone is convinced by the durability and flexibility of the ETF structure, or thrilled by its rise. Even Jack Bogle was a sceptic. Shortly before he passed away, Vanguard’s founder wrote that while he would unhesitatingly call the ETF the 21st century’s “most successful financial marketing idea”, he archly noted that “whether it proves to be the most successful investment idea of the century remains to be seen”.
Undoubtedly, people are doing silly things with ETFs, which is affecting markets. For example, packaging up derivatives that would normally be off-bounds to most retail investors is a potentially dangerous regulatory workaround. Moreover, unlike mutual funds, ETFs cannot be closed to new investors — a structural flaw in some areas where there can be diminishing returns if the investment vehicle becomes too big.
Most of all, there will probably always be question marks around the resiliency of the share creation-and-redemption process that underpins the ETF ecosystem. The structure held up well in the crucible of the global financial crisis and the Covid-19 market crash, but every crisis is subtly different and the next one could reveal hidden faultlines.
However, at some point, critics need to stop blaming the wrapper for all that ails markets and instead point the finger at people that put dumb or dangerous stuff inside it, or invest without understanding what they are buying.
No one blames mutual funds writ large for every bout of idiocy that has befallen investors in one, and ETFs should not be treated as a homogenous blob either. The mutual fund is not going the way of the dodo any time soon, but the next age of investing likely belongs to the ETF.