Why ETFs Won’t Replace Mutual Funds

February 27, 2017

I was recently at a breakfast where the presenter all but called mutual funds legacy offerings that are inferior to ETFs. And why not, given the 2016 continuation of fund flows out of mutual funds and into ETFs?

In fact, according to ICI, in 2016, $228 billion flowed out of mutual funds, while ETFs took in $284 billion.

But does this mean money is flowing from mutual funds to ETFs because they are superior vehicles? I think costs are the drivers of these fund flows, and it so happens that ETFs, on average, have lower costs than mutual funds.

Looking At Fund Family Flows

Let’s look at the fund family garnering the most total assets last year—Vanguard.

A Vanguard spokesperson told me that Vanguard took in $303 billion in U.S. cash flows in 2016. Of that amount, just over $93 billion went into ETFs, yet nearly $210 billion went into old-fashioned mutual funds. Though approximately 84% of the fund flows went to index funds, roughly 16% flowed into Vanguard active funds.

Another low-cost mutual fund family, Dimensional Fund Advisors (DFA), also saw high inflows. DFA took in $21.4 billion in 2016 net inflows, growing roughly at the same percentage pace as Vanguard.

Here’s The Real Story

I argue the data reveals that the real story isn’t about asset flows from the mutual fund wrapper to the ETF wrapper. It’s not even about fund flows from active to passive.

It’s about investors realizing the impact of costs on their investment returns, and moving from more expensive funds to less expensive.

Not all ETFs are low cost and broad, but the ones that gathered the most inflows were.

Elisabeth Kashner, FactSet’s director of ETF research, says “investor behavior in 2016 made tons of sense. Cheap, simple vanilla strategies, which emphasize mimicking the market rather than taking bets against it, gained steam. More complex strategies proved to be a harder sell, despite massive promotion of the space. Tactical strategies, such as currency hedging, fell out of favor.”

 

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