Recipe For ETF Success: Scale & Network Effect

The steady rush of assets out of mutual funds and into ETFs turned into an “avalanche” recently, according to data from the Investment Company Institute.

For the week ending Oct. 19, $16.9 billion flowed out of equity mutual funds, the largest amount in five years, as reported by Reuters. Meanwhile, equity ETFs pulled in $2.4 billion. As the inimitable Josh Brown put it: “Dude.”

Looking back year-to-date, the numbers are even more staggering: $188 billion out of equity mutual funds, and $72 billion into equity ETFs. That’s a $250 billion swing in less than 10 months.

No Secret To ETF Success

There are, of course, lots of reasons for this. As I’ve explained in more than 100 “ETFs 101” talks I’ve given over the past five years, ETFs have five core advantages over traditional mutual funds: They are inherently more tradable, cheaper, tax efficient, transparent and flexible than traditional mutual funds.

Just like a calculator is better than an abacus, the ETF structure is simply a better, more modern, more efficient technology for delivering exposure to the market than mutual funds.

But there is an additional big factor people don’t talk about much but which is a critical reason why the ETF juggernaut will continue: scale and the network effect.

Understanding Network Effects

The term “network effect” is borrowed from the technology industry and is defined by Wikipedia as follows:

In economics and business, a network effect (also called network externality or demand-side economies of scale) is the effect that one user of a good or service has on the value of that product to other people. When a network effect is present, the value of a product or service is dependent on the number of others using it.

Part of the network effect typically involves scale—the more people use a product, the cheaper it becomes to deliver. But a true network effect is distinguished by the positive impact that the interaction of different participants has on the whole.

The classic example is the telephone. The value of one telephone is zero. If you have two telephones, that’s useful. With 10 telephones, it starts to get interesting. With 6.8 billion connections (the actual number of cellphone subscriptions in the world), it’s one of the most powerful tools on the planet.

Mutual Funds, Scale & The Un-Network Effect

Actively managed mutual funds suffer as they grow. As laid out in academic papers like this one from Yan, there is a “significant inverse relationship between fund size and fund performance.” In other words, large active mutual funds stink.

The reasons are obvious. When you manage a $1 billion fund, you can make a good $10 million investment and have a significant impact on your fund’s performance. When you manage $100 billion, that $10 million investment is not worth making.

More importantly, big funds suffer from liquidity challenges: They can’t move into and out of investments fast enough without impacting the price, so they are shut out of some of the more interesting alpha opportunities.

There are benefits to scale for mutual funds—large funds tend to have lower expenses—but these benefits are overwhelmed by the negative-performance head winds.

There is also no network effect: Even ignoring the challenges of scale, a fund with a million shareholders is no better than one with one shareholder.

ETFs, Scale Advantages & The True Network Effect

With ETFs, the story is almost precisely the opposite.

Because most ETFs track indexes, the problem of finding alpha is largely irrelevant. Meanwhile, the benefits of scale are immediate: Because ETFs don’t deal with individual shareholders directly, the amount of effort required to run a $10 billion ETF is very similar to the amount required to run a $10 million ETF.

You see the impact of this in the relentless expense ratio declines we’ve seen in the ETF space as it’s grown. The table below looks at three core categories of exposure for investors: U.S. equity, emerging markets and fixed income. 

In each case, when ETFs entered the market, they were instantly among the cheapest ways to gain exposure to the market. But since then, the relentless impact of scale and competition has pushed down prices between 75% and 81%.

ETF Shareholder Interaction & Liquidity

Whereas mutual fund expense ratios trickle lower as they grow, ETF expense ratios crash toward zero. It is a pricing trend you see in virtually any business with high levels of competition where the marginal cost of growing the business is close to zero.

Scale, however, is only half the story: There is also a direct benefit from ETF shareholders interacting with one another.

One clear place you see this is in spreads: The more trading there is in an ETF, the tighter the spreads and the cheaper it is to trade. But something special happens as ETFs truly get large.

Generally speaking, the liquidity of an ETF is typically a reflection of the liquidity of its underlying securities. But truly large ETFs can actually be more liquid than their underlying securities.

That’s how funds like the SPDR High Yield Bond ETF (JNK) or the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) can trade at $0.01 spreads while holding securities that trade at $1 spreads. With traditional mutual funds, no amount of scale will achieve this result.

Network Effect Boosts Tax Efficiency

The bigger place you see the impact of the network, however, is on tax efficiency. The tax efficiency of an ETF is driven by creation/redemption activity.

Specifically, when ETF shares are redeemed, the ETF has an opportunity to expunge its portfolio of securities with built-in capital gains, because these transactions occur in-kind. The more redemption activity, the more tax-efficient ETFs become.

This is why large, liquid equity ETFs virtually never pay out capital gains. Conversely, large mutual funds often have large embedded capital gains. When investors redeem shares, capital gains are generated that must be distributed to other shareholders.

In short, bigger is better in ETFs, while bigger is typically worse in traditional mutual funds. That is yet one more reason why the “avalanche” of flows out of mutual funds and into ETFs will only continue.

Matt Hougan is CEO of Inside ETFs, a division of Informa PLC. At the time of this writing, the author held none of the securities mentioned. He can be reached at [email protected].