Why ETFs Won’t Replace Mutual Funds

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.”

Follow The Expense Ratios

Kashner ran the numbers. Three ETF fund families—BlackRock, Vanguard and SSgA—attracted nearly 89% of the asset inflows last year. Those funds had a weighted average expense ratio of 0.19%.

By contrast, Wisdom Tree, First Trust and Deutsche Asset Management had a combined $23.4 billion in net outflows. Their weighted average expense ratio was nearly three times as much, at 0.56%.

That happens to be just a tad lower than the weighted average expense ratio of the average mutual fund in 2015, according to Morningstar.

Kashner says: “The relentless march of technology and transparency has enabled investors to compare investment options across providers and vehicles. ETF investors are controlling the one aspect that is within their reach at all times: out-of-pocket costs.”

Why Some Mutual Funds Are Superior To ETFs

The coming death of mutual funds has been greatly exaggerated. Vanguard took in more than twice the assets in mutual funds as it did in ETFs in 2016. In fact, as long as clients choose to custody at Vanguard, I typically recommend the Admiral share class mutual fund over the ETF, because the funds are superior in six ways.

1. Can buy fractional shares
2. No premium or discount—all transactions are at net asset value
3. No spreads between bid and ask
4. Less cash drag, as dividends are reinvested more quickly
5. Can do a tax-free exchange from mutual funds to ETFs, but not the reverse
6. Can do automated dollar cost averaging

Both the Admiral share and ETF share classes have the same expense ratio and are extremely tax efficient.

ETFs are great, and I’m all for low-cost ETFs. I’m also for low-cost mutual funds, and care more about diversification, costs and tax efficiency than I do about any wrapper.

So don’t paint mutual funds as bad or ETFs as good. Low-cost, broad and boring index funds are typically superior, regardless of whether it comes in a mutual fund or an ETF.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine.