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August 4, 2014

Monday Morning Memo: Mutual Funds Versus Exchange-Traded Funds–A Different Perspective

by Detlef Glow.

In discussions about whether active or passive funds are the better choice for an investor, performance statistics are often used to show that active management is a loser’s game, since the majority of active managers are not able to beat their benchmark after costs. Although this argument is probably right and despite the fact some active managers are able to produce consistently superior returns, this headline view doesn’t give all the reasons to prefer one fund over another. From my point of view it is important to look beyond the headline numbers to understand if one investment vehicle has a systematically competitive advantage over the other, since not all exchange-traded funds (ETFs) are passively managed and not all mutual funds are actively managed.

REUTERS/Christian Charisius

REUTERS/Christian Charisius

Expenses Are Killing Active Managers’ Alpha

It is common sense that a high management fee and even higher total expense ratios (TERs) are a burden fund managers need to overcome before their portfolio can outperform. It is even clearer that in order for fund managers to deliver high performance, the costs carried by the fund must be high. This basic assumption gives an advantage to ETFs, since these products have low TERs. But investors often do not realize that the TER, despite the name, does not cover all the expenses a fund is paying. The most important additional costs not covered within the TER are transaction costs, i.e., the price a fund manager has to pay to implement changes within the portfolio, whether these transactions are caused by inflows or outflows or by changes in asset allocation. And transaction costs are a point where an investor faces a huge difference between mutual funds and ETFs. While the transaction costs for investors who are buying or selling an ETF are directly paid via the bid/offer spread by the investor who causes the transaction, mutual funds pay these costs from their NAV, i.e., all investors in a given fund pay for the transactions caused by a single investor. In this regard the trading activity in and out of a popular fund can become very expensive for the investor and can be an obstacle for the fund manager in beating his benchmark. Since the only transaction costs paid by an ETF are the costs related to rebalancing the index, ETFs have a real competitive advantage, even against index-tracking mutual funds.

Is Swing Pricing a Solution?

Since more and more investors and fund managers are complaining about the fact that the transaction costs for investors buying/selling a fund are paid by the fund, promoters are looking for a solution to pass these costs back to the investor who caused them. Some fund promoters have introduced so-called swing pricing for their mutual funds, a concept similar to the bid/offer spread on an exchange. This means an investor who wants to buy a fund needs to pay a premium to the net asset value (NAV), while an investor who wants to sell shares of the fund has to accept a discount to the NAV. Since this spread would cover the transaction costs, it could vary widely from one day to the next, depending on the current portfolio constituents and their spreads on the market. A fund would have to publish three prices a day, making performance calculations more complex, which could cause some confusion for investors.


From my point of view the concept of swing pricing is one step in the right direction. However, since all types of funds would still lack transparency with regard to the transaction costs investors are paying, regulators would need to force fund promoters to disclose the fees and expenses paid to third-party and in-house brokers. That would ensure investors know they are paying for the transactions caused by the fund manager as well as by other investors.

In this regard it would seem ETFs at the moment are the vehicle of choice for investors, since they are very efficient, low-cost investment vehicles. That said, I know the realized return is the only thing that counts in the end. But it is important to know the advantages and disadvantages of a product, since it is the tool one uses to generate these returns. Therefore, investors should bear in mind the transaction costs at the fund level when they are selecting an investment vehicle; it might not be a good choice to bet on a vehicle with a competitive disadvantage.

The views expressed are the views of the author, not necessarily those of Refinitiv.

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