ETFs currently dominate the investment fund conversation. ETFs account for a large percentage of new fund organizations over the last few years. Many investment advisors might ask, is an ETF automatically the best choice for my firm? Or are there clear situations where a mutual fund remains the best solution?
To answer the question wisely, the RIA should first ask “what investors are my primary target audience?”, and “how will our new fund be distributed/marketed?”.
When qualified retirement plans are a significant portion of the investment advisor’s target audience, a traditional open-end mutual is usually the best choice. The primary reason is the way qualified retirement plans are administered by the plan administrator. Most retirement plan administrators have been using open-end mutual funds for many years, so their systems for receiving 401k contributions, making purchases on behalf of the qualified plan participants, and providing periodic participant and regulatory reports are all built around mutual funds and the DTCC’s well-tested FundSERV system for buying and selling mutual funds, where platforms for buying and selling through administrators, broker-dealers and direct with fund groups are commonplace.
ETFs must be purchased through a broker-dealer on an exchange. For a retirement plan, this is an entirely different process for making purchases and redemptions on behalf of qualified plan participants. A well-established plan that has been using open-end mutual funds for many years, would have to add additional infrastructure, combining FundSERV reporting with the broker dealer reports for trading activity, and multiple systems for reconciliation. Most retirement plan administrators have hesitated, balked, or stalled at adding such complexity and the “opportunity for something to go wrong”.
Mutual funds trade exactly at net asset value, but that value is determined only once per day. The lack of convenience or ability to trade during the business day must be weighed against the pure value of getting the trade at net asset value. This trade at the actual net value contrasts with the market auction pricing of ETFs. The price for an ETF is set by a bid/ask offer from market makers on the ETF’s exchange. The bid will always be slightly below intrinsic value and the ask will always be slightly above intrinsic value. The market maker will also hedge their offer as there is a time delay between when the ETF is offered to or acquired from the investor, and when the ETF trade can be settled with the ETF at the fund level. While there is an opportunity the broker dealer market maker will profit from that time differential, there is also the possibility the market prices of the underlying securities will move against the transaction, resulting in a loss. This need to hedge has a cost; most of the time there is a difference between net asset value and purchase price for ETFs.