Open end mutual funds continue to be a major segment of the investment industry, allowing investors across the full range of portfolio size and net worth to access diversified professionally managed portfolios at a reasonable cost.
Open end mutual funds are not without their limitations, however. Purchases and redemptions may only be made as of the closing net asset value, calculated as of the close of securities markets at 4pm. If an investor wants to liquidate during the day for whatever reason, a mutual fund does not have a mechanism for this flexibility.
Mutual funds have been slow to reduce their cost, or expense ratio. With the largest line item in most mutual fund’s expenses being the investment advisory fee, the question is why have advisory fees not come down as assets have continued to grow? The answer to this riddle is likely the cost of investment platforms like Schwab, Fidelity, TD Ameritrade, LPL and all the major wirehouses. Each of these platforms typically charge mutual funds a fee to process trades and hold mutual fund assets in client accounts, which must be paid as either a 12b1 fee or from the investment advisor fees or some combination thereof. This has kept mutual fund expenses artificially high while generating an amazing level of revenues for the broker dealer platforms.
How are ETFs different and how do they solve some of these mutual fund shortcomings?
Exchange traded funds (ETFs) solve the problem of intraday liquidity by trading on the stock exchanges like any common stock. Market makers and Authorized Participants (APs) offer ETFs to the investing public on a bid/ask basis with exchange provided valuations occurring every few seconds. ETFs have the same liquidity as any common stock, which is quite attractive to many investors.
ETFs have thus far typically had much lower expense ratios and investment advisory fees than traditional open-end mutual funds. Although each ETF has its own determination as to what fee levels to set, market forces have kept those expense structures low, and quite competitive. It is entirely possible the difference in fees paid to the platforms is a component of this difference.
ETFs have an additional advantage over open end mutual funds in tax efficiency. A properly managed ETF can avoid having to distribute realized capital gains to investors, which can be an annoyance for open end mutual fund shareholders that receive a 1099 and must pay tax on an investment they continue to hold. ETFs continue to increase in value without having to distribute the capital gain if managed correctly, which allows the investor to pay capital gains on his holding period gains in the ETF upon sale.
In another post we will examine circumstances where open end mutual funds remain the best solution.