Why Mutual Funds Are On Their Way Out

Mutual funds have dominated the investment landscape among individual investors for generations, offering access to professional money management of diversified portfolios of various types of assets at relatively low costs without huge up-front commitments of capital. Increasingly, though, exchange-traded funds have become an ever-larger force in the investment world, and despite some obstacles in getting off the ground, actively managed ETFs now appear to be on the horizon as an alternative that could eventually lead to the disappearance of traditional mutual funds entirely.

How ETFs beat index funds
Until recently, exchange-traded funds have largely focused on passive-investing strategies. With the transparency that ETFs are required to give investors, it makes sense to use predictable index-based strategies with ETFs. As of the end of 2012, the Investment Company Institute estimated the size of the ETF market at more than $1.33 trillion in assets under management, most of which is tied to passive indexes.

By contrast, only a few actively traded ETFs have come onto the market. Most of the ones that are available have been in the bond arena, where PIMCO Total Return ETF (NYSEMKT: BOND  ) has been by far the most popular, collecting billions of dollars under management. The reason: With so many more distinct bond issues than common stocks, it's a lot harder to front-run an actively managed bond ETF even if you know exactly what it's going to buy. By contrast, one big challenge that actively managed stock ETFs face is figuring out how to avoid losing their competitive advantage by having to disclose proprietary investment ideas on a much more frequent basis than their mutual fund counterparts have to make similar disclosures.

Who wants in on the action?
All that said, plenty of mutual fund companies have seen the writing on the wall and are eager to come to market with active ETFs. Mutual fund giants Fidelity, Franklin Templeton (NYSE: BEN  ) , Janus Capital (NYSE: JNS  ) , and Legg Mason (NYSE: LM  ) are just some of the companies looking to follow in PIMCO's footsteps with active ETFs. Each of these companies owes a huge portion of its profits to management fees on the billions in assets that it holds, and each recognizes the need to defend its turf by reaching into the ETF space. For Legg Mason and Franklin Templeton, which already offer closed-end mutual funds that trade on exchanges, moving to ETFs is an even shorter step.

An even more interesting proposal came from Eaton Vance (NYSE: EV  ) earlier this year, which asked the SEC to allow it to create what it calls an exchange-traded managed fund. Ideally, Eaton Vance would like to see the SEC allow it not to make daily disclosure of its holdings, with the company seeking to use what's known as NAV-based trading to help facilitate trade. With NAV-based trading, investors would agree to pay not a fixed dollar value for shares but rather a variable price above or below whatever turns out to be the day's final net asset value for the ETF's assets. Eaton Vance hopes that such an idea would satisfy any concerns about lack of daily disclosure of holdings while still allowing efficient intraday trading. Given that the SEC allows mutual funds to disclose holdings as infrequently as once per quarter -- with a lag allowed between the end of each quarter and the filing date -- it's not unreasonable to expect active ETFs eventually to get similar treatment.

Is a long decline coming?
To be clear, even index mutual funds are far from dead. The ICI pegged 2012 mutual fund assets at more than $13 trillion, or roughly 10 times what the ETF universe has in assets under management. In many areas, such as retirement plan investing, the use of mutual funds is so entrenched that it could take years or even decades for providers to switch away from funds and toward ETFs.

Still, whether it takes years or even decades, the primary advantages that mutual funds had are slipping away toward the ETF realm. Mutual funds won't disappear overnight, but you can expect them to become less relevant over time as new ETF innovations continue to appear and take root in the money management industry.

To learn more about a few ETFs that have great promise for delivering profits to shareholders, check out The Motley Fool's special free report "3 ETFs Set to Soar." Just click here to access it now.


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