VettaFi Voices On: Choosing Your Wrapper
Greetings, VettaFi Voices! Now seems like a good time to talk about wrappers and which ones are best for different situations. How do you decide whether to use an ETF, a mutual fund, or something else?
Todd Rosenbluth, VettaFi director of research: Now is a very good time to do so, since so many active managers are bringing ETF versions of established mutual funds to market. They’re giving advisors and end clients a choice. A few prominent ones with a longish ETF record that come to mind are T. Rowe Price, with the T. Rowe Price Blue Chip Growth ETF (TCHP) and Fidelity with the Fidelity Blue Chip Growth ETF (FBCG). We’ll have the manager of FBCG appearing next week at the Equity Symposium to answer questions.
However, this year we saw Franklin launch the Franklin Income Focus ETF (INCM), an ETF version of a nearly 75-year-old and extremely popular mutual fund. And JPMorgan is soon to launch an ETF version of its JPMorgan Hedged Equity Fund. The same team that runs this also runs the largest actively managed equity ETF, the JPMorgan Equity Premium Income ETF (JEPI).
The holdings of the ETF and mutual fund with a similar name have nearly identical portfolios. Minor changes are made to ensure there’s adequate liquidity for the ETF. But the choice is largely whether or not you want the tax efficiency benefits of an ETF, and are you comfortable with trading in a market.
I’m sure my colleagues will dive into this, but an ETF trades like a stock does, even if it holds bonds like INCM does. So there’s a bid/ask spread, and you need to put in an order to buy or sell sometime during trading hours. Hopefully using limit and not market orders.
Adding a Mutual Fund Share Class
Dave Nadig, VettaFi financial futurist: To me, one of the most interesting things we’ve seen recently is the F/m filing to make a mutual fund share class of their existing Treasury ETFs. I didn’t see that coming at all. However, there are two big primary use cases for the traditional ’40 Act mutual fund structure that are probably not going away anytime soon.
No. 1: Defined contribution plans like 401(k)s. Recordkeeping systems have largely been designed around NAV trading and fractional share accounting. (After all, it’s pretty hard to put a penny into an ETF. But with five decimal places to work with, you can get tiny tiny slices of a mutual fund).
No. 2: Anyone who’s uncomfortable or unable to transact in traditional equity markets. There are a large number of investors (and advisors) who either can’t (for legal or structural reasons) or won’t (for preference reasons) learn the whole process of submitting limit orders, monitoring market prices, and worrying about getting good executions.
If you’re in the latter two camps, the traditional mutual fund makes sense. So when F/m Investments filed for a mutual fund share class to be added to its ETFs, a bit of a lightbulb went off. The mutual fund is definitely not disappearing. It’s going to become an important niche vehicle. Like a three-row SUV, not everyone’s going to want one, but if you need one …
Meanwhile, all the way at the other end, I think we’ll continue to see the rise of “wrapperless” individualized accounts. Those could be truly wrapperless in a direct indexing platform or through more aggressive use of SMAs. I know advisors in both camps. Some use products like Franklin Templeton’s Canvas to manage complex tax and concentration issues for very high net worth clients. Some just run SMAs to hold unique bond portfolios for clients.
I deeply believe this is a “horses for courses” situation. Advisors should always be asking themselves, “Is this the right vehicle for this purpose?” Most of the time, the answer for ETFs is going to be “yes,” but not 100% of the time.
Rosenbluth: Agreed on the use cases for mutual funds. Most retirement plans only offer mutual funds as an option. Dave, since you mentioned F/m, let’s also mention that many firms have or plan to convert mutual funds to ETFs. Dimensional Funds has led the pack with DFUS and DFAS, but a few other firms have made the decision for investors that ETFs are a stronger alternative to mutual funds. I haven’t dug deep into the flows, but Dimensional has become the largest active ETF provider in part due to these conversions. For many asset managers, ETFs have become the priority, because for clients, they’ve become thee priority.
Nadig: ETFs are definitely where the “heat” is — and the conversions are the proof. But the DC market remains a bit of a “brake” on those becoming even broader. The funds that have converted so far all have one big thing in common — they’re not big 401(k) darlings.
Energy Infrastructure in Investment Vehicles
Stacey Morris, VettaFi head of energy research: Energy infrastructure is a fairly narrow category. As such, MLP investment options are particularly limited. It may be difficult for the manager of a mutual fund to outperform after fees when there are only so many securities to select. If an investor wants to access this space through a passive, exchange traded product, there are both ETFs and exchange-traded notes (ETNs). Investors can learn about key differences here. However, ETNs tend to be more suitable for tax-advantaged accounts because their coupons are taxed at ordinary income rates.
There are plenty of mutual funds focused on energy infrastructure, but a broad mutual fund probably won’t have much energy infrastructure exposure.
Heather Bell, VettaFi managing editor: As a very boring buy-and-hold investor, I still don’t see the point of mutual funds unless they’re the only choice. I recently spoke with the founder of a TAMP firm that offers a lot of very active strategies. He said ETFs are great unless you’re trading them frequently and the transaction costs overwhelm the savings one generally gets when buying a lower-cost ETF. However, this is less of an issue these days with commission-free trading having become pretty prevalent.
I have mutual funds in my 401(k), but whenever I can, I use ETFs. Although I may not look at my retirement accounts for months at a time, if things go pear-shaped in the market in a uniquely disastrous way, I like having the possibility of exiting my investments before the market close.
I don’t think I would ever exercise that choice, but I also never expected a global pandemic three years ago or Russia’s invasion of Ukraine. It’s nice to have that flexibility that mutual funds just can’t provide. ETFs are good for my anxiety, I guess you could say.
VTSAX vs. VTI
Roxanna Islam Swan, VettaFi associate director of research: I am still surprised among some investment circles how popular the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) is versus the Vanguard Total Stock Market ETF (VTI). I think it partially has to do with holding onto old habits.
Bell: Are you talking about retirement accounts or taxable accounts?
Islam: I think both. Maybe investors are familiar with the fund through their retirement account, and to them, that’s the holy grail ticker for equities even when they’re investing in a taxable account. Many are unaware of the advantages of VTI. That’s just all anecdotal though.
And I’m talking about whenever I read personal finance blogs, I always see recommendations for VTSAX.
Bell: I was thinking more about the average person. I’ll talk to pretty much anyone who wanders too close to me (probably because I’ve worked from home for 15 years with only house pets for company). If they ask me what I do for work, I inevitably have to explain what an ETF is about 95% of the time.
It initially surprised me that personal finance blogs would be promoting mutual funds. However, you’re talking about Vanguard mutual funds, so that’s not really a huge difference in terms of cost, I guess.
ETFs Vs. Individual Stock Picking
Swan: I’m definitely not a “pro” on the mutual fund side of this conversation. That’s just an observation I’ve had recently. But I do hear a lot of questions on why an ETF is appropriate versus picking individual stocks. And I addressed some of that in my research note this week.
First, I think there’s a lot of general frustration with trying to decide what direction a stock will go. A stock can beat expectations on the revenue line but then miss in the cost line. I think costs are harder to predict, because a lot of that is independent to an individual company. Even if you are on the nose for both revenue and cost expectations and get earnings right, you may completely miss on your valuation multiple and target price.
Plus, stocks trade on investor sentiment, so who really knows where a stock price will go? Sometimes a stock will completely miss earnings but have a good forward guidance. Then the stock price might take off after the earnings call. There are a lot of factors that can lead performance to go in an unexpected way (like the meme stock craze a couple of years ago).
I think when you put that into an ETF wrapper, it can either feel a lot better or a lot worse. Better because ETFs provide diversification. They can provide exposure to newer, smaller stocks that may be more difficult for an investor or an advisor to research. You’re letting someone else do the heavy lifting in terms of stock picking and rebalancing.
When It Feels Worse
But I think it can feel worse especially when you’re investing in a trend that’s not really materializing into performance. There are a lot of trends that are “more obvious” than others, and you can clearly see data illustrate this. More people are streaming movies and music. More people are buying EVs. These are real trends that you can see data for. So why aren’t ETFs like the First Trust S-Network Streaming and Gaming ETF (BNGE) or the Global X Autonomous & Electric Vehicles ETF (DRIV) more popular? Why aren’t they performing better?
I think it goes back to looking at individual stocks. When you’re investing in a trend, you’re investing in higher revenues across an industry. You’re not really counting on how individual companies are managing their costs, which is a huge factor for overall performance.
But I think over time, long-term trends will outweigh short-term costs. This is especially true when you look at market-cap-weighted ETFs. Those approaches weight larger companies that typically have better scale to manage certain costs higher than smaller companies. But it’s something that can definitely be frustrating in the short erm.
Rosenbluth: Thematic ETFs have made long-term investing so much easier. I was a financial advisor 25 years ago. That was just before the Internet went from boom to bust and then, years later, back to boom. At that time, you had to pick one to two stocks tied to a trend. Then you would hope for the best in finding winners and avoiding losers. DRIV has 75 or so holdings in it.
Stock Picking & Thematic ETFs
Islam: DRIV is up less than 25% year to date and Tesla’s stock (TSLA) is up over 120% YTD. Many people ask, why not just invest in Tesla? I don’t think there’s a right answer and it depends on your risk tolerance. Some people are very confident in their stock-picking. That’s fine, but I think something harder to figure out is, who is the next Tesla? If you invest in an EV ETF, maybe the “next Tesla” is hidden in there somewhere. You won’t get to participate in all of the potential gain because that position is diversified. But you get at least some of it.
Rosenbluth: I just did a webcast with Defiance on the Defiance Pure Electric Vehicle ETF (EVXX), which holds Tesla and just four other EV companies. It has diversification but still some stock concentration for people who really want a purer approach to thematics.
Islam: I think out of habit I’ve been speaking more on indexed ETFs. However, active ETFs help take stock picking to a professional level.
Rosenbluth: Good point. For example, Goldman Sachs has five active thematic ETFs tapping into their analytical team’s fundamental and valuation-based expertise. The Goldman Sachs Future Health Care Equity ETF (GDOC) is one that’s caught my eye. It’s different than an index-based healthcare sector ETF.
We largely skipped this, but ETFs tend to be much more tax efficient. So for taxable accounts, they make much more sense than mutual funds. Your cap gains are due mostly to your buying and selling, not someone else that owns the fund. ETFs primarily trade in the secondary market, and you don’t deal directly with the portfolio manager. Last year, mutual funds passed along a lot of cap gains to shareholders despite losing value.
Assets Moving From Mutual Funds to ETFs
Bell: That’s kind of a depressing double whammy! But the tax efficiency is one of the key features of ETFs. It’s one of the reasons I’m always going to go with a strategy in an ETF over the same strategy in a mutual fund. Unless it’s in a retirement account, I don’t see the point of owning a mutual fund. And I guess a lot of people agree. After all, mutual funds have been losing assets for years even as the ETF industry grows exponentially (though perhaps not this year).
Rosenbluth: Good point, Heather. The facts are the facts. Money continues to shift from equity mutual funds to equity ETFs. The pendulum has swung away from equity mutual funds.
Bell: Morningstar data says that mutual funds saw $1.3 trillion in outflows last year while ETFs pulled in $754 billion at the global level.
Nadig: That’s been the trend for 20 years, honestly.
Rosenbluth: Yes, but now there are more active ETFs to consider. It’s not just a shift from active mutual funds to index ETFs
Nadig: For sure, and that mutual fund number comes in despite continued growth in 401(k) flows. The ETF wrapper remains the best structure for most applications.
Rosenbluth: Final shout from me for people to join me for the Equity Symposium on September 21 at 11 a.m. ET. We will cover active ETFs with experts from Harbor and Goldman Sachs.
Originally published on ETFTrends.com on September 15, 2023.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our full schedule of upcoming CE-approved virtual events.