Writing earlier this year, I picked on fixed-income exchanged-traded funds, arguing that without the Federal Reserve’s unprecedented intervention in corporate credit markets, it’s unclear whether these relatively new vehicles for investing in bonds would have survived the liquidity crunch of March 2020.
Unsurprisingly, this didn’t sit well among those in the $5.5 trillion ETF industry. After getting an earful from several ETF defenders, I’m now convinced that talk of an “illiquidity doom loop” in ETFs was misplaced and that the Fed stealthily came to the rescue of the more entrenched fixed-income portion of the $18.2 trillion mutual-fund industry. And I’ll go one step farther: The lessons learned from the coronavirus crisis will accelerate the rise of ETFs and diminish mutual funds even faster than previously anticipated.
Just consider the stark difference in fund flows. ETFs took in a record $502 billion in 2020, according to Morningstar Inc. data, while investors pulled $289 billion from open-end mutual funds, easily breaking 2018’s record of $169 billion. It’s the fourth year in the past six that the funds have lost money. “But it is too soon to count out mutual funds as an investment vehicle,” Morningstar analysts Tony Thomas and Supreet Grewal wrote in a report.
That’s true when looking at the next year, or five years, or probably 10 years. Mutual-fund management is a massive business, with vast amounts of passive money flowing in each year through 401(k) retirement plans. ETFs haven’t caught on as an alternative for a number of reasons, ranging from their tax treatment to bureaucratic inertia. Mutual funds won’t suddenly disappear — but the point at which they lose their asset advantage to ETFs is fairly close at hand.
The best way to show this is the “organic growth rate” of U.S. ETFs and open-end mutual funds. This metric, in effect, reflects the annual growth of the two investment vehicles if the price of every stock, bond and other financial asset were unchanged from the previous year. It strips out the built-in asset advantage enjoyed by mutual funds that’s behind the almost $2 trillion increase in their total assets in 2020, even amid record outflows.
There’s simply no contest — and it hasn’t been close for quite some time.
Given the frenetic trading in shares of GameStop Corp. and other “meme stocks,” it might be tempting to conclude that the rise of no-fee trading for ETFs (but not mutual funds) among Robinhood and other discount brokerages is responsible for the disparity. That’s certainly part of it. ETFs can trade at any point when equity markets are open; open-end mutual fund shares don’t trade on an exchange. ETFs have no minimum investment, and some brokers even allow purchases of fractional shares; many mutual funds require thousands of dollars to invest.
The knock on ETFs, captured by the “illiquidity doom loop” phrase, is that their convenience would come at a steep cost during periods of market stress, especially for funds that own illiquid investments. This, of course, is precisely what happened in March 2020. At one point, about 70 fixed-income ETFs traded with at least a 5% discount to their net asset value, and 16 traded at a discount of 10% or greater. Many of them were marketed as tracking a benchmark.
That certainly sounds like a bad thing. But there’s reason to think this is actually a safer structure than mutual funds, even if the price shocks can seem extreme.
Open-end mutual funds price daily at their net asset value, or NAV. For equity funds, this is straightforward, given that stocks trade on an exchange and there’s a centralized accepted price. This is not as easy for fixed-income funds because many bonds will go days or even weeks without trading. Morningstar analysts attempted to quantify just how subjective corporate-bond pricing can be and found that March 2020 took this guesswork to new heights, “with large groups of bonds showing price-spread percentages in ranges of between four and nine percentage points and still numerous outliers pricing even wider than that.”