EVENTS

Date:	Wednesday, April 26, 2006
Time:	2:00 PM -- 4:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

April 2006

Competition for Mutual Funds from New Collective Investment Vehicles

Mutual funds compete for investor interest with many other forms of investment. Some of these competing forms are regulated under the Investment Company Act of 1940, but others are not. Panelists at an April 26 AEI conference, the eighth in the series entitled “Is There a Better Way to Regulate Mutual Funds?” discussed three competing forms of investment--exchange-traded funds (ETFs), separately managed accounts, and the customized portfolio management system known as FOLIOfn--and the competitive challenge they pose for mutual funds. ETFs are a relatively recent innovation and a rapidly growing alternative to the traditional mutual fund. They are regulated under the Investment Company Act and offer investors both diversification and other advantages that are not available in the traditional mutual fund structure. ETFs are based on indexes and are not yet available in managed form, so they do not offer individualized portfolios. Separately managed accounts and FOLIOfn are not collective investments and are not regulated under the Investment Company Act, but they do offer investors an opportunity to achieve investment diversification while allowing somewhat more individualized investment choice than mutual funds. Experts discussed the advantages and disadvantages of these competing modes of investment in relation to mutual funds.

Peter J. Wallison
AEI

At first it may seem anomalous to consider whether mutual funds face serious competition given that the industry holds almost $9 trillion in assets and serves over 90 million customers. Further, because the industry has been so dominant, it may also seem anomalous to consider whether regulation has been a problem and is in need of reform. Recently, however, ETFs and customized portfolios have been growing faster than mutual funds in the market for retail investment. This should be a warning signal for those concerned about excessive or excessively rigid regulation. Such regulation tends to stifle innovation and spurs competition from less-regulated or unregulated alternatives. As Americans become more affluent and sophisticated about what the financial world offers, they may not be satisfied with the mutual fund products that the industry is capable of providing under its current structure. At some point it may be necessary to authorize a less expensive alternative to the costly corporate structure for mutual funds required by the Investment Company Act.

T. Neil Bathon
Financial Research Corporation

The evolution of competition between product types has resulted, at least in part, from the way in which the distributors have changed. For example, most firms have gone from featuring brokers who sell products to having financial planners who offer investment advice and solutions. Also, there has been an increasing preference among firms for using a fee-based approach, as opposed to front-end loads and transaction charges. Currently, 44 percent of broker assets are fee-based, up from below 10 percent eight years ago. Another change is that due diligence teams have become much more rigorous in evaluating which asset managers get access to the distribution system. Finally, distributors are more selective about their products, whereas before, distributors tended to accept entire fund families when a particular firm applied. Now, distributors may accept only a few funds from each fund group.

Mr. Bathon went onto provide statistical profiles of the collective investment industry. In his accompanying PowerPoint presentation, there are charts depicting current data and projections for the growth of total assets under collective management, net sales of mutual funds and ETFs, the market share of the top five firms, the growth of lifecycle funds, separately managed account assets, multiple discipline products, asset growth of ETFs, variable annuities, and other categories.

Distributors are becoming more professional buyers, and as a result, a firm’s investment process has become a much more important factor in selling its products. Indeed, as the nature of the products, performance, and pricing stabilize among competitors, firms must look to other ways of differentiating themselves. Looking toward the future, firms will focus on the investment process, the corporate culture and how it affects reputation, and how the firm focuses on the distributor’s needs.

Mr. Bathon concluded with his outlook on the prospects for various forms of collective investment. He proposed that mutual funds will retain their place as the mainstay offering for the majority of retail investors. Variable annuities must undergo drastic changes in order to be a meaningful competitor for retirement funds. The market for ETFs should continue to expand, thanks to the growth of fee-based business, investors’ increased appreciation for indexing, and enhanced portfolio construction techniques. Finally, separately managed accounts should sustain their growth, due in large measure to the greater use of customization and tax-efficiency benefits.

Todd J. Broms and Gary L. Gastineau
Managed ETFs LLC

Over the past thirteen years, ETFs have grown to approximately $300 billion in assets. To grasp the primary advantages of ETFs, it is necessary to understand how transaction costs are borne under the respective structures for mutual funds and ETFs. Regarding mutual funds, whenever investors purchase shares or redeem shares for cash, the fund must pay transaction costs (commissions, bid-asked spreads, and market impact costs) in order to buy and sell the fund’s underlying securities. These transaction costs are borne by the fund itself, and hence are borne by all investors, even those who hold their shares for extended periods of time. ETFs operate in a different fashion. ETF shares are created when market-makers purchase a portfolio of securities that matches the ETF portfolio. Today’s ETF portfolios are based on indexes. For example, SPDRS (Standard & Poor’s depository receipts)--“spiders”--are based on the S&P 500 and are created in units of 50,000 shares (worth approximately $6.5 million per unit). The market-maker delivers the “basket” of securities to the ETF in exchange for shares of that ETF. The market-makers recover the transaction costs they have paid when they buy and sell ETF shares on the open market through stock exchanges. Thus, ETF investors ultimately bear the transaction costs for the sale and purchase of underlying securities when they either buy ETF shares or redeem them. Given that the investor entering and leaving the fund must pay the costs of these transactions, holders of ETFs do not suffer from market timing or late trading, practices that end up increasing costs for mutual fund investors. According to one study, which examined a sample of 166 equity and hybrid funds using data from 1985-1990, mutual fund shareholders lost on average 143 basis points in performance per year due to the fund share entry and exit transaction costs borne by the portfolio. ETFs also offer a high level of tax efficiency. Shareholders in a well-managed ETF pay capital gains taxes only when they sell their shares. While not every investor would benefit from the ETF structure--particularly those who trade frequently--most investors who hold fund shares for extended periods of time will do better in an ETF than in a mutual fund.

Sander Gerber
XTF Advisers and Hudson Bay Capital LP

Mr. Gerber created XTF Advisors with the mission of transforming the way Americans invest by guiding them into low-cost, tax-efficient portfolios--also known as separately managed accounts (SMAs)--of ETFs that best meet their long term goals. In particular, he set out to maximize investors’ after-tax return, which should be the primary factor in determining whether to make a certain investment and evaluating the success of one’s investment.

Unlike mutual funds, SMAs are individual investment portfolios managed by professional investment advisors, in which the investor owns the actual underlying securities. There are several benefits of SMAs compared to mutual funds. In addition to providing clients with direct ownership of the underlying securities, SMAs can be geared toward specific, personalized investment objectives, time horizons, and risk tolerance. In addition, whereas capital gains taxes are often imbedded in mutual funds and end up getting passed along to investors, the established cost basis for each security in an SMA enables investors to deal with taxes more efficiently. SMAs can be funded with cash, as well as with existing stocks and bonds, and investors can choose to exclude certain types of securities. For example, an investor might not want to have any stock in drug companies. Conversely, mutual funds are funded solely through cash, and the portfolio holdings are at the sole discretion of the portfolio manager. However, SMAs are generally for wealthier investors, typically carrying a minimum investment of $100,000.

XTF Advisors provides SMAs comprised of ETFs, which have numerous benefits over mutual funds, as well as other SMAs that are made of individual securities. In comparison with mutual funds, there are no issues of survivor bias; when a mutual fund performs poorly, the mutual fund firm will typically roll that fund into a better performing one. This practice can obscure the actual rate of return. Also, ETFs entail various tax and cost efficiencies that mutual funds do not.

Another tremendous benefit of ETFs is their transparency. In addition to ETFs being based on indexes, the custodian of an ETF must report to the market the exact composition of underlying securities every day. This transparency allows for greater monitoring of transaction costs and fund expenses, gives investors greater knowledge of the content of their portfolio, helps guard against hidden or imbedded costs, and enables self-policing. Given the transparency, regulation can be carried out in a less intrusive, less onerous manner.

One of the benefits of SMAs comprised of ETFs as compared to SMAs comprised of individual stocks is that the management of the former involves much less paperwork. Each time an SMA purchases shares of an individual stock, the management must fill out a special confirmation form. These paperwork requirements have encouraged many SMAs to change their approach and invest in ETFs. In addition, SMAs of ETFs offer diversification across all assets classes at a low cost. Moreover, SMAs of ETFs have fewer administrative service requirements, such as no required maintenance of phone banks, low accounting overhead, and low legal and trustee service overhead.

Steven Wallman
FOLIOfn

Mr. Wallman described FOLIOfn, the online brokerage and investment company he founded in 1998. To better understand this service, one should see his PowerPoint presentation, which shows how investors can use the FOLIOfn website.

FOLIOs are baskets of securities that can include any security, such as stocks, bonds, ETFs, and mutual funds. Unlike mutual funds but similar to SMAs, folios and their actual securities--as well as fractional shares--are owned by the investor. Investors can purchase a FOLIO as a single transaction, but they can also trade securities individually within FOLIOs. In addition, once an investor owns a FOLIO, it is possible to rebalance the securities as often as needed. Moreover, one can choose to exclude securities that include a product with which the investor does not want to be affiliated--tobacco for example. The FOLIOs are priced in real time and the investor knows exactly what the underlying securities are. Furthermore, there are different options for financial planning. While investors are the ones who ultimately purchase the FOLIO and trade its underlying securities, investors have a range of options regarding how active they want their advisors to be. In short, each FOLIO can be customized at any time to meet the personal and individual needs of each investor.

The aim of creating FOLIOfn was to combine the advantages of owning both individual stocks and mutual funds, and lose their respective disadvantages. Because investors own the underlying securities, just as people own shares of stock, they are open to tax efficiencies, can customize the securities they own, have voting rights with respect to the securities, and benefit from complete transparency in terms of what the investor is purchasing and what the price is at the moment of sale. In contrast, investors in mutual funds do not know the composition of underlying securities or the exact price at the time of sale; with mutual funds, the price is not known until the net asset value is calculated at the end of the day. The areas in which FOLIOs share the advantages of mutual funds are primarily diversification and professional portfolio management. Whereas investors purchasing securities through online brokerage services may only have a handful of different stocks, owners of FOLIOs, which can include stocks, ETFs, and mutual funds, have the advantage of being diversified across the market.

AEI staff assistant Daniel Geary prepared this summary.