The steady footrace between mutual funds and ETFs
admin | February 14, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Most managers of mutual funds have heard the footsteps of exchange traded funds for well over a decade, but the fixed income crew is faring better in the race than the equity crew. Fixed income mutual funds have grown faster than competing ETFs in recent years while equity mutual funds have fallen far behind. The difference arguably may be the greater ability of fixed income managers to invest in assets outside of benchmark indices and the challenges of building fixed income ETFs.
Cumulative inflows into taxable fixed income mutual funds have outpaced flows into similar ETFs since early 2017 by $107 billion, according to the Investment Company Institute (Exhibit 1). The mutual funds lost a sizable chunk of assets in late 2018 as Fed policy tightened, recession concerns rose and credit spreads widened. But the funds have since recovered lost ground. ETFs flows have run at a slower but much steadier pace. The advantage for funds follows a 10-year run where flows into competing fixed income mutual funds and ETFs roughly matched.
Exhibit 1: Taxable fixed income mutual funds have gained ground on ETFs
The experience for taxable fixed income mutual funds stands in stark contrast to equity mutual funds, which have fallen behind equity ETFs since early 2017 by $1.2 trillion (Exhibit 2). That comes after a 10-year period where equity mutual funds already had fallen behind equity ETFs by nearly $5 trillion. In the equity business, ETFs have steadily taken the field.
Exhibit 2: Equity mutual funds have steadily lost ground to equity ETFs
The difference between taxable fixed income and equity in the competition between mutual funds and ETFs begs for an explanation, and several seem plausible, especially the opportunity to invest outside of the main indices and the complexity of engineering an ETF.
Fixed income managers may have an easier time generating excess return over an index, especially by investing in diversifying assets outside the index. The Bloomberg Barclays US Aggregate Bond Index, for instance, only includes investment grade instruments with a minimum size, opening the door to excess return from smaller and often less liquid instruments. The index also does not include most non-agency MBS or CLOs, opening the door to excess return from those markets. The index also leaves out CMOs, allowing a manager to take advantage of relative value in that market or to add embedded leverage through interest-only or inverse interest-only securities. Unfortunately, rigorous tests of fixed income mutual funds’ ability to beat broad indices are in short supply.
Investing outside an equity index such as the S&P 500 likely is relatively harder. Equity investors can clearly invest in issuers with market cap or public float that falls below the S&P 500 thresholds or in non-US public companies. And while mutual funds could invest in private equity, regulatory and practical limits on illiquid securities arguably cap the opportunity. Plenty of work on equity mutual funds’ performance against broad indices shows limited sustained excess return.
Another plausible difference between taxable fixed income and equity is the complexity of creating a broad market ETF—harder in fixed income than in equity. The Bloomberg Barclays Aggregate Bond Index as of February, for instance, includes 11,120 distinct securities, many that rarely trade even though the securities get priced daily. The number of listed securities and the infrequent trading make it nearly impossible to replicate the index holdings, so creators of ETFs have to approximate the index by other means. The S&P 500, in contrast, includes a much smaller number of securities with quoted prices on public exchanges, making it relatively straightforward to replicate index holdings.
Fixed income mutual funds still face significant competition from ETFs, and that’s especially true of mutual funds that hold a large share of the portfolio in index assets with weightings that match the index—funds, in other words, that are closet indexers. Closest indexers eventually have to compete on price, and that’s a losing proposition against most ETFs. But the last few years suggest fixed income managers can stay ahead of ETFs much more successfully than their equity cousins.
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The view in rates
The coronavirus continues to shape the outlook for global growth and inflation and the level and shape of US rates. Even though the magnitude and mortality of the outbreak remains to be seen, the initial impact on China’s economy is clear and worrisome since China last year contributed 19% of global GDP. Expanding quarantines in China and voluntary and imposed restrictions on travel there have idled significant resources. It is likely that pent up demand will resurface once there’s clarity on the coronavirus and GDP should partially if bit fully rebound. Given the emerging scientific and public health collaboration to address the outbreak, it seems likely that the uncertainty around the outbreak will fall quickly. As it falls, rates should rise and the yield curve steepen.
The view in spreads
Despite concerns about China and global growth and inflation, the appetite for spread and compounding income is still strong. Investors have clearly stepped back at times to watch the coronavirus play out, but the trend seems to be increasingly to step back in. The US economy looks healthy enough to keep credit concerns at bay for investment grade companies and even most high yield companies, so spreads have room to compress further once uncertainty around the virus drops. MBS has some room to run tighter even though low rates stand to keep prepayments elevated through the spring, especially in Ginnie Mae MBS. If the economy moves above current expectations of less than 2% real GDP growth, spreads should tighten further.
The view in credit
A variety of measures of corporate leverage remain high, but leverage spells trouble only if growth falls below current expectations and financing for leveraged borrowers tightens. The downgrade of Kraft Heinz highlights the risk that some highly leveraged companies run with a world with sub-2% GDP growth, but that shouldn’t come as a surprise. It looks more likely that growth might slightly exceed expectations, lifting corporate fundaments. As for the consumer, that is a story of generally continued strength with low unemployment, strong income, rising net worth and low debt service as a share of income.