Mutual funds with large ETF portfolios are poor performers compared with their ETF-light rivals because they are not operated as effectively, says a joint study from three US universities.
With the proportion of mutuals that use ETFs growing from 7.7% in 2004 to just over 24% in 2014, the recent paper warns that investors are short-changed by actively managed funds that take significant positions in ‘passive investment’.
In The Use of ETFs by Actively Managed Mutual Funds, assistant finance professors at Illinois State University, Roger Williams University and Bridgewater State University assert that “funds holding ETFs in smaller amounts manage cash better and have improved market-timing ability”.
By contrast, funds that take larger ETF positions hold more cash, have poor market timing ability and generate a negative alpha of 2.14% per year.
The study points out that, while the number of domestic, equity-mutual funds available to investors has decreased since 2004 – from 3,651 to 3,239 – other figures show strong growth trends in the field, for example:
“While ETFs are not typically thought of as a primary investment vehicle for actively managed mutual funds,” the study says, “the use of ETFs within mutual fund portfolios has grown significantly, mirroring the growth of ETFs in the overall market.”
It adds: “If actively managed mutual funds are designed to provide investors with benefits beyond what can be obtained through the use of a passive investment, it warrants examination into the increasing use of passive ETFs within actively managed portfolios.”
The authors examined 1,145 domestic equity mutuals with passive ETF positions, directing their research with the question, Are ETFs being used by actively managed mutual funds to improve their performance?
Exploring the flow-management area of fund liquidity, the study says: “Holding an ETF position may allow fund managers to more easily deal with large in- and out-flows by removing the need to sell other securities during periods of out-flows and the need to invest in-flows into suboptimal investments – both of which create a drag on performance.”
However, it notes: “In all specifications of our model, we find a negative and significant relationship between the absolute value of flow and mutual fund performance. Interestingly, we do not find support for the use of ETFs providing any flow management benefit.”
Turning its attention to cash management, the study says: “Contrary to [previous research], we find strong support that high ETF-user mutual funds hold more cash. This is indicative of mutual funds with high ETF positions also managing cash poorly, if one assumes they are trying to avoid the established performance drag from large cash positions.”
In sum, the study concludes: “Actively managed mutual funds that allocate substantial portions of their portfolios to ETF positions exhibit no redeeming qualities. They are uniformly the worst-performing funds in our sample; holding increased cash positions, possessing poor market timing ability, and generating negative, risk-adjusted performance.”
It adds: “Given that actively managed mutual funds are designed to provide investors with benefits that cannot be accomplished through passive management, it comes as no surprise that actively managed mutual funds that allocated substantial portions of their portfolios to a passive investment fail to create value for investors.”