Model ETF portfolios throw American Funds investors under a bus.
Many investment advisors are switching their clients’ investments from traditional actively-managed mutual funds to model ETF portfolios. After decades of claiming that active managers can pick winning securities, they’re now saying that active management does not add value on the fund level − but the prudent timing of ETFs does.
That’s unlikely to happen. There’s no evidence that managers can time markets any better than picking stocks. This move to model ETF portfolios isn’t about adding value; it’s about adding fees.
Active fund companies continue to lose assets as brokers and advisors sell
American Funds assets peaked in October 2007 at $1.2 trillion, making it the nation’s largest fund family at the time and the largest provider of adviser-sold open-end mutual funds. Since their peak, assets have shrunk to $854 billion, mainly through redemptions. Growth Fund of America, once the nation’s largest fund, lost $33 billion in assets last year. This was the 4th year in a row for redemptions.
Other large actively-managed funds also lost substantial assets. Fidelity Diversified International’s assets are down to $22.9 billion from $56.8 billion in 2007. Dodge & Cox Stock’s assets have also dropped from $63.3 billion in 2007 to $36.6 billion today.
It’s not unusual for investors to flee when stocks fall, but investors continued redeeming shares from actively managed funds in 2009 and 2010, when stocks scored solid gains. And redemptions ramped up again in 2011, even though the market finished the year virtually unchanged.
Brian Reid, chief economist for the Investment Company Institute, the funds’ trade group, says two other factors are in play: First, investors have been piling into hybrid funds, such as target-date funds, which use a mix of stocks and bonds geared toward an investor’s retirement date. Second, investors are moving from actively-managed funds to index funds and exchange-traded funds.
ETFs and index funds take in billions during 2011
ETFs pulled in twice as much money in 2011 as mutual funds did. Traditional mutual funds gathered $58.58 billion in net new money in 2011, according to estimates by Morningstar, the Chicago-based financial data firm. That compares to inflows of more than $119 billion into ETFs last year, according to data compiled by IndexUniverse.
But this isn’t the whole story. New money moving into passively-managed index funds accounted for all the positive flows that mutual funds experienced, according to Morningstar. Index mutual funds saw net new investments of $66 billion in 2011. Remove this number from $58.58 billion in net new money to all mutual funds and actively-managed mutual funds suffered about $7 billion in outflows.
Advisors are behind the flows
Rather than relying on actively-managed mutual funds to add alpha, advisors are switching clients to model ETF portfolios that employ tactical asset allocation. They are convincing clients that low-cost ETFs and index funds offer a better solution because they claim managers have had success timing entry and exit points using these low-cost index alternatives. The new model uses tactical asset allocation and hybrid core and satellite models for the alpha generation story. Morningstar has a new report on this trend titled Putting Managed ETF Portfolios in Perspective.
Some advisors have a hidden agenda with their managed ETF portfolio recommendations. It’s known in the industry as “churning.” That is, advisors are recommending the switch to model ETF portfolios solely for the purpose of extracting more fees and commissions from clients who already paid them to buy other products.
Many individual investors are being switched out of American Funds to get into managed ETF portfolios. The investor had already paid upwards of 5.0% commission to buy American fund “A” shares. Now, an investor’s annual cost to stay in American funds is about 0.6%, assuming a diversified stock and bond portfolio. About 0.2% annually of this fee goes back to the advisors as a trailing commission. This is known as a 12b-1 fee. It’s the only amount the advisor receives as long as their client is in American funds.
Advisors who already earn a commission on American funds won’t stay satisfied for long with this small 12b-1 fee. One solution for these advisors is to swap clients into model ETF portfolios were they can earn 1.0% per year or more. No wonder assets are moving fast!
Model ETF portfolios throw American Funds investors under a bus
There are multiple layers of fees in model ETF portfolios sold by advisors. First, there is the expense of the ETF model manager. According to the largest model ETF manager, Windhaven Asset Management, their fee alone runs on average 0.7 to 0.8 percent when an advisor is in the picture. This is on top of this the 0.4 percent weighted average annual expense ratio for the ETFs they buy. Then, there is the advisor fee, which conservatively runs about 0.8 percent per year. Finally, commission costs are incurred when the ETF manager trades. Let’s call it 0.2 percent per year.
When you add together the model fee, ETF expense, advisor fee and trading costs, what is supposed to be a low-cost ETF portfolio easily runs 2.0 percent per year. That’s more than 3 times the cost of staying in a balanced portfolio of American Funds!
I’m all for low-cost ETFs and index funds, but not like this. What these advisors are doing isn’t indexing, it’s churning. This isn’t about low-fee; it’s about increasing fees, especially the part going to the advisors.
My recommendation is for owners of American Funds and other front-end loaded closet index funds that track the markets relatively closely to stick with those funds. Don’t spend three times as much for something that helps your advisor at your detriment.
If you want a low-fee index funds or ETF portfolio, one alternative is to build it on your own. It’s a great strategy that’s tough to beat providing you get rid of the riffraff in the middle. I’ve written several books on how to do it.
If you’d rather use an advisor, then make sure the total cost is below 1.0 percent per year. This includes the fund expenses, the advisor’s fee and any other cost, including commissions. Using a low-fee advisor is the best way to benefit from low-cost index funds and ETFs.
