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Are Mutual Funds Buying Into ETFs?

Herb Morgan has a good barometer to tell how hot the market for exchange-traded funds is getting. Just count the number of mutual funds promoters who approach him to set up a mutual fund that invests solely in ETFs, says the president of Efficient Markets Advisors.

"We're definitely hearing more about mutual funds buying into ETFs," said Morgan, whose firm manages $230 million. "Just the other day I had one of those 'fund in a box' promoters ask me to manage a mutual fund he would set up that would invest in ETFs. And that happens all the time."

Morgan, whose Del Mar, Calif., firm invests solely in ETFs on behalf of 11,000 individual accounts, was not persuaded. "I said it wasn't for us, at this point," he explained. "I mean, I feel that ETFs are the superior structure, so why would I put the superior structure in the lesser instrument?"

ETFs are investment vehicles akin to indexed mutual funds, but that trade on exchanges, throughout the day, as if they were individual stocks. They also often have lower expense ratios, less cash drag and a better tax efficiency (because ETFs don't disperse capital gains-taxed dividends) than do mutual funds.

Morgan's belief in that ''superior structure'' is not that unusual among money managers. The ETF industry has grown dramatically over the last five years, from $432.7 billion in assets under management at the end of 2006 to $1.2 trillion now, according to data from the ETF Industry Association. The number of different ETFs? Just 380 at end of 2006, compared to more than 1,485 now.

Now, even its chief rival, the mutual fund industry-which holds about 10 times the assets of ETFs-is taking notice, and putting shares of ETFs into those holdings.

But they don't publicize it. And, according to at least one market participant, they avoid ETFs that invest in stocks.

Based on stock screening platforms and trading patterns he has observed, one New York-based money manager who asked not to be named, said he isn't seeing mutual funds chase equity ETFs, but rather using them for specialty plays. "I really don't see the biggest mutual funds buying into equity ETFs-it is more acceptable in commodities, like gold, or foreign exposure, but not equities."

Any movement into ETFs by mutual funds has been difficult to track, said Bridget Bearden, a research analyst for Strategic Insight, a mutual fund research and consulting firm. "To calculate the percentage of mutual fund assets invested in ETFs, you would need to have the full portfolio holdings-by type or actual security-for each mutual fund," said Bearden. "After having the full holdings, the entire mutual fund universe would then need to be manipulated into some sort of database-so it's a combination of data limitations and time restraints."

Because of this difficulty, it has been hard to determine exactly how much of the mutual fund industry's $11.6 trillion is held in ETFs. A recent report from Deutsche Bank on ETF ownership at the end of 2011 showed that 53% of the market was held by large institutional investors, those with discretionary control over more than $100 million in client assets. The bulk of that is held by investment advisors and brokers. Mutual fund managers were listed in the Deutsche Bank report as holding just 2.8% of the ETF market, translating into roughly $30 billion in assets, a sliver of the mutual fund industry's total buying power.

Indeed, according to Strategic Insight, just one of the Top 100 mutual funds (ranked by July assets) listed an ETF as a Top 10 Holding Type.

That one fund, the $55 billion BlackRock Global Allocation fund, names an exchange-traded fund that invests in gold, GLD from State Street, as its third-largest holding with 1.14% of the fund invested in the ETF. BlackRock did not return a message for comment.

Joe Dickson, senior ETF investment strategist at Vanguard Mutual Funds, says the discussion on mutual funds and ETFs gets a little complicated because essentially ETFs are mutual funds.

"There's been a lot of talk lately about ETFs, their growth and how mutual funds are using these new vehicles. But ETFs are not new-they are simply wrappers for an investment approach," Dickson notes. "Mutual funds investing in ETFs is just the topic du jour."

That said, there are reasons mutual funds would seek out ETFs, he adds. The primary reason for mutual funds to buy into ETFs is to use the vehicles as a substitute for buying futures contracts while satisfying the requirement to have assets fully invested.

This strategy would also allow mutual fund managers to avoid the complexity and higher costs of futures contracts and of constructing and unwinding a futures bet.