Are mutual funds dinosaurs headed for extinction? Over the past 15 years, new fund flows have largely been directed towards ETFs and some experts predict that they will eventually replace mutual funds. During the 2024 Inquire Europe Autumn Seminar Anna Helmke, Assistant Professor of Finance at Vanderbilt University, presented her research ‘Will ETFs Drive Mutual Funds Extinct?’ which shows that they will not become obsolete, at least not as quickly as some may think.
For those who were unable to attend her presentation, a summary has been made:
The research focused on three key questions: 1) how different structures affect fund payoffs, 2) how investors should choose between ETFs and mutual funds, and 3) the impact on a fund’s vulnerability to early redemptions, particularly during economic stress. Helmke argued “when investors face heterogeneous liquidity needs, index ETFs and mutual funds can co-exist because they provide investors with different liquidity provision services. Index mutual funds may provide investors with higher payoffs when they have to liquidate at short notice. On the other hand, […] ETFs provide investors with higher long-term payoffs and feature reverse run risks by incentivizing investors to remain invested when everybody else is selling.”
“If we had perfectly liquid markets, these two structures would give us exactly the same result, meaning they would give investors exactly the same payoff. However, some markets are imperfectly liquid.” The model presented relies on a diamond-Divik-style portfolio choice framework where investors, categorized as patient or impatient based on their liquidity needs, decide between ETFs and mutual funds. It highlights that mutual funds may lag in adapting to flow-induced transaction costs, making their net asset values less responsive to market conditions, while ETFs benefit from arbitrage, which may create short-term price volatility. In that essence “impatient investors will liquidate their portfolios, but the patient investors, they have a choice between liquidating early or choosing to remain invested until the terminal period. And then in the terminal period, all index and fund payoffs are realized.”
Over the long term, “ETF price will eventually converge back to the index price”, making their payoffs independent of past fund flows. “On the other side, the mutual fund payoff, by definition, is always equal to the fund net asset value (NAV)”, and are influenced by past flows, creating a potential long-term externality that can be costly for remaining investors. This externality arises from factors like NAV staleness and large redemptions during market stress. Helmke adds that “when markets are liquid at the aggregate as well as the index level, then over the short term, think about on the daily basis in periods of market stress, the mutual fund will provide investors the higher payoff than the same index ETF.”
In terms of portfolio choice, rational investors decide between ETFs and mutual funds based on their liquidity needs, represented by the probability of having to liquidate shares early. Investors compare the expected payoffs from each option, balancing the short-term price impact and mispricing of ETFs with the long-term externality costs of mutual funds. This leads to a “cutoff equilibrium,” where those with high liquidity needs prefer mutual funds, while those with lower liquidity needs prefer ETFs. The fund structure impacts the expected payoff slope, influencing investor decisions.
Following equations and theory, Helmke provided some data. “In periods of market stress, like March 2020, the ETF trades at a substantial discount relative to the NAV. You should remember that these are index funds, so the average fees on these funds are three, four basis points. Therefore, an average mispricing of 1.5 percentage point can be quite large and costly for investors who have to liquidate at short notice. This is especially true in less liquid market classes, such as international equities”. She added further that “In the COVID episodes, mutual funds suffered from way more outflows than ETFs and over the long term […] the ETF tends to outperform the same index mutual fund.”
“I conclude with this quote from Franco Modigliani which says that there’s two properties that all assets have in common or share in different degrees which are liquidity and risk. And just because index ETFs and mutual funds share the same type of fundamental risk, they hold the same fundamental index portfolio, many people usually treat them as equivalent. However, in this paper, I argue that ETFs and mutual funds differ quite substantially on the liquidity dimension. So you can think of ETFs as a market-based index investing technology that comes with the same frictions that market prices are associated with. In contrast, mutual funds can be considered more like a bank-side intermediary-based solution. So just because it’s easy to trade ETS intraday on exchange doesn’t mean that they will always provide investors with the highest payoff at short notice.“
View the research in full via : https://www.inquire-europe.org/event/autumn-seminar-2024-valancia-spain/