ETFs in Mutual Funds: a Raw Deal?

Ian Salisbury at SmartMoney raises an interesting point:

The whole point of actively run funds, their proponents say, is that a living, breathing fund manager has a better chance of sussing out great investment opportunities than an exchange-traded fund, which just blindly tracks an index. Indeed, that's one of the reasons actively managed funds have higher fees than ETFs -- to pay for all that expert guidance.

So it might come as a shock to some investors that the top holdings of several major stock mutual funds are actually ETFs.

One of the reasons why ETFs have become so popular in recent years is their lower costs relative to many mutual funds. But ETFs do have fees, so a mutual fund holding an ETF would be effectively layering additional fees on whatever amount of their portfolio invested in ETFs. This would be similar to fund-of-fund hedge funds, which accrue fees on both the fund itself and each of its fund holdings. SmartMoney has covered this issue before, and note that "if a mutual fund holds a big stake in an ETF, an investor can just buy the same ETF...and sell the fund."

Cory Banks at IndexUniverse takes a different angle by arguing that sometimes mutual fund managers need a place to temporarily park cash, and therefore need quick access to low-cost index tracking investments such as ETFs. Therefore it might not always be the case that ETFs in a mutual fund are always a bad deal:

Mutual funds have to equitize cash, either from inflows or dividends, or just because they sell something and don't see anything in the market they want to buy. They used to buy futures, where margins could climb sky high; now they use ETFs. It allows them to get quick, cheap exposure to the market.

You put the money to work in an index product, and then when you get a better idea, you buy some stocks and sell off that index position. It's the best way to handle "cash management."

And here's the dirty secret: everyone does it. In fact, you'll notice it frequently happens around the last day of the quarter, depending on what inflows, outflows and dividends different mutual funds receive.

Banks does concede that a mutual fund that holds only ETFs would be "a pretty blatant rip-off." We would agree that such a fund would likely be rip-off especially if the holdings of that fund remain relatively constant over time. In such a case, it would almost always be cheaper for the investor to simply replicate the portfolio of the mutual fund using the underlying ETFs themselves.