Why mutual funds invest in ETFs

When someone mentions mutual funds and ETFs in the same sentence, there’s a good chance he or she’s pitting one against the other. But, these vehicles can go together quite well.

Some manufacturers offer mutual funds that invest exclusively in ETFs. These are meant for people who want ETF exposure but don’t have the skill to DIY, or enough money to get into a fee-only advisor’s book. Kevin Gopaul, CIO at BMO Global Asset Management, notes the majority of mutual funds holding ETFs do so in this fashion. However, active managers are, increasingly, using ETFs to complement their stock- or bond-picking strategies. “One of our largest mutual funds,” says Gopaul, “now has a tactical position of about 11% in ETFs.”

Read: How to answer common fee questions

Here’s when, and why, it makes sense for mutual funds to use ETFs.

1. Sitting on cash

Sometimes managers have more money than they know what to do with. Investor inflows or proceeds from selling fund holdings can mean larger cash positions than desired. And it isn’t always easy to spend money.

“As a manager’s assessing the marketplace and looking for new ideas, she doesn’t want to plunk that money into securities on which she hasn’t done sufficient due diligence,” notes Michael Cooke, head of distribution at PowerShares Canada. “She wants to be invested, but wants to take her time with a more measured approach. Sometimes she might use an ETF to have market exposure, as she’s looking for other good ideas to populate the portfolio.”

Usually referred to as cash equitization, this is probably the most common use of ETFs in mutual funds. Howard Atkinson, president of Horizons ETFs, notes that years ago, fund managers would often unload their ETFs before quarterly reporting “so it wouldn’t show that they had held an ETF.” But this practice isn’t as common today, he adds. “You’ll see funds now holding ETFs through quarter-end and year-end.”

2. Faraway places

Another reason managers use ETFs is to get efficient access to global markets.

“Not every manager may have the in-house investment capabilities or the trading and settlement capabilities to trade in these systems. There’s a lot of infrastructure around going into different marketplaces,” says Gopaul. “So, instead of creating an entire portfolio management capability around buying Europe and Japan, for example, they’ll buy the ETF to get quick exposure.”

Read: How often should you rebalance?

Adds Cooke: “If you’re looking at emerging markets, you might own securities in 20 countries. You have to have custodial accounts in all those countries, and you’re investing in different currencies. It can become quite onerous and expensive to invest directly in these securities. From a trading standpoint, it’s more efficient to use the ETF.”

3. Easy access

In some cases, an ETF is more liquid than its underlying basket. This is especially true with bonds.

“There’s less price transparency and there’s no centralized exchange through which fixed income instruments trade,” Cooke explains. “As a result, it can be quite mechanical and clumsy to trade individual bonds, even for a large institution.”

And fund managers can more easily access ETFs on the secondary market. The ETF provider isn’t creating new units; the manager’s buying existing units from someone who wants to unload them.

Read: Canada’s ETF industry booming

4. Smaller stocks

ETFs can also make it easier to build a mutual fund that includes mid- and small-cap stocks. Cooke notes one of his low-volatility funds uses this approach. It screens the S&P/TSX Composite Index for the least volatile names. That means lots of blue chips, but stocks with lower market caps get in as well. Some of these smaller companies aren’t as liquid as large caps.

“They’re held by fewer investors and generally trade less volume. Institutional market makers can source and trade these stocks in larger quantities and with lower trading costs.”

5. Growing pains

The main reason clients buy mutual funds is they don’t have enough investable assets to diversify with individual names. Mutual funds in their early stages can have a similar problem, notes Atkinson.

“They want to diversify, but they don’t have enough AUM to do it on an individual securities basis. [So] they get their diversification through an ETF.”

Read: Which ETFs are hot?

6. Tactical shifts

Some clients want nimble funds that can capitalize on changing market conditions through regular tactical shifts. Cooke says ETF mutual funds are their best bet.

He illustrates with one of his fixed-income strategies. It has five main components: long-term Canadian government bonds, short-term Canadian investment-grade corporates, U.S. high-yield, emerging market debt, and real return bonds. “We have both strategic and tactical allocations to each. The manager decided to use ETFs instead of trying to buy individual securities, because they’re making tactical adjustments on a monthly basis.”

House funds only?

If you’re putting clients in funds that use ETFs, ask the manager about his selection process. In particular, ask if his firm also offers ETFs, or if he uses them exclusively. Is he free to buy from other manufacturers if there’s a better fit?

Kevin Gopaul, CIO at BMO Global Asset Management, notes plenty of managers from other firms come to BMO for ETF exposure. But, he says, BMO ETFs aren’t a shoo-in with BMO’s own mutual fund managers.

“Our ETF sales team treats our internal portfolio managers just as external clients. They’ll pitch them and say, ‘I noticed from annual filings that you have a competitor’s ETF in your portfolio. We just launched a new product, here’s how you can use it.’ ” Managers are free to accept or reject these pitches.

“Sometimes the competitor may have some differentiating features in its product that the manager wants,” adds Gopaul. He says the choice should be based on what the manager’s trying to accomplish, rather than who’s offering the product.