By David Randall and Jessica Toonkel
NEW YORK (Reuters) – If you can’t beat them, buy them.
That’s the theory underlying a move by a growing number of mutual fund managers at companies including T. Rowe Price and Eaton Vance to slip shares of indexed exchange traded funds into their actively managed fund portfolios.
Over the last five years – a period in which active fund managers have both underperformed and lost market share to ETFs – the number of actively-managed equity funds that hold ETFs in their top-10 holdings has jumped 174 percent, to a total of 148, according to Lipper data. In the past year, the number of active equity funds with ETFs as a top-10 holding has risen more than 23 percent, to 120, according to Lipper.
Fund managers say that they are turning to low cost ETFs as a way to mitigate the effects of so-called cash drag – the underperformance that comes from the 3 percent to 5 percent of assets that a manager typically holds in cash to meet investor redemptions. One study in the Journal of Financial Management published in 2006, for instance, found that cash holdings cut the performance of the average equity fund by 0.70 percent a year.
Putting money into ETFs rather than having it sit in cash is a “cheap and efficient way to gain exposure to the equity market and it helps us avoid cash drag,” said Chris Sunderland, an institutional portfolio manager with the $69 million Eaton Vance Hexavest U.S. Equity Fund, which had the SPDR S&P 500 ETF as its second-largest holding at the end of March, according to Lipper data. The fund charges investors 1.4 percent annually, compared with the 0.09 percent levied by the SPDR ETF.
While ETFs are not as liquid as cash, they are often more liquid than individual securities.
Still, a fund that holds an ETF within its top holdings which tracks its benchmark will have a harder time outperforming that benchmark over time, raising the question as to why investors should buy a managed fund instead of a cheaper passive fund.
The William Blair Small Cap Growth fund, for example, has outperformed all but 13 percent of its peers despite holding an iShares ETF that tracks the benchmark Russell 2000 index as its top holding in its most recent portfolio. The position allows the fund a liquid way to stay invested without sacrificing performance, said co-manager Michael Balkin.
And though opting for ETFs instead of cash may help make fund manager’s performance numbers rise in line with the index in an up market, investors may not always benefit, fund experts say. For example, a fund that invests its reserves in ETFs rather than cash may be setting itself up for losses should the market have a sudden reversal.
“If you are fully invested and the market falls, then you are going to fall with it,” said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ.
To be sure, some active fund managers only hold the ETFs for short periods of times – sometimes weeks – and executives said that owning ETFs was not a core part of their strategies. For example, Eaton Vance keeps ownership of ETFs to less than 5 percent of the fund.
NEW CASH STRATEGY
The inclusion of passive ETFs into stockpicking funds as an alternative to cash comes as active managers are increasingly under pressure to beat their benchmarks and justify their higher fees.
Just one in five mutual fund managers outperformed their respective benchmarks last year, the worst performance in more than a decade, extending a seven-year skid in which stockpickers have not beat passive funds by a significant margin. Over the same time, index funds and ETFs have brought in more than $450 billion in investor assets, while those run by stockpickers have lost more than $430 billion, according to Lipper data.
The types of funds that are turning to ETFs range from international small cap funds to gold funds to mid-cap growth funds, according to Lipper.
The T. Rowe Price Institutional Frontier Markets Equity Fund and the T. Rowe Price International Concentrated Equity Fund both had ETFs as top 10 holdings at the end of last year.
Both funds, which are less than a year old, temporarily use ETFs when they cannot invest inflows, either due to stringent foreign ownership rules in some countries or if international markets are closed, a spokeswoman said.
As of March 31, the T. Rowe International Concentrated Equity Fund did not own any ETFs and the Institutional Frontier Markets Equity Fund held less than 1 percent in the Market Vectors Vietnam ETF, down from over four percent, in December.
Not all of these funds are turning to ETFs for cash reasons alone. Passive ETFs – which can cost as little as 0.06 percent of assets, compared with the 1.2 percent charged by the typical actively-managed mutual fund – can allow fund managers low-cost access to expensive foreign markets when they cannot buy local shares directly.
The Causeway International Small Cap fund, for instance, has an Indian small-cap ETF as its largest holding because regulatory issues prevent it from holding Indian shares in a local account, said Arjun Jayaraman, the fund’s portfolio manager.
For the funds that do use ETFs to avoid cash drag, the benefits are mixed. The Toreador Core fund, for instance, has bested 97 percent of its peers over the last three years, a period in which it has often held an S&P 500 ETF within its top 10 holdings. Its strategy of opting for an ETF to manage its cash flows “has been helpful at a time when the market has been up,” said Paul Blinn, one of the fund’s co-managers.
(Reporting by David Randall and Jessica Toonkel; editing by Linda Stern and John Pickering.)