The following is an excerpt from the article “Turning Fund Distribution on Its Head” by Scott Burns and Paul Justice of Morningstar. Read the full article here.
The arguments over which is the better vehicle, ETFs or mutual funds, usually get bogged down in quarrels about active versus passive (which is a different debate), investor behavior, and product proliferation. All of these diversions miss the point. What we are really debating is technology. Both vehicles are technologies for gathering a broad group of investors together to combine assets under a single manager. One is Depression-era technology, however, and the other is digital-age technology.
Mutual funds are often referred to as 1940 Act funds, referring to not only the securities act that created them, but also the time period in which they were created. In 1940, the mutual fund was cutting-edge technology. Can you imagine being an asset manager in 1940 and being told that you had to price your fund and clear all trades at the end of the day, each and every day? Remember, this was a paper-trading world where trades were done on the floor of the stock exchange by people flashing funny hand signals at each other. On top of that, you had to communicate your portfolio holdings to all of your investors quarterly in public filings and mail annual reports!
In 1940, these changes were massive and onerous to fund companies, but they allowed for the creation of the $9 trillion mutual fund industry that we see today. But it isn’t 1940 anymore; it is 2011, and the technology has made what was probably considered impossible in 1940 laughable today in terms of its capabilities.
Enter the digital age’s answer to gather assets communally: ETFs. Why, in today’s computerized environment, do investors need to wait until the end of the day to know what price they purchased their fund at? Would you buy a car that way? Would you go to the dealer at 10 a.m. and say, “I want to buy that station wagon,” only to have the salesman tell you that you should give him $16,000 now, come back at 3 p.m., and then after everyone else has bought their car, he’ll tell you how much car you bought? Of course not, but that is how mutual fund technology works.
ETFs are investment vehicles for the digital era. Daily liquidity is possible because the trading technology has made it possible. Tax efficiency is improved with the injection of a secondary market in addition to a primary one. Daily disclosure is not only required but also feasible with low-cost distribution on the Internet. In 1940, you couldn’t have disseminated daily holdings if you wanted to. But most important, the digital technology is cheaper.
