The mutual fund wrapper is on its last legs, as many will become exchange-traded funds (ETFs), according to Hector McNeil, co-chief executive officer and founder of HANetf.
In the UK, ETFs are mostly associated with passive investments, but they can be actively managed too, he explained. That’s something US investors will be more familiar with than those on this side of the pond, as two-thirds of all the new ETFs coming to the US market over the past two years have been active strategies.
“People often conflate ETFs and passives and talk about them interchangeably, but ‘ETF’ is just the wrapper,” McNeil said.
“With mutual funds and ETFs, it's like mobile phones versus landlines: it's the same technology, but more advanced. There's a technology move going on”.
And the changes this will bring about will be as revolutionary as those caused by the smartphone.
“Managers of mutual funds are like the dinosaurs, looking in the sky and seeing a little black spot and saying: 'No, that's nothing to worry about'. And as it comes closer, they see it has 'ETF' written on it, just prior to it hitting them in the face.”
There are several advantages to the ETF model. Firstly, it makes sense from an e-commerce perspective, with investors being able to buy ETFs on an exchange and trade them in a more straightforward manner from their favourite platforms.
“My son is going to want to do everything on his mobile phone, he's not going to wait a week to get a statement back from a mutual fund provider,” McNeil said.
“And it also will seem very strange to him that funds don’t have a price. You wouldn't go into a car garage and say ‘I really like that red car over there, how much is it?’ and the person says: ‘You got to buy it first, and then I'll tell you afterwards’. You just wouldn't in any other world.”
There's a good tax reason as well for why active ETFs will do very well in Europe, according to McNeil.
“A UCITS ETF in Ireland only pays 15% withholding tax on US equities, whereas a UCITS mutual fund will pay 30% withholding tax,” he explained.
This means that for everyone investing with an active fund in US equities (and US equities make up about 50% of most portfolios) and those equities are yielding 3%, there’s a 45 basis points yield loss generated by the difference in the withholding tax treatment of the mutual fund versus the ETF.
“When people start to realize that there's an actual tax advantage to the way you hold US equities between the different wrappers, they’ll switch around. Tax is one of the main reasons why people have switched from mutual funds to ETFs in the US,” said McNeil.
The fact that ETFs tend to be cheaper and the perception that they are more transparent and more liquid will also accelerate the trend.
This revolution also resonates with the distributors, who can expand their client base and offer their products more easily across geographies.
“People like my mum could buy one share in an ETF but it'd be very difficult for a lot of mutual funds to manage a much broader investor base. Distributors can also acquire a pan-European footprint quite easily, as it's a lot easier than setting up different offices in different areas,” said McNeil.
“So it's all coming together at the same time to grow the market. Today it accounts for more than $10trn, but Bank of America estimated that by 2035 it will be $50trn, so that’s a massive growth.”
All of this is already happening, especially in the US but also in Europe. In April 2023, HSBC Asset Management converted four global bond index funds (amounting to $6bn of assets under management) into ETF form, and moves such as this will become even more popular.
“Everybody was really surprised because HSBC is usually quite sleepy and they were the first in Europe. That's been a big deal and waking everybody up,” said McNeil.
This doesn’t mean mutual funds will die off, however.
“Legacy assets take a long time to move and people are slow to change habits too, so there’ll be a few mutual funds with a lot of legacy money for a long time, but eventually, they will convert. On the other hand, new money tends to move quicker, because it isn't capital gains taxed or hasn’t got any legacy issues keeping the money there.
“Over time, all new products will be ETFs, but that’s not going to happen overnight. I'll be well out of the industry by then, but certainly that's the direction of travel,” he concluded.