New research on index investing recommends the inclusion of ETFs in retirement accounts as an alternative investment option to open-end mutual funds.
Until recently, both ETFs and mutual funds controlled roughly equal shares of the over $9 trillion index fund market. Mutual funds have existed for much longer than ETFs, but in 2023, ETFs caught up with mutual funds and now dominate the U.S. index fund market, Helmke said recently on the Wharton Business Daily radio show on SiriusXM. “ETFs have attracted, on average, more than 60% of the new capital flows into index funds. Based on the flows, it seems like ETFs are becoming the preferred option for investors in the passive investing space.”
Helmke’s study was centered on differences in the payoffs offered by same-index ETFs and mutual funds to their investors. It challenges the notion that ETFs are strictly better for investors with short-term liquidity needs just because they are traded intraday on exchange. In her blog, she set out the context for her study: Both ETFs and mutual funds are built on the concept of passive investing in a diversified index of securities. Both funds perform liquidity transformation, hold identical portfolios, and charge similar fees on an asset-weighted basis. The key difference between the two is that ETFs are traded on stock exchanges at the prevailing price, and mutual funds are bought or redeemed on the basis of their net asset values (NAVs) at the end of a trading day.
Patience Pays in Index Investing
Helmke showed in her study that ETFs holding relatively less liquid securities can provide investors with lower short-term payoffs compared to mutual funds anchored on the same index. Less liquid securities generally include those composed of corporate bonds or international equities, for which the liquidity mismatch between the index portfolio and fund shares is large. Yet, in times of market stress and heightened volatility, even liquidity in highly traded segments like large cap domestic equities can temporarily dry up, leading the corresponding index ETF to trade at a discount relative to its NAV. ETF investors who are forced to sell their units at short notice during these stress episodes will experience lower payoffs than those who have invested in mutual funds. Index mutual funds’ guaranteed redemption at the NAV provides investors with short-term liquidity insurance.
Conversely, Helmke’s study found that ETFs may be better for long-term investors who are patient and who can flexibly time their liquidation. “If you have your portfolio invested for the long term and you don’t care about which specific day you want to liquidate your fund holdings, then you may be better off with ETFs because over the long term, ETFs outperform identical mutual funds quite significantly,” she said. Whereas mutual funds’ redemption at NAV can encourage short-term redemptions, potentially even culminating in fund runs, the market-based pricing mechanism of ETFs discourages run-like behavior by investors.
As a result, ETFs may be better suited for less liquid market segments. “In super liquid market segments — think about the S&P 500 or equivalent — my research suggests that ETFs and mutual funds can coexist because they’re virtually identical from a liquidity provision perspective,” Helmke said.
ETFs vs. Mutual Funds: Modeling Outcomes
Helmke made her case with a model where rational investors, each facing a different probability of needing to sell fund shares prematurely, allocate their wealth between an ETF and a mutual fund that tracks the same benchmark index.
She arrived at three theoretical findings: One, ETF investors can experience lower returns when they have to sell at short notice during periods of market stress because of the faster price discovery and mispricing risk in ETF shares. For instance, during the COVID-19 market sell-off in March 2020, U.S.-based index ETFs traded at an average discount of 32.5 basis points, she noted.
In contrast, mutual fund investors receive short-term liquidity insurance through the guaranteed redemption at the fund NAV. But on the flip side, the staleness in mutual fund NAVs over the short term implies that investors who do not redeem and remain invested for years could end up with lower payoffs. “Outflows from ETFs only have temporary effects on investors’ payoffs, whereas mutual fund flows can have persistent effects on investors’ payoffs,” she wrote in her blog.
Her second finding was that ETFs’ market-based pricing mechanism gives rise to “reverse run” incentives. When more investors want to sell ETFs than buy, ETF prices drop, she stated. This encourages shareholders to remain invested or even buy additional ETF shares. Such a scenario may especially materialize when banks acting as liquidity providers in the ETF markets face balance sheet constraints.
In her third finding, Helmke showed that investors who have flexibility in their redemptions should prefer ETFs over mutual funds. Such investors who are not in any hurry should not be worried about short-term ETF discounts. On the other hand, investors with urgent liquidity needs, such as those who allocate a part of their portfolio to manage short-term cash needs, are better served by investing in open-end mutual funds.
Pointers for Regulators
Helmke highlights the implications of her findings for investors, regulatory authorities, and asset managers. Below are her main recommendations:
ETFs must be included as an investment option in index fund selection for retirement funds. ETFs could be an alternative to open-end mutual funds for retirement account holders who are interested in investing in less illiquid market segments during their wealth accumulation phase. With ETFs, they can avoid a scenario where they subsidize premature redemptions by other retirees and non-retirement account holders in periods of market illiquidity, she pointed out.
As a case in point, regulators could consider a novel design for “target-date” funds that weighs the benefits of mutual funds with that of ETFs. (Target-date funds currently focus on the margin of debt versus equity.) “As an investor ages and becomes more exposed to short-term liquidity shocks, her portfolio should drift from ETFs to mutual funds, everything else equal,” she wrote in her blog.
Regulators must be aware of investor trade-offs between ETFs and mutual funds when they design fund liquidity management tools. Swing pricing is one potential tool to reduce the risk of runs in open-end mutual funds. Swing pricing is a mechanism that adjusts the NAVs of mutual funds to account for flow-induced transaction costs, thereby protecting the interests of the shareholders who continue to stay invested in the funds at times when others are selling. The Securities and Exchange Commission in November 2022 proposed to make swing pricing mandatory for most U.S.-based open-end mutual funds, sparking vehement criticism from both asset managers and politicians, Helmke noted. Some reports suggested that the SEC may drop that proposal. Her paper provides a new angle on the debate. “My results imply that swing pricing may help mutual funds because it restores their capacity in providing long-term liquidity compared to same-index ETFs,” she added.
Regulators should avoid endorsing Vanguard-style multi-share class structures, where ETF and mutual fund share classes coexist within a single fund portfolio, especially when the underlying index consists of less liquid securities. This arrangement tends to favor mutual fund shareholders at the expense of ETF investors.
