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 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.
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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.)
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