Todd Rosenbluth is directorof ETF and mutual fund research at S&P Global Market Intelligence. The S&PGlobal Market Intelligence rankings for exchange-traded funds and mutual funds,available through MarketScope Advisor, are quantitatively-derived and based on performance,risks, costs and a qualitative analysis of the underlying holdings. For importantregulatory information, please click here.
Changes in the standards to which financial advisers must adherewill likely support an ongoing trend of adoption for lower-cost passive mutual fundsand exchange traded funds, according to S&P Global Market Intelligence.
According to data from Morningstar, passive long-term funds gathered$413 billion of fresh money in 2015, while active ones bled $207 billion of assets.The gap between active products ($9.4 trillion) and passive products ($4.5 trillion)will likely further contract following implementation of a new Department of Laborrule, according to S&P Global Market Intelligence.
Under the Department of Labor's fiduciary rule, financial advisersproviding investment advice for retirement accounts will now be subject to a fiduciarystandard rather than the suitability standard. Previously, an adviser needed tohave a reasonable basis to believe that a recommended transaction is suitable forthe customer. Now, the adviser and their company are required to act with the careand diligence that a prudent person would exercise based on the current circumstances.
While the rule applies to retirement investments, we think firmscould treat all investment accounts similarly rather than provide different servicefor an IRA and a traditional account. Therefore, there are implications for allfunds used by an adviser, particularly those that do not look favorable from a performanceor cost perspective.
The average net expense ratio for large-cap core mutual fundsis 1.1%, according to data from Thomson Reuters Lipper, which is much higher thanthe 0.05% for Vanguard 500 Index Fund (VFIAX). But 225 of these share classes (27%of the large-cap core universe) have an expense ratio higher than 1.35%, makingthem expensive in our opinion.
During the five-year period ended April 5, the large-cap corepeer group (which primarily includes active, not passive, mutual funds) generatedan average annualized total return of 9.4%. This is much lower than the 11.3% gainfor the passively managed VFIAX. Moreover, 80 of the "expensive" fundswere in the bottom quartile during this period. High-cost mutual funds with poorperformance records will be harder for a financial adviser to justify, in our opinion.
In many cases, these funds have either an A share class, whichcomes with a 5.0% or higher front-end sales load, or a C share class, which comeswith a 1.0% sales charge on an annual basis until they are converted into A shareclasses after a few years.
Examples of these funds with more than $500 million in assetsinclude Davis New York Venture Fund C share class (NYVCX), Oppenheimer Rising DividendsC share class (OCRDX), and Virtus Equity Trend A share class (VAPAX).
In the past, from an adviser perspective, the appeal of thesefunds stemmed in part from their commission structure. However, the fiduciary standardcould cause more advisers to shift to a fee-based business model from one that chargedclients based on trading activity.
As advisers shift to a fee-based approach to building clientportfolios, there are more low-cost choices to consider across various investmentstyles. For example, according to S&P Global Market Intelligence research, thereare 14 mid-cap core ETFs, offered by 10 asset managers. IShares Core S&P Mid-CapETF (IJH), Schwab US Mid-Cap (SCHM) and Vanguard Mid-Cap ETF (VO) all have an expenseratio of 0.12% or lower.
Yet the sector exposure provided by these ETFs varies, whichwe think warrants additional due diligence in order for an adviser to understandwhat's inside. For example, at the end of February, consumer discretionary stockswere 19% of VO's assets, but 15% of SCHM's and 14% of IJH's.
S&P Global Market Intelligence has research and rankingson approximately 1,100 ETFs and 22,000 mutual fund share classes. Reports are availableon MarketScope Advisor and other client platforms.