June 2020 IssueLong scroll reading

The Mice that Roared: How Two Small Funds Threaten to Disrupt Two Large Industries

By David Snowball

On May 15, 2020, an unassuming filing with revolutionary potential appeared in the Securities and Exchange Commission’s EDGAR database. It was an N-1A, initial prospectus, filing for two ETFs: SmartETFs Dividend Builder ETF and SmartETFs Asia Pacific Dividend Builder ETF. Both unremarkably offered “to provide investors with dividend income and long-term capital growth.”

The real news appeared on page 9 of the document:

The SmartETFs Asia Pacific Dividend Builder ETF will adopt the performance history of its predecessor fund, the Guinness Atkinson Asia Pacific Dividend Builder Fund.

And on page 18:

At that time, SmartETFs Dividend Builder ETF will adopt the performance history of its predecessor Fund, the Guinness Atkinson Dividend Builder Fund.

And though they didn’t know it yet, two trillion-dollar industries – mutual funds and ETFs – were shaken.

Assuming final SEC approval, this will be the first instance in which a current mutual fund seamlessly transforms into an ETF, bringing along its asset base, long-term record, Morningstar (and MFO) ratings, and analyst coverage. Conversions of hedge funds into mutual funds are common, and conversions to or from the world of closed-end funds are rare but not unprecedented.

Allowing a mutual fund to become an ETF is unprecedented. And, potentially, very good, very disruptive news.

The packaging of professional money management services for the common investor has a series of milestones:

1893: closed-end funds, which trade on secondary exchanges like stocks, launch

1928: the first open-end mutual funds, including the first no-load Scudder fund, launch. Those first launches included the Massachusetts Investors Trust and Wellington Fund. By 1929, there were 19 open-end funds and 700 CEFs.

1940: the Investment Company Act of 1940 sets in place the regulations that still form the basis of the industry’s rules. For that reason, cognoscenti sometimes refer to “’40 Act funds.”

1993: launch of the first exchange-traded fund, State Street’s S&P 500 Trust ETF. Originally all ETFs shared three characteristics: they were passive, they could be bought and sold minute-by-minute with “fresh” prices, and their portfolios were fully transparent. That transparency was critical since you want to be sure that the amount you paid for a share of an ETF was exactly the same as the value of the securities in the portfolio.

2008: launch of the first actively-managed ETF, Bear Stearns Current Yield ETF (YYY). A very philosophical ticker symbol. The fund sought “as high a level of current income as is consistent with the preservation of capital and liquidity,” which is to say that it was a sort of high-yield money market fund. Still fully transparent, but actively managed.

2020, April: the first non-transparent, actively-managed ETFs launch, the American Century Focused Dynamic Growth ETF (FDG) and American Century Focused Large Cap Value ETF (FLV). While both of the ETFs were brand new, FDG was a near-clone of an existing fund that continues to operate: the five-star $400 million American Century Focused Dynamic Growth Fund (ACFOX).

2020, July: the first direct conversion of mutual funds into transparent, actively-managed ETFs occurs.

For whom is that good news?

The shareholders of Guinness Atkinson Dividend Builder Fund (GAINX) and Guinness Atkinson Asia Pacific Dividend Builders Fund (GAADX) are the first and surest winners. ETFs have four advantages, three of which are structural, over mutual funds:

  1. They have structurally lower costs. Mutual funds are subject to several sets of expenses, such as state registrations and “stocking fees” at brokerages such as Schwab, that ETFs don’t have to bear. That allows an adviser to offer the exact same services for less in an ETF wrapper than in a fund wrapper.
  2. They allow investors to control the timing of capital gains taxation. Most mutual funds generate tax bills annually because accrued capital gains from portfolio trading have to be distributed in the year in which they’re accrued. As a result, investors pay capital gains even in years where they fund lost money and they did not sell any fund shares. With ETFs, the capital gains bill comes due when the shares are sold.
  3. They might be marginally more tax efficient. One source of portfolio churn, hence taxes, is forced selling to meet redemptions. There are a couple of structural features of ETFs that allow them to avoid generating taxable events.
  4. They have not been repeatedly defamed by self-interested marketers and lazy financial journalists looking for cheap stories. “80% of mutual funds failed to beat the market last year” is utterly fatuous – beating the market isn’t the goal, one year is an irrelevant time period, risk matters as much as returns, very nearly all passive products also trail the market – but has made it hard to approach investors, young, professional or otherwise. The term “skunked” comes to mind. The repackage offers a clean slate.

The owners of mutual fund boutiques are potentially the second set of winners if they choose to be. The excess structural costs of operating a mutual fund are largely fixed expenses; that is, a $20,000 fee is assessed whether you manage a million or a billion. As a result, reducing the structural costs that are unique to the mutual fund wrapper has the greatest impact on small funds. A $20,000 savings will have a far greater effect on the expense ratio of the $14 million Guinness Atkinson Dividend Builder than on the $814 million Eaton Vance Dividend Builder. In discussions last year, the president of Guinness Atkinson was estimating 60-80 bps savings. That’s roughly in line with the American Century experience, where the ETF version of Focused Dynamic Growth charges half what the mutual fund version does, 45 bps versus 85 bps (subsidized).

Similarly, the challenge of broad availability disproportionately impacts small funds. Platforms such as Schwab reportedly have a $100 million minimum for considering the inclusion of a fund on their platform, and then only for a substantial price. As a practical matter, the only way for a fund to reach $100 million is if they’re on the platform but, Catch-22 ho! they can’t get on the platform until …

That said, many of the owners of boutique firms are remarkably resistant to innovation. I’ve heard the phrase “well, that’s the way we do things here” rather more than “we need to look at things with fresh eyes and embrace change or this thing’s going to become a death spiral!”

To whom is the disruption coming?

Disruptee #1: The ETF industry, many of whose players are doomed anyway.

There’s an awful lot of unwarranted strutting about by “players” in that industry. Their general demeanor is “we’re ETFs and we’re the Kings of Creation.”

Nice story. Delusional, but still nice.

Two things to consider:

  1. the ETF industry is dominated by a handful of mutual fund companies.

    If we look at the 50 most successful ETF launches of the past three years, you notice some familiar names:

    American Century, BlackRock, Columbia, Invesco, Janus, JPMorgan, PIMCO, Schwab, State Street, Vanguard, USAA …

    When you take out offerings from traditional fund companies, you have eliminated 40 of the top 50 new ETFs.

    Those same firms offer all of the 100 largest ETFs. The first pure-play ETF issuer on the list might be … Morningstar? FlexShares Morningstar Global Upstream Natural Resources Index appears around #190 with $3.1 billion in assets. (USCF appears higher on the list with the USCF Oil ETF (USO) that suffered a 75% price collapse this year, has apparently been cut off by its broker from buying futures contracts, and is apparently under federal investigation for improper risk disclosure so I’m not quite sure of its status.)

  2. many independent ETFs linger at death’s door.

    About a thousand ETFs had been liquidated by the start of 2020, while others had been “creatively repurposed” so that one day’s Cloud Computing ETF is the next day’s Industrial Hemp Fund. The long-running ETF Deathwatch had 399 names on its list in March; 54 names had been removed in the month, nearly half of those through … well, death. Deathwatch tracks funds with under $25 million in assets and low trading volume. Academic studies put the … uh, deadline, at about $30 million in assets.

    Take a quick snapshot of the 655 ETFs launched in the last three years. Three hundred and sixty – 55% – are at or below the $30 million deadline with many other ETFs launched in the period already liquidated.

We reported last year on a series of news analyses that suggest that ETF marketers might be consciously gaming the system to generate a self-sustaining bandwagon effect. Take the case of one of the most explosive ETF launches ever … a JPMorgan Japan fund?

The Invesco QQQ Trust (QQQ) was the ETF to capture the largest inflows this week―$1.2 billion―but the week belonged to another fund, the JPMorgan BetaBuilders Japan ETF (BBJP). Inflows for BBJP totaled more than $1 billion during the period, which is remarkable considering the fund had less than $10 million in assets a little over a week ago. (‘BBJP’ 2nd-Fastest ETF To $1B Assets, 28 July 2018)

How can you explain a billion dollars swooping in over the course of a week? A carefully constructed bandwagon and, it seems, just one of many. Asjylyn Loder of The Wall Street Journal reports:

JPMorgan Chase & Co. launched an exchange-traded fund last June that invests in Japanese stocks. The fund raised $1.7 billion in six weeks, making it one of the fastest ETFs ever to surpass $1 billion in assets.

The biggest buyers: JPMorgan’s clients.

By buying JPMorgan’s ETFs on behalf of customers, JPMorgan’s private bank and wealth management divisions helped the JPMorgan BetaBuilders Japan reach $3.3 billion in assets by the end of the year.

It wasn’t an isolated case. JPMorgan’s ETFs raised $15.6 billion last year, most of it from JPMorgan affiliates … The tide of client money helped boost the New York bank from an ETF also-ran to the 10th largest ETF issuer. By the end of 2018, JPMorgan affiliates owned 53% of the firm’s ETF assets, and the bank was the top shareholder of 23 of its 31 ETFs.

JPMorgan isn’t the only ETF issuer that steers clients into in-house funds. Almost every issuer has repackaged some of their ETFs into other investment products … The practice has even earned its own nickname: BYOA, for “Bring Your Own Assets.” (JPMorgan ETFs Are a Hit, but With Its Own Clients, 11 March 2019 – with thanks to Ms. Loder for her excellent reporting)

That essentially corroborates the investigative work done by Elizabeth Kashner at ETF.com. In “Tough Times for New ETFs” (2/21/2019), she makes two interesting points: ETF liquidations are rising steadily and almost no new ETF launches lead to sustainable asset levels. In general, the only ETFs that make serious money are the ETFs that are used in the portfolios of other funds. Beyond that, for all the hype and pageantry, it looks like the market has peaked.

Deep, cleansing breath. Deep, cleansing breath. I am not picking on the ETF industry. I’m merely suggesting that things are not nearly as secure as the headlines portray.

500 mutual funds have under $100 million in assets but have earned four- and five-star ratings from Morningstar. If even a fraction of those funds transitioned to ETFs, bringing long, exceptional records, and suddenly low expenses, and improved tax efficiency, it would upset the ETF equation in a major way.

Disruptee #2: the mutual fund industry, many of whose players are doomed anyway.

Which is pretty obvious.

Bottom line: Nothing’s guaranteed. It might be that the SmartETF path is seen as too burdensome, or the simple pigheadedness prevails. There are surely marketing questions to be answered since many traditional firms still offer loaded funds or have comfortable existing relationships with advisors that they don’t want to disrupt.

That said, the SmartETF launch opens a pathway to relevance for hundreds of small, strong mutual funds … and a new challenge for many of their ETF peers.

Guinness Atkinson Dividend Builder embodies an entirely sensible strategy, well-executed and popular with European investors. We’ve profiled the fund in the past, and we’ll offer a Launch Alert with updated information as soon as the ETF goes live.

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About David Snowball

David Snowball, PhD (Massachusetts). Cofounder, lead writer. David is a Professor of Communication Studies at Augustana College, Rock Island, Illinois, a nationally-recognized college of the liberal arts and sciences, founded in 1860. For a quarter century, David competed in academic debate and coached college debate teams to over 1500 individual victories and 50 tournament championships. When he retired from that research-intensive endeavor, his interest turned to researching fund investing and fund communication strategies. He served as the closing moderator of Brill’s Mutual Funds Interactive (a Forbes “Best of the Web” site), was the Senior Fund Analyst at FundAlarm and author of over 120 fund profiles. David lives in Davenport, Iowa, and spends an amazing amount of time ferrying his son, Will, to baseball tryouts, baseball lessons, baseball practices, baseball games … and social gatherings with young ladies who seem unnervingly interested in him.