Is The Greater Use of ETFs in Mutual Funds Positive?

by: Richard Kang

State Street Global Advisors yesterday declared that the SEC has given all its ETFs exemptive relief from constraints imposed under the Investment Company Act of 1940, thus allowing mutual funds greater flexibility in terms of holding these ETFs. Without this allowance, mutual funds are governed by the Act's various fixed restrictions, specifically the following limits listed in Section 12[d][1][A]:

· A fund can not hold more than 3% of the total outstanding voting shares of another investment company

· A fund can not invest more than 5% of its total assets in a single investment company

· A fund can not invest more than 10% of its total assets in two or more investment companies

For those whose interests lean toward self-torment, they may wish to peruse the full text of the Act.

Although the exemptive relief allows for the above constraints to be surpassed, the order does specify certain terms and conditions specific to investments made in ETFs. This type of exemptive relief is nothing new as SSGA had a similar order for its SPDR (NYSEARCA:SPY) and DIAMONDS (NYSEARCA:DIA) ETFs from the SEC in May 2004.

Despite this, I question if the exemptive relief is a good thing. On the one hand, if the growth of ETFs [in terms of numbers and asset size] is due to their general acceptance by the ordinary investor as well as institutions, why shouldn't mutual funds be allowed to hold them in significant amounts?

However, I wonder for what purpose mutual funds would want to have significant ETF holdings, or at least so much so that this exemptive order from the SEC was required. This is not an issue for index mutual funds as they can position their portfolio in a highly cost effective manner through derivatives and direct security positions. The issue is then with active managers: Why would they want to hold significant ETF holdings? Perhaps they are global tactical asset allocators who hold positions in various asset classes and see ETFs as the most effective means to implement truly tactical decision. That's a good example.

What I fear is the potential other case where ETFs are simply used to gain broad market exposures instead of the manager implementing security selection decisions which is the norm in traditional mutual funds. As an ETF user myself [and for our clients' portfolios], I understand the appeal of ETFs. But if actively managed mutual funds hold significant ETF positions, does this dilute the active role of the manager? I suppose it all depends on what the mandate of the manager is, but if there is "dilution", what value is the manager providing relative to the fees charged.

Bottom line:
The generally accepted flaw of mutual funds is that so many of them provide nothing more than index-like returns. Depending on what the new increased allowance for ETF holdings will do to the mutual fund industry in aggregate, the phenomenon of "closet indexing" could become worse. On the other hand, if mutual funds take a more tactical approach to the use of ETFs, including the use of shorting, then we could see the increasing blurred/merged world of mutual funds and hedge funds. We are already seeing investment companies who are involved in the management of both types of funds and this has brought forth concerns regarding conflicts that benefit HF investors to the detriment of MF investors.

Again, I bring up the focus on the two poles of the portfolio spectrum [ETFs and hedge funds] and how the investment industry is now going through a incredible period of change.