At long last the fund rating company, Morningstar, has decided to put mutual funds and exchange traded funds (ETFs) on a level playing field when it comes to fund ratings and comparisons1. Beginning on November 30, 2016, Morningstar did away with segregated categories for mutual funds and ETFs and merged both types of open-ended investment vehicles into all-encompassing categories. This change is rooted in migrating investor preferences as assets flow into ETFs at the expense of often-times poorer performing, higher cost, and tax-inefficient actively managed mutual funds. Indeed, according to the Investment Company Institute, ETF assets have grown more than seven-fold since 2006 while mutual fund assets have grown less than two-fold over the same period.

Source: FactSet. As of 9/30/2016.

So, what does all this mean for financial advisors and why is it important?

As fiduciaries, financial advisors have the burden and responsibility to allocate client funds in a way that suits clients’ best interests. Morningstar’s tearing down of the wall that once divided mutual funds and ETFs means that no longer can the legal structure of an investment product be reason enough to segregate analysis of the two vehicles. Instead, the benefits and features of the investment – the historical performance, fees, transparency, tax consequences, capacity constraints, etc. – must now be considered for all open-ended vehicles equally, regardless of the legal wrapper under which the product operates. Once the differences between mutual funds and ETFs are brought into the spotlight, suitability analysis may squarely favor ETFs over mutual funds in many cases.

1Morningstar announced in a letter to clients effective November 30, 2016 it will combine ETFs and open- end mutual funds into a single peer group. Read Morningstar’s FAQ.

How ETFs and Mutual Funds Contribute to Performance Outcomes

Let’s begin by isolating the distinctive characteristics of the various types of ETFs and mutual funds to equip fiduciaries to determine which types of vehicles most adequately serve the client’s best interest in the context of asset allocation. In our analysis, the change in the fund rating environment may help shine a spotlight on preferable elements of ETFs, making clear that in some cases an ETF could suit a client’s best interest more appropriately than a mutual fund.

The below table summarizes some of the key features associated with the most widely used classes of equity mutual funds and ETFs. The unique characteristics of each class of fund define its most appropriate place in the asset allocation. In general, equity funds that are tax-efficient, have low-to-medium fees, are not capacity constrained, and are diversified may be best used as core allocations. Conversely, equity funds that are tax inefficient, have medium-to-high fees, are capacity constrained, or are undiversified may be best used as satellite allocations due to possessing one or several deficiencies, or niche exposures. Furthermore, the performance goal of the fund classes should be considered, as well as whether or not that particular vehicle is operating in a way that allows it to achieve its goal. For example, if a fund class is alpha-seeking (it seeks to outperform the market on a risk-adjusted basis), it should also have high active share (a measure of how different a portfolio is relative to its benchmark), since high active share is a prerequisite to outperformance.1

Source: Gavekal Capital. These are the opinions of Gavekal Capital. See disclosures for further information on differences between ETFs and mutual funds.

1Martjin Cremers and Antti Petajisto, “How Active is Your Fund Manager?” March 31, 2009.