Morningstar Advisor - August/September 2011 - (Page 39)

technologies for gathering a broad group of investors together to combine assets under a single manager. One is Depression-era technology, however, and the other is digital-age technology. Mutual funds are often referred to as 1940 Act funds, referring to not only the securities act that created them, but also the time period in which they were created. In 1940, the mutual fund was cutting-edge technology. Can you imagine being an asset manager in 1940 and being told that you had to price your fund and clear all trades at the end of the day, each and every day? Remember, this was a paper-trading world where trades were done on the floor of the stock exchange by people flashing funny hand signals at each other. On top of that, you had to communicate your portfolio holdings to all of your investors quarterly in public filings and mail annual reports! In 1940, these changes were massive and onerous to fund companies, but they allowed for the creation of the $9 trillion mutual fund industry that we see today. But it isn’t 1940 anymore; it is 2011, and technology has made what was probably considered impossible in 1940 laughable today in terms of its capabilities. Enter the digital age’s answer to gathering assets communally: ETFs. Why, in today’s computerized environment, do investors need to wait until the end of the day to know what price they purchased their fund at? Would you buy a car that way? Would you go to the dealer at 10 a.m. and say, “I want to buy that station wagon,” only to have the salesman tell you that you should give him $16,000 now, come back at 3 p.m., and then after everyone else has bought their car, he’ll tell you how much car you bought? Of course not, but that is how mutual fund technology works. ETFs are investment vehicles for the digital era. Daily liquidity is possible because the trading technology has made it possible. Tax efficiency is improved with the injection of a secondary market in addition to a primary one. Daily disclosure is not only required but also feasible with low-cost distribution on the Internet. In 1940, you couldn’t have disseminated daily holdings if you wanted to. But most important, the digital technology is cheaper. Fund Distribution, Meet Your Wal-Mart Traditional mutual fund platforms are often called supermarkets. The name is very fitting to their role in the history of the asset-management world. Like real grocery stores, they stock a lot of products on their shelves and charge a tidy little markup for doing so. Like a grocery store, there are lots of distributors and middlemen who take their cuts along the way, ultimately raising the costs for consumers. That is until Wal-Mart WMT (or a big-box retailer of your choice) came along and ruined it for everyone who had their hand in the cookie jar. Wal-Mart cut out the middleman, cleared the shelves of marginal products, and introduced a very competitive generic substitute. This is happening in the fund world today, and what is asset management’s Wal-Mart? The national exchanges. The exchanges are the real disruption to the traditional asset-management distribution world; ETFs are just the technology that they are exploiting to do so. The exchanges mean open architecture and flat rates for transactions. The fact that they are leveraging billions of dollars of transactions allows them to transact funds at $6 for retail investors or pennies a share for larger investors. That is opposed to the 40-basis-point trailers or the $45 transaction fees charged by a mutual fund supermarket, not to mention the loads and trailers that commission-based advisors charge. Most discount brokerage platforms allow investors to buy certain ETFs without paying any transaction costs. Now that is progress! Like what happened with grocery stores and Wal-Mart, not everyone will make it to the other side in the asset-management world. Wal-Mart destroyed the old grocery store model, its distributors, and the marginal products that paid for shelf space in the old days. Under this model, the best products thrive—with best meaning those that deliver premium results (perceived or real) and those that charge low prices. The same will be true in asset management. Low-cost passive funds are the proxy for generic. Managers and shops with premium brand names and, more important, premium results will still get to charge premium prices. Does This Mean Active Is Dead? A simple conclusion for many is that if and when this all comes to be, active management is dead. That is not what we’re advocating by any means. Marginal active managers are going to have a tough time surviving, for sure, but there are solid managers who will still be able to draw assets to their funds. The real test is coming. PIMCO intends to launch an actively managed ETF version of its Total Return strategy, and our disruption theories and the future of asset management are riding on the success or failure of this launch. If we’re correct, then this ETF should have no trouble attracting a massive amount of assets. Priced at 0.55%, it is slightly more expensive than the mutual fund version’s institutional share class (0.46%), costs the same as the transaction-fee Harbor Fund version, and is significantly cheaper than the A shares (0.85%). By the way, that fee difference between the institutional and A share classes costs the A shares a star in their Morningstar Rating for funds. Retail investors get a 4-star option, but institutional investors get a 5-star fund—for the exact same fund strategy. If you are a doubter of active ETFs, ask yourself this: In a fee-based, fiduciary world, how could an advisor ever recommend a marginal 3-star fixed-income fund with a load or a trailer when an ETF such as PIMCO Total Return is available on the exchange for all investors, with no minimum investment, at 0.55%? The answer is MorningstarAdvisor.com 39 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011