Yahoo Finance The scenario in which mutual funds may trump index funds
For most investors, saving for retirement through 401(k)s, IRAs, or other long-term investment accounts, index funds and ETFs has become the go-to method.
With ultra-low costs of ownership—a 0.03% expense ratio for this US total stock market ETF, for example—index funds and ETFs allow regular investors to save on costly management fees, which can eat into earnings. While most ETFs that track the broad US market indexes, like the S&P 500, have expense ratios under 0.10%, mutual fund average expense ratios are around six times higher. (An index fund is a type of mutual fund whose portfolio is constructed to match or track the components of a market index, like the Dow or the S&P 500 index.)
The other big advantage that’s led a major move toward passive management is that index funds have outperformed actively managed funds. In the past 25 years, only about 20% of actively managed funds beat their benchmark indexes. With the value of human stock-picking under a cloud of doubt, there’s been a shift to owning the entire market—or specific indexed portions. More than $1 trillion has been invested in passive funds in the past three years as active funds have hemorrhaged money. Just last week, BlackRock, the world’s largest money manager by assets, announced in its third-quarter earnings that investors pulled $546 million from the firm’s actively managed funds and poured more than $88 billion into its ETFs and indexed funds.
The success of index funds—and stocks, for that matter—for regular investors has ridden on relevant and important companies being and becoming public. But the market’s public availability to ordinary investors may not necessarily be a given. According to the Wall Street Journal, a growing number of companies are failing to see benefit in being public, instead relying on a steady stream of private money to develop. As the Journal put it, “the US is becoming ‘de-equitized,’ putting some of the best investing prospects out of the reach of ordinary Americans.” Similarly Barron’s noted last year that the time between first venture funding and IPO has grown considerably since 2000, from 3.1 to 7.4 years, and that pre-IPO companies are larger and more developed.
If more important companies go or stay private, mutual funds may gain an advantage. Today, actively managed mutual funds do invest in private companies, and are one of the few ways ordinary investors can get a taste of promising companies that haven’t gone public.
“If actively-managed mutual funds are availing themselves of the increasing number of large-but-private companies, that might give them an advantage over ETFs and other index-based funds,” says Jerry Davis, a professor at Michigan’s Ross School of Business.
At the moment, it’s a very small taste. For example, just 1.7% of the Fidelity Contrafund’s (FCNTX) holdings were in private companies in 2015, which are often disclosed to investors in their prospectus or annual report—if they’re big enough. On the larger end, Reuters noted, there are funds like T. Rowe Price’s New Horizons (PRNHX)—currently closed to new investors—holding around 4% in pre-IPO companies, including the unicorn WeWork. By SEC rules, however, a mutual fund could have up to 15% of its assets in private companies, giving fund managers some leeway to expand those holdings (they price daily through an independent valuation committee).
If the public markets fail to attract and important index-worthy, economy-driving companies, funds with exposure to these private companies may not necessarily compensate for investors not having public access to them. The private exposure could merely be perfunctory, a tiny scrap of an Uber or Airbnb for the public to fight over. In other funds, the private portion may own a few desired stocks in an otherwise unappetizing basket of risky startups.
It’s not clear whether this shrinking trend will continue. Last year may have been tepid for IPOs—the worst year since the Great Recession—but many analysts have predicted a big year for IPOs in 2017, indicating that many companies will continue to see the advantage in going public. Still, businesses have good reason to stay private. Going public means disclosures, short-term shareholders to argue with, and as the Journal notes, the late-stage private fundraising markets have a lot in common with the public markets—lending the benefits of liquidity for people selling and more information for people buying. But even if it doesn’t take back ground from index funds, private companies will keep mutual funds very relevant.
Ethan Wolff-Mann is a writer at Yahoo Finance focusing on consumer issues, tech, and personal finance. Follow him on Twitter @ewolffmann.
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