The ETF’s subtle advantage over a mutual fund

There is nothing original in this post. However, with a number of mutual funds closing their doors over the last few days, I thought it might be worthwhile discussing why an ETF structure should be more resilient than the standard mutual fund.

ETF’s and mutual funds are both derivative securities. Their intrinsic value depends on a set of primitive securities such as individual stocks and bonds. They differ, however, in one crucial respect – the ETF can be traded with a third party on the stockmarket while the mutual fund requires subscriptions and redemptions to be handled by the fund itself. A mutual fund investor has no choice but to deal with the fund, while the ETF is either open or closed depending on the choice of the investor. This choice has an enormous effect on the stability of the fund during periods of market stress.

Mutual funds suffer froma ‘free-rider’ problem. This is because there is an incentive for every investor to both (i) trade at an NAV that doesn’t reflect the current price of the primitive securities, and (ii) impose the costs of withdrawing from the fund on their fellow shareholders. During periods of market volatility, the mutual fund’s daily strike price may be several percent away from true NAV. This creates the incentive for an existing shareholder to redeem if the daily trade price is higher than the NAV or subscribe if the trade price is lower. If one investor starts to game the fund at the expense of others, there is an incentive for the other investors to react by doing the same thing, and this creates a run on the fund. Mutual fund operators are awake to this, and many impose redemption fees or exercise their right to close the fund completely – this latter decision can ruin the operator’s entire business.

ETF’s, on the other hand, are different in that the investor can choose to trade with the fund directly or exchange their shares on market. The ‘free rider’ problem goes away since this enables arbitrage between existing investors and the primitive securities that exist in the fund. There is no ‘trade price’ struck by the fund – just a set of on market or direct subscriptions/redemptions determined by whether the on-market price is higher or lower than the NAV.

In Price Theory parlance, the ETF structure effectively internalises the ‘free rider’ externality that exists with standard mutual funds. This does not mean that an ETF will always trade at NAV. But it does mean that the costs of trading at a different price relative to NAV are borne by the two parties to that transaction, rather than fobbed off to the existing shareholder base. This should eliminate runs on mutual funds, reduce turnover and increase market efficiency.