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Some More Nails in the Mutual Fund Coffin

Some More Nails in the Mutual Fund Coffin

Two things happened this month that hammered a couple of more nails into mutual fund coffin.  First we saw the Third Avenue announced that they are suspending investor redemptions from their junk bond fund.  They way mutual funds work if an investor wants to redeem shares then the mutual fund manager either uses cash on hand or sells securities to send the investor cash.  Under normal circumstances this is no problem, funds keep cash and typically own liquid securities that can easily be cashed in.  However, under extraordinary circumstances, like when a fund owns junk bonds that are tanking and not easy to sell and when more investors than normal want cash, that can create a problem.  That is what happened with Third Avenue, they either couldn’t, or didn’t want to sell bonds at a steep discount so they locked shareholders in.  ETFs work differently.  Normally, when an investor goes to sell they don’t sell to the ETF issuer, they sell to a buyer on the market.  If an investor, or investors, want to liquidate large amounts then a trading firm called an authorized participant (AP) sends a request to redeem to the fund custodian.  Instead of getting cash they get a basket of securities that the fund owns and it is their responsibility to sell it on the open market.  If a junk bond ETF ran into trouble like Third Avenue investors could still sell, however the APs would probably extract some cost for ending up with a basket of illiquid securities.  At least as an ETF investors would have the choice of selling at a discount or holding on.  Now they have no choice.

The second thing that happened is that Eaton Vance announced the launch of Next Shares.  These are non-transparent ETFs that will allow actively managed mutual funds to offer ETF versions of their funds without everyone knowing what they own.  Eaton Vance’s launch will be followed by a number of other companies.  Wall Street still has to work out the technology to trade these but they will be cheaper and better than the mutual fund versions.  Any shareholder in an actively managed fund that has a Next Share version who doesn’t have built up capital gains should switch from the fund to the ETF.

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