The Great Fund Face-Off

Much of the inflows into ETFs are going to low-cost index funds—some $579 billion in the past year. Yet this is no longer simply an active-versus-passive debate: There are now 1,465 actively managed ETFs, and they received $185 billion in new money.

ETFs have lower overhead costs and greater tax efficiency, thanks to a structure that allows Wall Street’s “authorized participants” to help redeem shares of the ETFs in a way that takes appreciated stocks out of a fund’s portfolio without realizing any taxable capital gains.
Mutual funds, by contrast, are better for active managers who want to keep their best investment ideas secret, invest in illiquid securities, and control how much money is coming into a fund if it gets too big.

Some of the largest active mutual fund firms have started to offer active ETF versions of existing mutual fund strategies. “If there’s a different wrapper to get the underlying investment capability [of a money manager] that’s cheaper, more convenient, or more tax-efficient, I think it makes a lot of sense to move from a mutual fund into ETFs,” says Eric Veiel, chief investment officer of T. Rowe Price.

Consider the T. Rowe Price Blue Chip Growth fund and the T. Rowe Price Blue Chip Growth ETF, which are largely identical. These are large-cap stock funds, with ample liquidity in blue chips for an ETF structure to work. Because of the structural differences of ETFs, T. Rowe will likely never launch clones of some of its best mutual funds.

Indeed, depending on the strategy, the older mutual fund vehicle sometimes remains the champion. This will change with time as the ETF space grows. What follows is a guide as to which wins out—mutual fund or ETF—in 12 major Morningstar categories today. We haven’t based our verdicts on past performance numbers alone, but rather what we think will be the best options in the future.

Large-Cap U.S. Stock Funds

It’s hard to argue with the success of the biggest large-cap index ETFs, such as the $541 billion SPDR S&P 500 and its rivals iShares Core S&P 500 and Vanguard S&P 500.

But mutual fund GQG Partners US Select Quality Equity has a 18.9% five-year annualized return, well ahead of the 15% for the S&P 500 ETFs and besting all other competitors in Morningstar’s Large Blend fund category. Moreover, its 0.7% expense ratio is modest for an actively managed fund.

The fund’s co-manager, Brian Kersmanc, runs a concentrated portfolio of about 30 high-quality stocks with strong balance sheets and competitive advantages over their industry peers. He also trades a lot—the fund has a 148% annual turnover ratio. Both facts are relevant to the ETF versus mutual fund debate, as most ETFs must reveal their holdings every day, while mutual funds report them quarterly.

An active manager who aggressively trades a few positions runs the risk of getting “front-runned” by copycats who buy or sell a stock before the manager has finished building or liquidating a position, leading to higher trading costs and lower returns.

“We keep a tight lid on our [intellectual property], because quite frankly, that’s the most valuable thing that we have.” Kersmanc says. He doesn’t think the fund should have a transparent ETF clone, and while there are also so-called semitransparent ETFs that don’t disclose every holding daily, he still feels they reveal too much information.

It’s fair to ask whether GQG’s outperformance can continue. Everyone knows the S&P 500 is hard to beat, and that the funds that have outperformed the benchmark in the past are rarely the same ones to beat it in the future.

Every year, S&P Dow Jones Indices publishes a Persistence Scorecard tallying how many previously top-performing funds in different categories continue to beat their peers. The latest 2023 report found that for 179 large-cap stock funds with performance in the top 25% of their peer group in calendar year 2019, 59.2% stayed in the top quartile in 2020; but that number dropped to 6.7% in 2021, and 0% in 2022 and 2023. Meanwhile, in the past 10 years, the Vanguard S&P 500 ETF has beaten 90% of Large Blend funds.

“If active outperformance persists, what it tells us is that the outperformance tends to be the result of skill,” says Anu Ganti, U.S. head of index investment strategy at S&P Dow Jones Indices. “What we actually find in the data is that persistence is tough” and more likely “the result of luck.”

Nor has the success rate for active managers been any better in Large Growth or Large Value fund categories. Popular index ETFs such as Invesco QQQ and Vanguard Growth for growth, and Vanguard Value for value, have been fierce competitors.

Thus, though large-cap funds such as GQG’s might make excellent diversifiers for a portfolio, S&P 500 ETFs should retain their mainstay status, especially in taxable accounts.

Small-Cap U.S. Stock Funds

The news is better for small-cap mutual funds. “Mutual funds might have an advantage for small-caps for a couple of reasons,” says Adam Sabban, a Morningstar manager research analyst. “One is that you can’t close an ETF.” Small-cap stocks can be illiquid and difficult to trade, so responsible small-cap managers will often close their mutual funds to new investors if funds get too big.

Another factor: Wall Street analysts don’t comprehensively cover the thousands of small companies, since many are unprofitable or obscure businesses. That makes small-cap index ETFs tracking every small company, good and bad, easier to beat. Morningstar, which publishes its Active vs. Passive Investing U.S. Barometer Report every year, finds the success rate of active small-cap funds beating passive index ones to be more than double that of large-cap funds in the past 10 years, with 25% of active Small Value funds, 26% of Small Blend ones, and 41% of Small Growth ones winning. (There are similarly better results for active bond and international stock funds versus index ones.)

Manager Scott Barbee of the top-performing Aegis Value fund holds only about 60 small-cap and microcap stocks. “We’ve monitored the [ETF] market for a long time,” he says. “Our conclusion is that it would be very difficult to do what we do as an ETF.”

While Barbee worries about front-running, he’s also concerned about the dearth of authorized participants who help create and redeem ETF shares of the kinds of tiny stocks he owns. He has built relationships over decades with brokers who specialize in trading such illiquid stocks, helping him get the best pricing on the shares. Most authorized participants are focused on blue-chip stocks. Barbee has also closed Aegis Value to new investors in the past. His fund’s 18.6% five-year annualized return KOs the Russell 2000 Value’s 6.9%.

Other top small-cap managers express similar concerns about trading, capacity, and transparency. “I don’t think [offering an ETF] would serve new investors,” says John Barr, manager of Needham Aggressive Growth, which has crushed its Small Growth benchmark in the past five years with a 23.3% annualized return. “With small- or microcaps, I can take six months or a year to get in or out of a position. To report that on a daily basis—not good.”

Ryan Kelley, the co-manager of two other Morningstar category-dominating small-cap funds, Hennessy Cornerstone Growth and Hennessy Cornerstone Mid Cap 30, also worries about his trades being front-run. (Morningstar categorizes the latter fund as Small Value.)
Top-performing small-cap ETFs exist, such as Invesco S&P SmallCap 600 Revenue. But their strategies must be more diversified and/or invested in liquid stocks, so trading and capacity don’t become a concern.

Mutual funds win this round.

Bond Funds

Because of regulatory restrictions, bond ETFs must be fully transparent. Moreover, the advantageous ETF tax structure is of no value to investors seeking bond income, which, excluding municipal-bond income, is usually taxable.

Many big shops have launched active bond ETFs. These, however, are often “core” ETFs that are diversified in different bond sectors. Vanguard, for instance, launched two active ETFs, Vanguard Core Bond and Vanguard Core Plus Bond, in December.

The two ETFs “are examples where we asked, ‘Does this strategy have runway for a long period in order for it to absorb [asset] growth?’” says Dan Reyes, head of Vanguard’s portfolio review department. He concluded they were “ETF-able” because they invest in liquid Treasury, mortgage, and corporate debt, with “multiple levers that they can pull to generate outperformance.” One can say the same regarding the excellent Fidelity Total Bond ETF and its mutual fund sibling, Fidelity Total Bond.

Things get interesting with more specialized strategies. Both the BlackRock Flexible Income ETF and the BlackRock Strategic Income Opportunities mutual fund are managed by the well-regarded Rick Rieder. Strategic Income Opportunities “is designed to be more of an unconstrained bond fund, to go anywhere,” says Jon Diorio, head of product for BlackRock’s U.S. wealth division. The ETF has some flexibility, but not as much: “Strategic Income Opportunities could own less liquid [bonds] or even illiquid private assets. We would not do that in [the ETF].”

As with small-caps, the more illiquid the bond type, the less ETF-able it is. Two of the best-performing high-yield bond mutual funds in the past five years— Fidelity Capital & Income and BrandywineGlobal High Yield —far outdistance their ETF competitors. Fidelity has delivered a 6.7% annualized return and Brandywine, 6%, more than double the 2.8% return of the largest ETF, the $17 billion iShares iBoxx $ High Yield Corp Bond.

Notably, even the Fidelity High Yield Factor ETF’s 4.4% five-year return lags behind its mutual fund cousin. “We’ve got a screen on [the ETF] for liquidity and quality,” says Greg Friedman, Fidelity’s head of ETF management and strategy. But Fidelity Capital & Income has no such restrictions and can buy private and distressed debt.

“The mutual fund wrapper has been written off for dead,” says Bill Zox, co-manager of BrandywineGlobal High Yield. “But for high yield, we think that it’s a better wrapper than the ETF.” Zox can take months to build a position, so ETF transparency is disadvantageous.

There are also unique active core mutual funds such as Leader Capital High Quality Income, which has trounced its peers in Morningstar’s Intermediate Core-Plus Bond category by investing in high-quality floating-rate debt when interest rates were rising. “We would not be comfortable publishing [our holdings] every day,” says manager John Lekas.

Given the increasing competition from lower-cost core bond ETFs, Leader Capital’s specialized core fund makes more sense as a supplementary holding. By contrast, high-yield mutual funds win versus ETFs.

Balanced Funds

Balanced ETFs that hold both stocks and bonds are generally few and lackluster, but not because of any structural flaws in ETFs. Many ETF investors are financial advisors who prefer separate stock and bond ETFs to make their asset-allocation decisions.

“A majority of advisors like to have the [individual asset class] building blocks themselves so that they can then customize [portfolios] for their individual clients and be seen to be adding some value, as opposed to just saying, ‘Well, look, this T. Rowe Price Capital Appreciation strategy is really good. I’m just going to put you in it, and that’s all you need to do,’” says T. Rowe’s Veiel.

T. Rowe Price Capital Appreciation is a terrific balanced mutual fund that is, unfortunately, closed to new investors. But there are other excellent open ones that are suffering significant outflows, such as Vanguard Wellington, Vanguard Wellesley Income, and American Funds Capital Income Builder, which have each lost more than $7 billion in the 12 months ended May 31.

Lack of advisor interest isn’t the only reason. Target-date funds that determine allocations based on an investor’s expected retirement date have supplanted balanced funds in 401(k) plans. “Balanced funds are in systemic decline,” says Morningstar analyst Ryan Jackson.

Yet the five-year returns for two of the best balanced mutual funds, Disciplined Growth Investors and Fidelity Puritan, beat every comparably allocated target-date or balanced ETF by a wide margin.

Disciplined Growth will probably never launch an ETF clone, as its managers are hyperfocused on controlling asset flows. But Fidelity Puritan, which has suffered $2.2 billion in outflows in the past year, might make the leap. “We have a lot of things on our [ETF] wish list,” Fidelity’s Friedman says when asked about it. “Obviously, I can’t go into what they are.”

Mutual funds win—for now.

International Funds

The best-performing international stock funds in the past five years are small-cap value ones. Yet small-cap ETFs’ liquidity and transparency problems are worse overseas. Regulators don’t allow most foreign stocks to be in semitransparent ETFs, so front-running is always possible. Moreover, most foreign stock indexes exclude many companies, which often have zero Wall Street analyst coverage. That creates opportunities for active managers.

“It’s just this large pond with few fishermen,” says Mark Costa, co-manager of the Brandes International Small Cap Equity mutual fund. “There are 7,000 [foreign small] companies, but when you look at the passive ETF strategies, they’re really hugging the benchmark and the benchmark only incorporates about 3,000 to 3,500 names. So it’s only capturing about half of the opportunities.”

The Brandes fund has delivered the best five-year annualized return for a foreign stock fund, at 13.5%. The iShares Currency Hedged MSCI EAFE SmallCap ETF has the best foreign small-cap ETF return at 9.6%, but that’s largely because the U.S. dollar has been so strong versus foreign currencies. The best-performing large-cap foreign stock options—such as Artisan International Value, which is closed to new investors, and Goldman Sachs GQG Partners International Opportunities —are mainly mutual funds—except when the ETF is currency-hedged.

Costa has no interest in launching an ETF of this strategy, but Brandes has launched a large-cap Brandes International ETF, since Costa thinks there’s enough liquidity.

The top emerging market funds are also small-cap focused: Matthews Emerging Markets Small Companies and JOHCM Emerging Markets Discovery. The wrinkle here is Matthews also launched a fully transparent sibling ETF, Matthews Emerging Markets Discovery Active, in January. Both the mutual fund and the ETF also invest in mid-cap stocks, so manager Vivek Tanneeru says there’s enough liquidity.

Then again, the funds’ advisor, Matthews Asia, which oversees about $8 billion currently, has suffered outflows of $4.2 billion in the past year, according to Morningstar. The pressure in such an environment to launch ETFs is extreme, even when mutual funds are the better option.

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