Active Stock Fund Managers Load Up On ETFs, Scrimp On Cash

New Cash Strategy

The inclusion of passive ETFs into stockpicking funds as an alternative to cash comes as active managers are increasingly under pressure to beat their benchmarks and justify their higher fees.

Just one in five mutual fund managers outperformed their respective benchmarks last year, the worst performance in more than a decade, extending a seven-year skid in which stockpickers have not beat passive funds by a significant margin. Over the same time, index funds and ETFs have brought in more than $450 billion in investor assets, while those run by stockpickers have lost more than $430 billion, according to Lipper data.

The types of funds that are turning to ETFs range from international small cap funds to gold funds to mid-cap growth funds, according to Lipper.

The T. Rowe Price Institutional Frontier Markets Equity Fund and the T. Rowe Price International Concentrated Equity Fund both had ETFs as top 10 holdings at the end of last year.

Both funds, which are less than a year old, temporarily use ETFs when they cannot invest inflows, either due to stringent foreign ownership rules in some countries or if international markets are closed, a spokeswoman said.

As of March 31, the T. Rowe International Concentrated Equity Fund did not own any ETFs and the Institutional Frontier Markets Equity Fund held less than 1 percent in the Market Vectors Vietnam ETF, down from over four percent, in December.

Not all of these funds are turning to ETFs for cash reasons alone. Passive ETFs - which can cost as little as 0.06 percent of assets, compared with the 1.2 percent charged by the typical actively-managed mutual fund - can allow fund managers low-cost access to expensive foreign markets when they cannot buy local shares directly.

The Causeway International Small Cap fund, for instance, has an Indian small-cap ETF as its largest holding because regulatory issues prevent it from holding Indian shares in a local account, said Arjun Jayaraman, the fund's portfolio manager.

For the funds that do use ETFs to avoid cash drag, the benefits are mixed. The Toreador Core fund, for instance, has bested 97 percent of its peers over the last three years, a period in which it has often held an S&P 500 ETF within its top 10 holdings. Its strategy of opting for an ETF to manage its cash flows "has been helpful at a time when the market has been up," said Paul Blinn, one of the fund's co-managers.