INVESTING: Watch out, mutual funds-a competitor eyes your turf

Mutual funds became truly dominant in the early 1980s when our government strengthened the 401(k) rules. Most 401(k) plans do not allow participants to buy individual stocks, or much of anything besides mutual funds. So these massive institutions are supported by legions of workers mechanically depositing small amounts every month.

The gig has gotten even better for the fund providers over the last 25 years because 401(k) participants have developed habits of doing almost nothing with their money after they select how they want the money invested. Less than 20 percent of all 401(k) investors made any change in the last 12 months. These fund providers are fat and happy now, but I think changes are in the wind.

Mutual fund companies likely feel they dodged a bullet after surviving the fundtiming scandals of the last few years. Maybe that’s why they are having a little trouble seeing the next big challenge that’s coming at them like a freight train-exchange-traded funds, or ETFs.

I began using ETFs in 1996. ETFs are individual stocks that hold a basket of a certain type of stock. SPY, for example, is a one-stop shop for an investor who wants to buy the entire S&P 500 in one click. There are hundreds of ETFs covering every conceivable market segment. There are even ETFs that do nothing but short the market.

ETFs have more advantages over mutual funds than I can count. One of the biggest is that you can trade them any time during the day, just like a stock. Mutual funds can only be bought or sold at the end of the day.

Another major benefit is the fee difference. Mutual funds average 1.25 percent, while ETFs average 0.30 percent. The higher fees at the mutual fund companies make even less sense when you consider the funds typically do not outperform the indexes they are designed to benchmark.

As of today, there aren’t many 401(k) plans that allow investors to buy ETFs. I think that is going to change, though, and when it happens in force, you will not recognize the industry as it stands today.

The companies sponsoring most of the mutual funds will have to radically change how they operate. Brokers like Charles Schwab, which receive huge kickbacks from the funds every time an investor buys one, will have to seek new revenue streams. Mutual fund operations, like Rydex and Profunds, are beginning to offer ETFs, which may salvage their business model. But for the most part, problems are coming.

Sometimes, I highlight an obvious trade I am taking. In April, it was shorting the home builders, and that turned into a cherry play. Today, it looks like shorting the bond market. Since the last few weeks have apparently convinced everyone the Fed is done raising interest rates, those same everyones have been buying bonds until their hands are bleeding.

This is an extremely hard one-way trade, and those moves rarely work, especially in the short term. And guess what? I am selling short the ETF TLT, which represents the 30-year U.S. government bond. I will keep you posted on how the trade works out.