Jamie Spencer
Exchange-traded funds (ETFs) have surged in popularity, becoming a preferred investment vehicle for many investors. Since their inception in 1993, ETFs have grown to amass nearly $9.7 trillion in assets by August 2024, according to Morningstar data. Though mutual funds still lead with $20.3 trillion in assets, ETFs have rapidly closed the gap, growing their market share from 14% to 32% over the past decade. Michael McClary, chief investment officer at Valmark Financial Group, sums up the appeal: “The structure of an ETF is a superior fund structure to a mutual fund, especially for taxable accounts.” Here’s a look at the four primary reasons behind the explosive growth of ETFs.
1. Tax Efficiency: A Key Advantage
ETFs and mutual funds both pool stocks and bonds managed by professionals, but the difference in how they’re taxed sets ETFs apart. Unlike mutual funds, which typically generate capital gains taxes during internal transactions, ETFs trade on exchanges like individual stocks. This structure allows ETF investors to avoid many of the capital gains taxes that mutual fund investors face.
“This is tax magic that’s unrivaled by mutual funds,” explains Bryan Armour, director of passive strategies research at Morningstar. In 2023, only about 4% of ETFs distributed capital gains to investors, compared to over 60% of stock mutual funds. However, McClary notes that for investors with tax-advantaged accounts like 401(k)s, the tax efficiency of ETFs becomes less of a differentiating factor since capital gains taxes aren’t a concern in those accounts.
2. Lower Costs: An Easy Win for Investors
Another factor driving the rise of ETFs is their lower cost structure. ETFs, especially those tracking indexes, often come with lower fees compared to actively managed mutual funds. The average ETF carries a fee of 0.50%, while the average mutual fund fee is over twice that at 1.01%.
“Low costs and greater tax efficiency are an easy win for investors,” Armour says, highlighting one of the core reasons behind the migration to ETFs. In the first half of 2024, 80% of the net money flowing into index stock funds went to ETFs, signaling a long-term shift toward more affordable investment options.
3. Shifting Financial Advice Models Favor ETFs
The way financial advice is delivered has also played a role in ETFs’ growing popularity. Many brokerage firms have moved away from a commission-based model, where advisors earned fees from selling specific financial products, to a fee-based model where they charge a flat percentage of assets under management.
“ETFs work well for fee-based advisors because they’re less likely than mutual funds to carry sales-related costs,” Armour points out. McClary echoes this sentiment, adding that “a whole generation of advisors only used mutual funds. Now, finding a quality advisor that doesn’t use ETFs to some capacity is hard.” This shift has reduced conflicts of interest, making ETFs an appealing option for both investors and financial advisors.
4. Regulatory Support Fuels ETF Launches
Regulatory changes have further fueled the growth of ETFs. In 2019, the Securities and Exchange Commission (SEC) passed a rule that simplified the process for asset managers to launch ETFs. As a result, the market has seen a boom in the number of available ETFs. In 2023, 578 new ETFs were launched, compared to just 182 new mutual funds.
This streamlined process has made it easier for investment firms to expand their ETF offerings, providing investors with more options tailored to specific sectors, investment strategies, or themes.
The Drawbacks of ETFs
Despite their many advantages, ETFs aren’t without potential downsides. One of the key features of ETFs is that they disclose their holdings daily, unlike mutual funds, which may disclose them quarterly. While transparency is a benefit, most investors do not regularly check the underlying securities, so this feature may not hold significant value for all.
Additionally, because ETFs trade like stocks, investors have the ability to buy and sell them throughout the day. While this offers flexibility, it also opens the door for frequent trading, which can lead to unnecessary losses for those who try to time the market.
ETFs Poised for Continued Growth
The rise of ETFs is no fluke. Their tax efficiency, lower costs, alignment with the changing landscape of financial advice, and regulatory support have combined to make them an increasingly popular option for investors. As more people seek out cost-effective, tax-efficient ways to build their portfolios, ETFs are positioned to continue growing and potentially outpace mutual funds in the future.
