Moyo Studio | E+ | Getty Images
Exchange-traded funds (ETFs) have steadily gained popularity among investors in recent years, a trend experts say is largely due to advantages such as lower taxes and fees than mutual funds. That's what it means.
The first ETF debuted in 1993. Since then, ETFs have raised about $9.7 trillion through August 2024, according to Morningstar data.
Mutual funds hold more investor money at $20.3 trillion, but ETFs are on the rise. ETF market share of mutual fund assets has more than doubled over the past decade, from 14% to about 32%, according to Morningstar data.
“The simple fact is that the ETF structure is a better fund structure than a mutual fund, especially in taxable accounts,” says Valmark Financial, which uses ETFs to build its clients' financial portfolios.・Michael McCrary, group chief investment officer, said:
Here are four reasons McCrary and other experts say ETFs have become so popular.
1. They have “tax magic”
Svetikud | E+ | Getty Images
ETFs are similar to mutual funds in many ways. Both are baskets of stocks and bonds overseen by professional money managers.
However, there are some differences.
At a high level, ETFs trade on stock exchanges like shares in publicly traded companies. Investors typically purchase mutual funds directly from investment companies.
At a more micro level, many ETF investors Experts say it could potentially avoid fund-level capital gains taxes imposed by many investors who hold shares in mutual funds.
Investors typically owe capital gains taxes to the IRS on investment gains from the sale of financial assets, such as investment funds or individual stocks or real estate.
However, mutual fund managers may also generate capital gains taxes within the fund itself when buying and selling securities. These taxes are passed on to all of the fund's shareholders.
In other words, these investors would be hit with a tax bill even if they did not personally sell their holdings.
But experts say the structure of ETFs allows most managers to trade the funds' underlying stocks and bonds without triggering a taxable event for investors.
It's “tax magic that can't be matched by mutual funds,” says Brian Armor, director of North American passive strategy research at Morningstar and editor of the ETF Investor newsletter. I wrote earlier this year.
Armor said in an interview that about 4% of ETFs distributed capital gains taxes to investors in 2023, compared with more than 60% of equity mutual funds.
However, the benefits vary depending on the fund's investment strategy and asset class. Investors who own actively managed mutual funds that trade frequently are more exposed to tax losses, while investors who own market-capitalization-weighted index funds or bond funds may find that the tax benefits of ETFs are less I cannot,” Armer wrote.
Additionally, “taxation discussions are not important in retirement accounts,” McCrary said.
Workplace retirement plans such as 401(k) plans and personal retirement accounts are tax-advantaged. Investors are not obligated to pay capital gains taxes associated with the transaction, as they would be with a taxable brokerage account.
“The 401(k) world is a place where mutual funds can still make sense,” McCrary said.
2. Low cost
The first ETFs were index funds. SPDR S&P 500 ETF Trust (spy).
Index funds, also known as passively managed funds, track market indexes such as: S&P500.
These tend to be cheaper than actively managed stocks that aim to pick winning stocks that outperform their benchmarks.
Experts say investors have equated ETFs with index funds since their inception, even though index mutual funds also exist. The first actively managed ETFs were available until 2008.
As a result, ETFs are benefiting from investors' long-term gravitational pull toward index funds and away from active funds seeking lower costs, experts say.
Armor said the average ETF costs half as much as the average mutual fund, at 0.50% and 1.01%, respectively.
ETF accounted for 80% of net assets According to Morningstar research, investors will be invested in index stock funds in the first half of 2024.
“Lower costs and better tax efficiency is a no-brainer for investors, and I think that's a simple answer that's very effective for ETFs,” Armor said.
That said, investors should not assume that ETFs are always the lowest-cost option.
“You may find an index mutual fund that costs less than a comparable ETF.” According to March 2023 report by Michael Iachini, Head of Manager Research at Charles Schwab.
3. Changes to financial advice fee model
Nitat Terme | Moments | Getty Images
Financial advisors are also making changes that could benefit ETFs, Morningstar's Armer said.
Retail brokerages have traditionally made money from commissions on sales of funds and other investments.
However, many companies are moving to so-called fee-based models, where customers pay an annual fee, say 1%, based on the value of the assets held in their account. The strength of this model, proponents say, is that it does not influence advisors' investment recommendations as committees do.
Low costs and high tax efficiency are easy returns for investors, and I think this is a simple answer that is very effective for ETFs.
brian armor
North American Passive Strategy Research Director, Morningstar Inc.
This change is “one of the most important trends in the retail brokerage industry over the past decade.” According to To McKinsey.
ETFs are suitable for fee-based advisors because they are less likely to carry assets than mutual funds. Sales related expenses Things like sales volume and 12b-1 fees, Armor said. The latter is an annual fee that mutual funds charge investors to cover marketing, distribution, and other services.
Brokers may charge fees for purchasing ETFs, but many large brokerages have eliminated those fees.
“There's been a whole generation of advisors who only used mutual funds,” McCrary said. “Quality is hard to find now [advisor] That means not using ETFs to a certain extent. ”
4. SEC rules make it easier to launch an ETF
securities and exchange commission Armor said it issued rules in 2019 to make it easier for asset managers to launch ETFs and streamline portfolio management for active managers.
As a result, financial companies are debuting more ETFs than mutual funds, increasing the number of funds available to investors.
For example, in 2023, fund companies issued 578 new ETFs compared to 182 mutual funds, according to Morningstar.
Potential disadvantages of ETFs
Stock trader on the New York Stock Exchange.
Michael M. Santiago | Getty Images News | Getty Images
That being said, ETFs do have their downsides, and some of their stated benefits may be oversold.
For example, most ETFs (unlike mutual funds) disclose their holdings on a daily basis, but for investors who have little need to frequently check the underlying securities, such transparency “Adds very little,” Armer wrote.
Additionally, while ETFs trade throughout the day like stocks, investors' orders for mutual funds are priced only once a day, at the close of the market.
But being able to trade ETFs like stocks “isn't really a benefit for most investors,” Armer said. This is because frequent buying and selling is generallyIt's a losing proposition for the average investor, he said.
Experts say certain ETFs can be difficult to trade, and the difference between offer and bid prices can be large, creating costly situations for investors. In contrast, mutual funds always trade without Yachini said there is such a “bid-ask spread.”
Unlike mutual funds, ETFs cannot reach new investors, Armor said. He said it can be difficult for some actively managed ETFs to execute on their investment strategies if the fund gets too large.
