Rosalind Evans
Exchange-traded funds (ETFs) have become increasingly popular among investors, with their growth driven by distinct advantages over traditional mutual funds. According to Morningstar data, ETFs have amassed approximately $9.7 trillion in assets since August 2024, since their inception in 1993. In contrast, mutual funds still lead with $20.3 trillion but have seen their market share relative to mutual funds rise from 14% to 32% over the past decade. “The simple fact is, the structure of an ETF is a superior fund structure to a mutual fund, especially for taxable accounts,” says Michael McClary, chief investment officer at Valmark Financial Group. Here are four main reasons why ETFs have seen explosive growth.
1. Tax Efficiency: The ‘Magic’ of ETFs
ETFs share similarities with mutual funds; both are collections of stocks and bonds managed by professionals. However, a key difference lies in their tax treatment. ETFs trade on stock exchanges like individual stocks, while mutual fund transactions typically occur through investment companies. This structural difference allows ETF investors to avoid many capital gains taxes associated with mutual funds.
Bryan Armour, director of passive strategies research at Morningstar, highlights this benefit, stating that “this is tax magic that’s unrivaled by mutual funds.” In 2023, around 4% of ETFs distributed capital-gains taxes to investors, compared to more than 60% of stock mutual funds. However, McClary notes that in tax-advantaged accounts like 401(k)s, the tax efficiency of ETFs is less relevant since investors do not incur capital gains taxes.
2. Lower Costs: A Financial Advantage
ETFs have also gained favor due to their lower cost structures. The first ETF, the SPDR S&P 500 ETF Trust (SPY), was an index fund that typically incurs lower fees than actively managed funds. This trend has continued, as the average ETF fee is 0.50%, while the average mutual fund fee is 1.01%. According to Armour, “Low costs and greater tax efficiency are an easy win for investors, so I think that’s the simple answer that’s been so effective for ETFs.”
Moreover, ETFs have accounted for 80% of net money into index stock funds in the first half of 2024, underscoring a long-term shift among investors toward cost-effective options.
3. Shift in Financial Advice Models
The landscape of financial advice has also transformed, benefiting ETFs. Many retail brokerage firms have transitioned from a commission-based model to a fee-based model, where clients pay an annual fee based on their account value. This shift minimizes conflicts of interest, allowing advisors to recommend the best options for their clients without the influence of commissions.
Armour notes that “ETFs work well for fee-based advisors because they’re less likely than mutual funds to carry sales-related costs.” McClary adds, “A whole generation of advisors only used mutual funds. Now, finding a quality advisor that doesn’t use ETFs to some capacity is hard.”
4. Regulatory Changes Easing ETF Launches
In 2019, the Securities and Exchange Commission (SEC) enacted a rule that simplified the process for asset managers to launch ETFs. This regulatory change has increased the number of ETFs available to investors. In 2023 alone, 578 new ETFs were launched, compared to only 182 mutual funds.
While ETFs offer many benefits, experts caution that they also have drawbacks. For instance, although ETFs disclose their holdings daily, this transparency may not be valuable to investors who do not need to check underlying securities frequently. Furthermore, the ability to trade ETFs throughout the day, like stocks, can disadvantage many investors who may incur losses through frequent trading.
The remarkable growth of ETFs can be attributed to their tax efficiency, lower costs, changes in financial advice models, and supportive regulatory measures. As more investors seek cost-effective and tax-efficient portfolio options, ETFs are poised to continue their upward trajectory.
