Personal Finance
Top reasons why exchange-traded fund growth has ballooned
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Exchange-traded funds have steadily gained popularity among investors in recent years — a trend experts say is largely due to advantages like lower tax bills and fees relative to mutual funds.
The first ETF debuted in 1993. Since then, ETFs have captured about $9.7 trillion, according to Morningstar data through August 2024.
While mutual funds hold more investor funds, at $20.3 trillion, ETFs are gaining ground. ETF market share relative to mutual fund assets has more than doubled over the past decade, to about 32% from 14%, per Morningstar data.
“The simple fact is, the structure of an ETF is a superior fund structure to a mutual fund, especially for taxable accounts,” said Michael McClary, chief investment officer at Valmark Financial Group, who uses ETFs to build financial portfolios for clients.
Here are four reasons why McClary and other experts say ETFs took off.
1. They have ‘tax magic’
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ETFs resemble mutual funds in many ways. They’re both baskets of stocks and bonds overseen by professional money managers.
But there are a few distinctions.
At a high level, ETFs trade on a stock exchange, like the stock of a publicly traded company. Investors generally buy mutual funds directly from an investment company.
On a more micro level, many ETF investors can sidestep the fund-level capital gains taxes incurred by many investors who own mutual fund shares, experts said.
Investors generally owe capital-gains tax to the IRS on investment profits, typically from the sale of investment funds or other financial assets like individual stock and real estate.
However, mutual fund managers can also generate capital-gains taxes within a fund itself when they buy and sell securities. Those taxes then get passed along to all the fund shareholders.
In other words, these investors get a tax bill even if they personally didn’t sell their holdings.
The structure of an ETF, however, allows most managers to trade a fund’s underlying stocks and bonds without creating a taxable event for investors, experts said.
This is “tax magic that’s unrivaled by mutual funds,” Bryan Armour, director of passive strategies research for North America and editor of the ETFInvestor newsletter at Morningstar, wrote earlier this year.
In 2023, about 4% of ETFs distributed capital-gains taxes to investors relative to more than 60% of stock mutual funds, Armour said in an interview.
But the advantage depends on a fund’s investment strategy and asset class. Investors who hold actively managed mutual funds that trade often are more susceptible to tax loss, whereas those with market-cap-weighted index funds and bond funds “don’t benefit that much from the tax advantage of ETFs,” Armour wrote.
Additionally, “the taxable argument doesn’t matter in a retirement account,” McClary said.
That’s because workplace retirement plans like a 401(k) plan and individual retirement accounts are tax-advantaged. Investors don’t owe capital-gains taxes related to trading as they would in a taxable brokerage account.
“The 401(k) world is a place where mutual funds can still make sense,” McClary said.
2. Costs are low
The first ETF was an index fund: the SPDR S&P 500 ETF Trust (SPY).
Index funds, also known as passively managed funds, track a market index like the S&P 500.
They tend to be less expensive than their actively managed counterparts, which aim to pick winning stocks to outperform a benchmark.
Investors have equated ETFs with index funds since their inception, even though there are also index mutual funds, experts said. The first actively managed ETF wasn’t available until 2008.
ETFs have therefore benefited from investors’ long-term gravitation toward index funds, and away from active funds, as they seek lower costs, experts said.
The average ETF costs half as much as the average mutual fund, at 0.50% versus 1.01%, respectively, according to Armour.
ETFs accounted for 80% of net money into index stock funds in the first half of 2024, Morningstar found.
“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,” Armour said.
That said, investors shouldn’t assume ETFs are always the lowest-cost option.
“You may be able to find an index mutual fund with lower costs than a comparable ETF,” according to a March 2023 report by Michael Iachini, head of manager research at Charles Schwab.
3. Financial advice fee model changes
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Financial advisors have also undergone a shift that’s benefited ETFs, said Morningstar’s Armour.
Retail brokerage firms historically earned money from commissions on the sale of funds and other investments.
However, many firms have moved toward a so-called fee-based model, whereby clients incur an annual fee — say, 1% — based on the value of the holdings in their account. A virtue of this model, according to advocates, is that it doesn’t influence an advisor’s investment recommendation as a commission might.
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.
Bryan Armour
director of passive strategies research for North America at Morningstar
The shift is “one of the most important trends in the retail brokerage industry over the past decade,” according to McKinsey.
ETFs work well for fee-based advisors because they’re less likely than mutual funds to carry sales-related costs like sales loads and 12b-1 fees, Armour said. The latter is an annual fee that mutual funds charge investors to cover marketing, distribution and other services.
While brokerage firms may charge a commission to buy ETFs, many large brokerages have ditched those fees.
“There was a whole generation of advisors who only used mutual funds,” McClary said. “Now, it’s hard to find a quality [advisor] that doesn’t use ETFs to some capacity.”
4. SEC rule made ETF launches easier
The Securities and Exchange Commission issued a rule in 2019 that made it easier for asset managers to launch ETFs and streamlined portfolio management for active managers, Armour said.
As a result, financial firms have been debuting more ETFs than mutual funds, increasing the number of funds available for investors.
In 2023, for example, fund companies issued 578 new ETFs, relative to 182 mutual funds, according to Morningstar.
Potential drawbacks of ETFs
Stock traders on the floor of the New York Stock Exchange.
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That said, ETFs have drawbacks while some of their stated benefits may be oversold.
For example, while most ETFs disclose their holdings every day (unlike mutual funds), such transparency “adds little value” for investors, who have little need to check underlying securities frequently, Armour wrote.
Additionally, ETFs trade throughout the day like a stock, while investors’ orders for mutual funds are only priced once a day, when the market closes.
But the ability to trade ETFs like a stock is “not much of an advantage for most investors,” Armour said. That’s because frequent buying and selling is generally a “losing proposition” for the average investor, he said.
Certain ETFs may also be tough to trade, a situation that could add costs for investors due to wide differences between the asking price and the bidding price, experts said. By contrast, mutual funds always trade without such “bid/ask spreads,” Iachini said.
Unlike mutual funds, ETFs can’t close to new investors, Armour said. If the fund gets too big, it can sometimes be difficult for certain actively managed ETFs to execute their investment strategy, he said.
Entrance to NYU Langone Hospital, New York City.
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New York University’s Grossman School of Medicine made history in 2018 when it became the first top-ranked medical program to offer full-tuition scholarships to all students, regardless of need or merit.
The number of applicants, predictably, spiked in the year that followed. But then, the share of incoming students considered “financially disadvantaged” sank to 3% in 2019, down from 12% in 2017, reports showed.
“Tuition-free schools can actually increase inequity,” said Jamie Beaton, co-founder and CEO of Crimson Education, a college consulting firm.
“Tuition-free colleges experience surges in application numbers, dramatically boosting the competitive intensity of the admissions process,” he said. “This in turn can skew admissions towards middle- or higher-income applicants who may be able to access more effective admissions resources, such as tutoring or extracurriculars.”
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“Our goal for tuition-free education was to clear pathways for the best and brightest future doctors from all backgrounds to attend NYU Grossman School of Medicine without the stress of taking on the average $200,000 in debt medical students typically incur,” Arielle Sklar, a spokesperson for the school told CNBC. “This allows students to align career choices with their passions in medicine rather than immediate economic pressures.”
Sklar, however, did not directly address the issue of declining low-income student enrollment.
Since the initiative by NYU’s Grossman School of Medicine, other top schools and programs have embraced the tuition-free model.
Harvard University was the latest undergraduate school to announce that it will be tuition free for undergraduates with family incomes of up to $200,000 beginning in the 2025-26 academic year, following similar initiatives at Vanderbilt University, Dartmouth, University of Pennsylvania and Massachusetts Institute of Technology.
Nearly two dozen more schools have also introduced “no-loan” policies, which means student loans are eliminated altogether from their financial aid packages.
In the case of Harvard, “you may see a trend of families with income closer to $200,000 outcompeting low-income students for slots,” Beaton said. “This may shift the proportion of Harvard students from the top 1% of income down, but it might also decrease the share of low-income students to the benefit of middle or middle-upper income families.”
More generous aid packages and tuition-free policies remove the most significant financial barrier to higher education but attract more higher-income applicants, other experts also say.
“Even though it sounds like lower-income students are going to be advantaged, it’s the middle class that’s going to win here,” said Christopher Rim, president and CEO of college consulting firm Command Education.
“These colleges are trying to build a well-rounded class, they need middle class and wealthy students as well,” he added. “They are not trying to take fewer rich kids — they need them because they’re the ones that are also going to be donating.”
For lower income students, “anything that increases the number of applications will be detrimental,” said Eric Greenberg, president of Greenberg Educational Group, a New York-based consulting firm.
Nearly all students worry about high college costs
These days, taking on too much debt is the top worry among all college-bound students, according to a survey by The Princeton Review.
College tuition has soared by 5.6% a year, on average, since 1983, significantly outpacing other household expenses, a recent study by J.P. Morgan Asset Management also found.
This rapid increase means that college costs have risen much faster than inflation, leaving families to shoulder a larger share of the expenses, experts say.
For the 2024-25 school year, tuition and fees plus room and board for a four-year private college averaged $58,600, up from $56,390 a year earlier. At four-year, in-state public colleges, it was $24,920, up from $24,080, according to the College Board.
To bridge the affordability gap, some of the nation’s top institutions are in an “affordability arms race,” according to Hafeez Lakhani, founder and president of Lakhani Coaching in New York.
However, overall, most institutions do not have the financial wherewithal to offer tuition-free or no-loan aid programs, added Robert Franek, The Princeton Review’s editor in chief. “More than 95% of four-year colleges in the U.S. are tuition driven,” he said.
Even if a school does not offer enough aid at the outset, there are other ways to bring costs down, according to James Lewis, co-founder of National Society of High School Scholars.
“Get beyond, ‘I can’t afford that,”‘ he said. “A lot of institutions will have a retail price but that’s not necessarily what a student will pay.”
Many schools will provide access to additional resources that can lower the total tab, he said, either through scholarships, financial aid or work-study opportunities.
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The tax deadline is days away — and the IRS is urging taxpayers to file returns on time and “pay as much as they can.”
However, if you can’t cover your total tax balance, there are options for the remaining taxes owed, according to the agency.
For most tax filers, April 15 is the due date for federal returns and taxes. But your federal deadline could be later if your state or county was impacted by a natural disaster.
If you are in the military stationed abroad or are in a combat zone during the tax filing season, you may qualify for certain automatic extensions related to the filing and paying of your federal income taxes.
Additionally, those living and working abroad also have extra time to file.
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If you’re missing tax forms or need more time, You can file a tax extension by April 15, which pushes the federal filing deadline to Oct. 15.
But “it’s an extension to file, not an extension to pay,” said Jo Anna Fellon, managing director at financial services firm CBIZ.
File by April 15 and ‘pay what you can’
If you can’t cover your balance by April 15, you should still file your return to avoid a higher IRS penalty, experts say.
The failure-to-file penalty is 5% of unpaid taxes per month or partial month, capped at 25%.
By comparison, the failure-to-pay penalty is 0.5% of taxes owed per month, limited to 25%. Both penalties incur interest, which is currently 7% for individuals.
File on time and pay what you can.
Misty Erickson
Tax content manager at the National Association of Tax Professionals
“File on time and pay what you can,” said Misty Erickson, tax content manager at the National Association of Tax Professionals. “You’re going to reduce penalties and interest.”
Don’t panic if you can’t cover the full balance by April 15 because you may have payment options, she said.
“The IRS wants to work with you,” Erickson added.
Options if you can’t pay your taxes
“Most individual taxpayers can qualify for a payment plan,” the IRS said in a recent news release.
The “quickest and easiest way” to sign up is by using the online payment agreement, which may include a setup fee, according to the agency.
These payment options include:
- Short-term payment plan: This may be available if you owe less than $100,000 including tax, penalties and interest. You have up to 180 days to pay in full.
- Long-term payment plan: You’ll have this option if your balance is less than $50,000 including tax, penalties and interest. The monthly payment timeline is up to the IRS “collection statute,” which is typically 10 years.
The agency has recently revamped payment plans, to make the program “easier and more accessible.”
Misinformation and lack of trust in traditional institutions runs rampant in our society.
The regulated financial sector is no different, particularly among young people. Roughly 38% of Gen Zers get financial information from YouTube, and 33% from TikTok, according to a recent Schwab survey.
As a former regulator and author of kids’ books about money, I am truly horrified by the toxic advice they are getting from these unqualified “finfluencers” — advice which, if followed, could cause lasting damage to their financial futures.
Most troubling are finfluencers who encourage young people to borrow. A central theme is that “chumps” earn money by working hard and that rich people make money with debt. They supposedly get rich by borrowing large sums and investing the cash in assets they expect to increase in value or produce income which can cover their loans and also net a tidy profit.
Of course, the finfluencers can be a little vague about how the average person can find these wondrous investments that will pay off their debt for them. Volatile, risky investments — tech stocks, crypto, precious metals, commercial real estate — are commonly mentioned.
‘The road to quick ruin’ for inexperienced investors
Contrary to their assertions, these finfluencers are not peddling anything new or revelatory. It’s simply borrowing to speculate.
For centuries, that strategy has been pursued by inexperienced investors as the path to quick riches, when in reality, it’s the road to quick ruin. There is always “smart money” on the other side of their transactions, ready to take advantage of them. For young people just starting out, with limited incomes and tight budgets, it’s the last thing they should be doing with their precious cash.
Debt glorification is not the only bad advice being peddled on the internet.
You can find finfluencers advising against diversified, low fee stock funds in favor of active trading (without disclosing research consistently showing active trading’s inferior returns). Or ones that discourage individual retirement accounts and 401(k) plans as savings vehicles in favor of real estate or business startups (without mentioning lost tax benefits as well as the heavy costs and expertise needed to manage real estate or high failure rates among young companies).
Some encourage making minimum payments on credit cards to free up money for speculative investments (without mentioning the hefty interest costs of carrying credit card balances which compound daily).
Why are so many young people turning to these unqualified social media personalities for help in managing their money instead of regulated and trained finance professionals?
One reason: the finfluencers make their advice entertaining. It may be wrong, but it’s short and punchy. Materials provided by regulated financial service providers can sometimes be dry and technical.
Where to get trustworthy money advice
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They may be boring, but regulated institutions are still the best resource for young people to get basic, free information.
FDIC-insured banks can explain to them how to open checking and savings accounts and avoid unnecessary fees. Any major brokerage firm can walk through how to set up a retirement saving account. It’s part of their function to explain their products and services, and they have regulators overseeing how they do it.
In addition, regulators themselves offer educational resources directly to the public. For young adults, one of the most widely used is Money Smart, offered by the Federal Deposit Insurance Corporation — an agency I once proudly chaired.
There are also many excellent regulated and certified financial planners. However, most young people will not have the budget to pay for financial advice.
They don’t have to if they just keep it simple: set a budget, stick to it, save regularly, and start investing for retirement early in a low-fee, well-diversified stock index fund. They should minimize their use of financial products and services. The more accounts and credit cards they use, the harder it will be to keep track of their money.
Above all, they should ignore unqualified “finfluencers.”
Check their credentials. Question their motives. Most are probably trying to build ad revenue or sell financial products. In the case of celebrities, find out who’s paying them (because most likely, someone is).
Regulated finance needs to reclaim its status as a more trustworthy source for advice. The best way to do that is, well, provide good advice. Every time a young adult is burnt by surprise bank fees, seduced into over borrowing by a misleading credit card offer, or told to put their retirement savings into a high fee, underperforming fund, they lose trust.
I know regulation and oversight are out of favor these days. But we need a way to keep out the bad actors, and practices to protect young people new to the financial world. It’s important to their financial futures and the future of the industry as well.
Sheila Bair is former Chair of the FDIC, author of the Money Tales book series, and the upcoming “How Not to Lose $1 Million” for teens. She is a member of CNBC’s Global Financial Wellness Advisory Board.
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