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.
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As U.S. markets continue to suffer steep declines in the wake of the Trump administration’s new tariff policies, you may be wondering what the next best move is when it comes to your retirement portfolio and other investments.
Behavioral finance experts warn now is the worst time to make any drastic moves.
“It is dangerous for you — unless you can read what is going to happen next in the political world, in the economic world — to make a decision,” said Meir Statman, a professor of finance at Santa Clara University.
“It is more likely to be driven by emotion and, in this case, emotion that is going to act against you rather than for you,” said Statman, who is author of the book, “A Wealth of Well-Being: A Holistic Approach to Behavioral Finance.”
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That may sound easier said than done when headlines show stocks are sliding into bear market territory while J.P. Morgan is raising the chances of a recession this year to 60% from 40%.
“When the market drops, we have sort of a herd instinct,” said Bradley Klontz, a psychologist, certified financial planner and managing principal of YMW Advisors in Boulder, Colorado. Klontz is also a member of the CNBC FA Council.
That survival instinct to run towards safety and away from danger dates back to humans’ hunter gatherer days, Klontz said. Back then, following those cues was necessary for survival.
But when it comes to investing, those impulses can backfire, he said.
“It’s an internal panic, and we’re just sort of wired to sell at the absolute worst times,” Klontz said.
‘Never trust your instincts when it comes to investing’
When conditions are stressful, our frame of reference narrows to today, tomorrow and what’s going to happen, Klontz said.
It may be tempting to come up with a story for why taking action now makes sense, Klontz said.
“Never trust your instincts when it comes to investing,” said Klontz, particularly when you’re excited or scared.
Meanwhile, many investors are likely in a fight or flight response mode now, said Danielle Labotka, behavioral scientist at Morningstar.
“The problem with that, in acting right away, is that we’re going to be relying on what we call fast thinking,” Labotka said.
Instead, investors would be wise to slow down, she said.
Just as grief requires moving through emotional stages in order to eventually feel good, it’s impossible to jump to a good investing decision, Labotka said.
Good investment decisions take time, she said.
What should be guiding your decisions now
Many investors have experienced market drops before, whether it be during the Covid pandemic, the financial crisis of 2008 or the dot-com bust.
Even though we’ve experienced volatility before, it feels different every time, Labotka said.
That can make it difficult to heed to the advice to stay the course, she said.
Investors would be wise to ask themselves whether their reasons for investing and the goals they’re trying to achieve have changed, experts say.
“Even though the markets have changed, why you’re invested, your values and your goals probably haven’t,” Labotka said. “These are the things that should be guiding your investments.”
While there is the notion that life well-being is based on financial well-being, it helps to take a broader view, Statman said.
At any moment, no one has everything perfect when it comes to their finances, family and health. In life, as in an investment portfolio, all stocks don’t necessarily go up, and it’s helpful to learn to live with the good and the bad, he said.
“Things are never perfect for anyone,” Statman said.
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As the stock market continues to fall, some investors are eager to “buy the dip,” or purchase assets at temporarily lower prices. Financial advisors, however, urge clients to stick with long-term investing plans amid the latest volatility.
U.S. stocks plunged on Thursday after President Donald Trump issued sweeping tariffs on more than 180 countries and territories. The sell-off continued Friday after China unveiled plans to impose a 34% retaliatory tariff on all goods imported from the U.S.
As of Friday afternoon, the Dow Jones Industrial Average was down more than 1,700 points following a 1,679.39 drop on Thursday. Meanwhile, the S&P 500 was off 4.8% after losing 4.84% the previous day. The tech-heavy Nasdaq Composite slid by 4.9% after plummeting 5.97% on Thursday.
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If you’re looking for buying opportunities while assets are down, here are some things to consider, according to financial advisors.
Timing the market is ‘impossible’
When asset values fall, there’s often chatter in online communities like Reddit about whether to “buy the dip.” Typically, investors aim to buy at a discount and expect an eventual recovery, which could lead to future gains.
While buying cheaper investments isn’t a bad idea, the strategy can be tricky to execute since, of course, no one can predict stock market moves, experts say.
“We never recommend timing the market, mostly because it is impossible to do without simply getting lucky,” said certified financial planner Eric Roberge, CEO of Beyond Your Hammock in Boston.
Instead, you should “stick to a thoughtful, rules-based investment strategy designed to get you through to your long-term goals,” he said.
Keep a ‘disciplined approach’
When buying assets during a market downturn, you need a “disciplined approach,” according to CFP Jay Spector, co-chief executive officer of EverVest Financial in Scottsdale, Arizona.
For example, some investors linger in cash while waiting for rock-bottom prices. But no one can predict the bottom of the market, experts say.
Waiting on the sidelines can be costly because the best returns can follow the biggest dips, according to research from Bank of America.
Rather than trying to time the bottom, you should consider “dollar-cost averaging,” which systematically invests your money at set intervals, Spector said. The strategy can capture lower prices while reducing risk, he said.
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