ETFs Will Soon Beat Advisors’ Mutual Funds: Report

Financial advisors will soon – and for the first time – hold more of their clients’ assets in exchange-traded funds than in mutual funds, according to a new report from Cerulli Associates.

Nearly all advisors use mutual funds and ETFs, about 94% and 90% respectively, Cerulli said in a report released on Friday.

However, advisors estimate that by 2026 a greater share of client assets, 25.4%, will be invested in ETFs compared to the share of client assets in mutual funds, at 24%, Cerulli said.

If that happens, ETFs would be the “asset manager product vehicle” most commonly allocated to individual stocks and bonds, cash accounts, annuities and other types of investments, Cerulli said.

Currently, mutual funds account for 28.7% of client assets and ETFs for 21.6%, the report said.

ETFs and mutual funds are similar. They are essentially a legal structure that allows investors to diversify their assets across many different securities, such as stocks and bonds.

But there are important differences that are making ETFs increasingly popular with investors and financial advisors.

ETFs hold approximately $10 trillion in U.S. assets. While that’s about half of the approximately $20 trillion in mutual fund assets, ETFs have steadily eroded mutual fund market share since their introduction in the early 1990s.

“ETFs have long been attractive to investors,” said Jared Woodard, investment and ETF strategist at Bank of America Securities. “There are tax benefits, the costs are a bit lower and people like the liquidity and transparency.”

ETF investors can often avoid certain tax bills that many mutual fund investors must pay annually.

Specifically, mutual fund managers generate capital gains within the fund when they buy and sell securities. This tax liability is then passed on to all fund shareholders each year.

However, the ETF structure allows most managers to trade stocks and bonds without triggering a taxable event.

By 2023, 4% of ETFs had capital gains distributions, compared with 65% of mutual funds, says Bryan Armour, director of passive strategies research for North America at Morningstar and editor of the ETFInvestor newsletter.

“If you don’t pay taxes today, that amount increases” for the investor, Armor said.

Of course, ETF and mutual fund investors are both subject to capital gains taxes on investment gains when they eventually sell their holdings.

Liquidity, transparency and low costs are among the top reasons why advisors choose ETFs over mutual funds, Cerulli said.

According to data from Morningstar, index ETFs have an average expense ratio of 0.44%, which is half the 0.88% annual fee for index mutual funds. Active ETFs have an average fee of 0.63%, compared to 1.02% for actively managed mutual funds, Morningstar data shows.

Lower fees and tax efficiency lead to lower overall costs for investors, Armor said.

Investors can also trade ETFs like stocks during the day. Although investors can place an order in a mutual fund at any time, the trade is executed only once a day after the market closes.

ETFs also generally disclose their portfolio positions once a day, while mutual funds typically disclose their positions on a quarterly basis. ETF investors can see more regularly what they are buying and what has changed within a portfolio, experts say.

However, there are limitations to ETFs, experts say.

First, mutual funds are unlikely to relinquish their dominance in workplace retirement plans such as 401(k) plans, at least in the short term, Armor said. ETFs generally don’t give investors a leg up on their retirement accounts, as 401(k)s, individual retirement accounts and other accounts already enjoy tax benefits.

Furthermore, unlike mutual funds, ETFs are unable to reach new investors, Armor said. This could put investors at a disadvantage against ETFs with niche, concentrated investment strategies, he said. Money managers may not be able to execute the strategy well because the ETF gets more investors depending on the fund, he said.