ETFs Are Gaining Popularity
ETFs, or exchange-traded funds, had a record year in 2021 as net inflows eclipsed $900 billion. If you put that amount in context to the two previous years of $507 and $476 billion, the growing popularity of ETFs is clear. The big year was mostly due to the influx into US equity ETFs - $717 billion rising from $242 billion in 2020.
On the other hand, mutual funds registered net outflows of about 29 billion. The 2021 margin between ETFs and mutual funds inflows was massive. Mutual fund assets total about four times that of ETFs1 so while 2021 was notable, mutual funds are still the leading investment vehicle.
But why the big shift? Are ETFs a better investment than mutual funds?
Let’s dive into the similarities and differences of ETFs and mutual funds. Both are investment funds that are registered with the SEC under the Investment Company Act of 1940 and represent a way for investors to diversify with a professionally managed collection of individual stocks or bonds.
The major differences between ETFs and mutual funds include how investors buy and sell them, how prices are set, and the types of costs investors should consider.
- How to buy and sell - mutual funds are bought and sold directly between investors and the fund at the end of each business day. Unlike mutual funds, ETF shares can be bought and sold throughout the day, similar to stocks.
- How prices are set - the price of a mutual fund is not determined until all stock prices settle at the end of the business day. The closing mutual find price is defined as the fund’s net asset value (NAV), which is the closing market prices of the portfolio's securities. ETFs are different. A price of a share or unit of an ETF is based on a unit or share of a basket of stocks/bonds held by the ETF company. Because it trades separately from the underlying stocks, the price of an ETF may vary from the value of the stocks it represents, depending on how robust and volatile the market is. Few traders in a wildly priced market may mean that by the time the EFT is sold, the price is different than when the order was entered. For this reason, we prefer the mutual fund’s method of trading; plus, we avoid the intra-day market timing conundrum.
- Types of costs:
- Management fee - both ETFs and mutual funds have expense ratios which represent the cost to manage the investment vehicle. ETFs have generally been passively managed and track market indices, meaning their expense ratios typically are under 0.2. Mutual funds’ expense ratios are around 0.5 and can be much higher than 0.5 if involved in active management.
- Transaction cost - many brokerage platforms now charge low or sometimes no commissions to buy or sell ETFs whereas mutual funds are between $25-75. However, ETFs are similar to trading stocks and, as with trading any individual stock, there are other trading costs to consider, such as bid/ask spreads and market intra-day volatility.
- Income Distributions – unlike mutual funds, ETFs are largely able to limit long-term capital gain distributions to zero or close to zero. However, a manager’s investment strategy and approach also matter when it comes to tax efficiency. For example, Dimensional Fund Advisors mutual fund managers try to limit a portfolio’s turnover and maintain flexibility in managing distributions for income and both short and long-term capital gains to improve tax efficiency.
Clearly based on 2021’s net inflows, there are many investors who are advocating that ETFs are more efficient than mutual funds. We will continue to watch ETFs and conduct our investment due diligence to determine what investment vehicle is best for you.
1According to the Investment Company Institute, in 2021, US registered mutual funds had $27 trillion in assets, compared with $7.2 trillion in assets for US ETFs. At year-end 2021, there were 8,887 mutual funds and 2,690 ETFs in the US. Keep in mind that mutual funds have been offered for almost a century while ETFs are still “young” in the investment arena, with the first ETF being launched in 1993.
Investment Company Institute. "2022 Investment Company Fact Book," Pages 2 and 21.