The asset management industry is witnessing a significant shift in investor preferences, as recent data from Cerulli Associates reveals that financial advisors are on the brink of allocating more client assets to exchange-traded funds (ETFs) than to mutual funds for the first time. This development marks a turning point that could reshape investment strategies and client portfolios, reflecting broader trends in the financial services sector.
According to the report, an overwhelming number of financial advisors, approximately 94%, utilize mutual funds, while a close 90% also incorporate ETFs into their investment strategies. However, projections indicate a shift in the allocation of assets. By 2026, advisors expect an estimated 25.4% of client assets to be invested in ETFs, compared to just 24% in mutual funds. If this forecast materializes, ETFs will claim the top spot as the most widely used investment vehicle, surpassing not just mutual funds but also individual stocks and bonds, cash accounts, annuities, and other investment types.
Currently, mutual funds constitute 28.7% of client assets, whereas ETFs hold 21.6%. This changing landscape highlights a growing acceptance of ETFs as viable investment options, primarily driven by their inherent characteristics and advantages that appeal to both advisors and investors.
ETFs and mutual funds share the fundamental purpose of allowing investors to diversify their portfolios across a range of securities like stocks and bonds. However, there are pivotal differences that have allowed ETFs to gain traction. With approximately $10 trillion in U.S. assets, ETFs represent a formidable force in the financial market, despite holding only half the assets of mutual funds, which total around $20 trillion.
Key attributes that drive the popularity of ETFs include their tax efficiency, lower expense ratios, liquidity, and transparency. Jared Woodard, an investment strategist, pointed to these factors as reasons why ETFs have been so attractive for investors. For instance, one of the most compelling benefits of ETFs is the ability to minimize tax liabilities. Unlike mutual funds, which can generate capital gains that are passed on to all shareholders, ETFs are structured to allow the majority of managers to trade securities without triggering taxable events. In 2023, only 4% of ETFs distributed capital gains, starkly contrasted by 65% of mutual funds.
This tax efficiency means that investors in ETFs can compound their returns without the annual tax burden that often accompanies mutual fund investments, as noted by Bryan Armour of Morningstar. In other words, the money that remains untaxed can lead to greater long-term gains for ETF investors.
Investor costs are a critical consideration when choosing between investment vehicles. Data from Morningstar reveals that index ETFs carry an average expense ratio of 0.44%, which is nearly half that of index mutual funds at 0.88%. For active funds, ETFs average 0.63%, while actively managed mutual funds reach an average of 1.02%. The lower fees associated with ETFs translate into substantial savings for investors over time.
Additionally, ETFs offer superior liquidity, which allows investors to trade them throughout the day like stocks. Mutual funds, by contrast, only execute trades at the close of the market, introducing a level of delay that can affect pricing and execution. Furthermore, ETFs disclose their holdings daily, affording investors greater insight into their investment choices compared to mutual funds, which typically reveal their holdings on a quarterly basis.
Despite the growing preference for ETFs, there are notable limitations that should not be overlooked. For instance, mutual funds continue to dominate retirement investment vehicles, such as 401(k) plans, where their tax-advantaged status remains a significant factor. ETFs do not offer additional tax advantages in such accounts, as retirement accounts are designed to be tax-advantaged by nature.
Moreover, certain ETFs may struggle to effectively manage large inflows of capital, particularly those with specialized investment strategies. As an ETF grows in popularity, the potential for asset congestion can impede the money manager’s ability to execute the strategy effectively.
As financial advisors continue to embrace ETFs, the structure of client portfolios is likely to transform. With advantages that align well with contemporary investment priorities—such as cost efficiency, transparency, and adaptability—ETFs are poised to play an essential role in wealth management strategies moving forward. Nevertheless, a balanced perspective that recognizes the strengths and limitations of both ETFs and mutual funds will be crucial for any investor aiming to optimize their portfolio for the future.