Investors Move Money into ETFs as Fund Strategies Expand, Providing Retail Investors with More Options

The rise of Exchange Traded Funds (ETFs) has been pretty spectacular. Proceeded by the advent of Mutual Funds, ETFs offer greater liquidity and a more creative portfolio of offerings than your parents’ Mutual Funds. While passive ETFs currently dominate, there has been a rise in actively managed ETFs with strategies that can replicate hedge-fund-like offerings, all made available to the general public.

According to Deloitte, Mutual Funds experienced a net outflow of $2.9 trillion during the past ten years, while ETFs saw net inflows of $4.5 trillion. While passive strategies remain larger, active strategies have been growing faster in terms of ETF cash inflows. The report shares that between 2021 and 2023, 460 net-new active ETFs were launched while the number of active mutual funds declined. By 2030, actively managed ETFs are predicted to top $4.4 trillion.

Highlighting the benefits of ETFs, Gil Baumgarten, CEO of Segment Wealth Management, says that mutual funds, which have been around since the 1920s, can offer diversification for smaller investors. However, traditional open-ended mutual funds have commingled accounting, and such activity creates taxable events for all investors, not to mention heightened fees.

“This degrades the after-tax effect of investing in a mutual fund. ETFs function differently; being listed securities like a stock. This avoids the liquidity issues created by departing shareholders who redeem. Being a listed security means that every shareholder in the ETF owns his or her own cost basis by way of a process called “creation units,”  explains Baumgarten. “Shareholders participate in the same common pool, but the taxes on ingress and egress are different. This gives ETFs a far better set of tax rules to compound over a long time of holding the shares. This not only benefits both the math of deferred gain and resulting compounding but also serves to preserve the powerful step-up-in-basis rule, which can make unrealized gain tax-free.”

Baumgarten also points to the cost difference between ETFs and Mutual Funds. He says that ETFs have been at the forefront of the “low cost revolution”  as many ETFs are managed by computers that seek to match an Index. This evades the cost of expensive portfolio managers.

“The success of these funds has come at the expense of traditional actively managed mutual funds. But the fund companies and their shareholders seem determined to morph the mutual fund offerings into ETFs, which is how the marketplace is evolving,” Baumgarten adds.

Baumgarten states that fund companies and optimistic investors “keep the dream of outperformance alive” despite the unlikely math of high fees.

“Investing requires a certain amount of optimism, and investing in active strategies exemplifies a certain level of hope. The proliferation of active ETFs does solve the tax problems created by commingled accounting, so the proliferation of active ETFs seems quite predictable. While some ETFs may have nominal 12b-1 fees, most do not. This also serves to split the difference between active open-end funds and ETFs while finding some more efficient lower-fee and lower-tax middle ground.”

He states that brokerages have been slow to accept ETFs as a replacement for their lucrative mutual fund businesses and the “gravy train of 12b-1 fees.”

While the brokerages may not like the decline of Mutual Funds and affiliated fees, Baumgarten says, “they have come around to the idea that having half of something is better than all of nothing.”