Why Investors are Flocking to ETFs

When exchange traded funds (ETFs) arrived on the scene a couple of decades ago, not even the most prophetic investor or financial pundit expected such massive popularity and growth. According to the Investment Company Institute, U.S. investors had a whopping $3.4 trillion invested in ETFs in 2018 — which was more than twice the amount invested in 2013.

So, that begs the million — or make that 3.4 trillion — dollar question: why are investors in love with ETFs, including many that have dramatically reduced or completely eliminated their mutual fund holdings and raced head first into ETF country? It typically boils down to these reasons:

  1. Relatively Lower Capital Gains Taxes

The only term that rankles investors more than “management fees” is “capital gains taxes”. While ETFs don’t (unfortunately) eliminate capital gains taxes from the picture, they do significantly reduce them relative to mutual funds. This is because ETFs incur capital gains taxes only when they are sold, while mutual funds incur capital gains taxes whenever shares are traded.

  1. Affordability

Speaking of dreaded management fees: with mutual funds, the MER (management expense ratio) can be startling high; exceeding three, four or even five percent of the overall value. This often leads to a very painful and unwelcome surprise for passive retail investors — i.e. everyday middle-class folks who buy mutual funds and hold onto them for decades — who, upon retirement, realize that they have effectively paid out tens or hundreds of thousands of dollars in management fees (and here’s the worst part: even during periods where their mutual funds actually lost value!). ETFs, on the other hand, are tied to the return of a specific benchmark (e.g. the Dow Jones), and as such there is no complex asset selection — which translates into significantly lower management fees.

  1. Simplicity

Let’s face it: the investment landscape can be ridiculously complex. Against this convoluted backdrop sits ETFs, which are wonderfully simple — like a Zen garden, a minimalist painting, or stylish modern office interior design. All buying and selling is completed through a single transaction, and transferring ETFs from one investment firm to another is typically straightforward. What’s more, unlike mutual funds, ETFs don’t force investors who want to move their funds to close their positions — and possibly make an untimely, undesirable and costly trade — before a transfer can take place.

  1. Transparency

Both ETFs and mutual funds provide transparency to investors. However, ETFs report all holding on a daily basis, while mutual funds report holdings four times a year. For some investors, this is not a meaningful factor. But for others who take a more active interest in their investments, it’s essential.

The Bottom Line

Do all of the above reasons mean that you should run out and put your mutual funds, personal savings, and all of your other available capital into ETFs? Of course not. You definitely need to do your research, and align your investments with your goals and tolerance for risk. Still, once you do your homework and speak with a credible, objective, independent (and preferably fee-only) financial advisor, you’ll likely find that ETFs should e part of your strategy and portfolio.