Here’s Why ETFs Run Circles Around Mutual Funds

When State Street introduced the SPDR S&P 500 ETF in 1993, the company introduced the U.S. to exchange-traded funds (ETFs). Almost 30 years later, assets in ETFs are growing at a rapid pace with no signs of slowing down.

According to data from the Investment Company Institute (ICI), there were about $6.5 trillion in ETF assets through the end of June 2021. That’s more than six times as much as there were 10 years ago when there were about $1 trillion in ETF assets. On an annualized basis, ETF assets have grown by about 22% per year since the end of 2011.

Mutual fund assets currently stand at $21.5 trillion as of June 30, up from about $8.9 trillion at the end of 2011, according to ICI data. That’s an annualized growth rate of about 9.7% over that period.

Why have investors embraced ETFs? Several factors have contributed to the rapid growth of ETFs relative to mutual funds. Here are three key reasons.

Image source: Getty Images.

1. They look like mutual funds but act like stocks

Like index mutual funds, ETFs invest in a portfolio of stocks from an index, like the S&P 500, Nasdaq, or some variation. For example, the previously mentioned SPDR S&P 500 ETF invests in the stocks in the S&P 500 — like an index mutual fund. But the key difference is that ETFs trade on an exchange like an individual stock, with their own ticker.

So, you can buy and sell shares of your ETF during the day while the exchanges are open, just like you would with a stock. Mutual funds don’t price out until the end of the trading day, so there’s no intraday trading. That’s a convenience that a lot of investors appreciate.

It should also be noted that there is no investment minimum with ETFs. If you only have $100 to invest, you can buy a few shares of an ETF through your brokerage and start investing. With most mutual funds, there is an investment minimum between $1,000 and $3,000 — although there are some with less. This makes ETFs far more accessible to many investors, who can start small and increase their positions over time.

2. ETFs are cheaper, on average

Because the vast majority of ETFs are passively managed, meaning they track the performance of an index, they are less expensive than mutual funds. That’s because more than half of mutual fund assets are actively managed, meaning there is a portfolio management team that picks the stocks that go into the portfolio. That active management, the buying and selling that goes along with managing the portfolio, carries a higher expense ratio than an index fund or ETF. Some mutual funds also have sales commissions, which ETFs do not.

According to ICI, the average expense ratio for a mutual fund at the end of 2020 was 1.18%, which means that for every $10,000 invested, $118 goes to fees. The average expense ratio for ETFs according to ICI was 0.47%, which means that the fees are $47 per every $10,000 invested. On an asset-weighted basis, the average mutual fund has an expense ratio of 0.50% compared to 0.18% for an ETF, according to ICI.

3. There are tax advantages to ETFs

Another benefit of ETFs is the tax advantages they have over most mutual funds. Mutual funds and ETFs are both required by law to distribute any capital gains they generate, so when a position in the fund is sold for a gain, it is distributed to investors who must, in turn, pay a tax on that gain. These gains are not related to the investor selling shares of the fund — it is for gains on individual stocks within the portfolio.

Mutual funds routinely generate capital gains whenever they sell holdings at a profit. However, ETFs do not typically incur these types of taxes because due to the structure of ETFs, positions aren’t often sold for cash; rather, ETFs typically create or redeem ETF shares by making stock transfers in kind. But, keep in mind, there can be capital gains taxes if you sell shares of an ETF for profit.

Performance-wise, ETFs, and index mutual funds, have largely outperformed actively managed funds during the long bull market run over the past decade. That’s not to say the trend will continue, but given their high performance, accessibility, and low fees, it’s no wonder that more investors have flocked to ETFs.

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Dave Kovaleski has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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