In a significant shift within the financial advisory space, a new report from Cerulli Associates suggests that advisors will soon hold more of their clients’ assets in exchange-traded funds (ETFs) than in mutual funds. This marks a turning point as ETFs gain traction over traditional mutual funds among financial planners.
Currently, nearly all advisors—94% and 90%—utilize mutual funds and ETFs, respectively. However, by 2026, advisors expect to allocate 25.4% of their clients’ assets to ETFs, surpassing the 24% allocation anticipated for mutual funds. If predictions hold true, ETFs will become the most favored investment vehicle among wealth managers, outstripping individual stocks, bonds, cash accounts, annuities, and other asset classes.
As it stands, mutual funds represent 28.7% of client assets, compared to 21.6% for ETFs. Despite similarities in structure and purpose, crucial distinctions have fueled the rise of ETFs.
ETFs, for instance, now hold approximately $10 trillion in U.S. assets, dwarfing yet steadily encroaching on the $20 trillion mutual fund market. Since their inception in the 1990s, ETFs have been steadily chipping away at mutual funds’ market share.
Jared Woodard, an investment and ETF strategist at Bank of America Securities, noted the appeal of ETFs, highlighting benefits such as tax advantages, lower expenses, and their liquidity and transparency, which have long made them attractive to investors.
One major appeal for ETF investors is the potential to bypass certain annual tax liabilities that mutual fund investors typically face. Mutual fund managers create capital gains through the buying and selling of securities, passing these tax obligations to shareholders annually. In contrast, the ETF structure allows most trades without triggering taxable events. In 2023, only 4% of ETFs distributed capital gains compared to a significant 65% of mutual funds.
Bryan Armour, director of passive strategies research for North America at Morningstar and editor of its ETFInvestor newsletter, emphasized the benefit, mentioning that avoiding taxes today allows that money to compound over time, increasing investor returns.
Nevertheless, investors in both ETFs and mutual funds eventually face capital gains taxes on profits when they sell their holdings. The preference for ETFs among advisors also stems from their liquidity, transparency, and lower fees compared to mutual funds. Index ETFs boast an average expense ratio of 0.44%, significantly lower than the 0.88% for index mutual funds. Active ETFs carry a 0.63% fee on average, compared to 1.02% for actively managed mutual funds, per Morningstar data. This tax efficiency and reduced fees mean lower overall costs for investors.
In addition to cost benefits, ETFs can be traded like stocks throughout the day, contrasting with mutual funds, which are limited to post-market close trades. ETFs also frequently disclose their portfolio holdings daily, offering more transparency than the typically quarterly disclosure of mutual funds, providing investors greater visibility into their investments.
However, experts note some limitations of ETFs. For instance, mutual funds continue to dominate workplace retirement plans, such as 401(k)s, which might not change soon due to existing tax advantages of these accounts. ETFs also lack the ability to close to new investors, which could potentially disadvantage them in specialized, niche investment strategies. As such funds gather more investors, delivering on their investment strategies may become challenging.
