The first exchange-traded fund debuted into the early 1990s

4 top reasons why exchange-traded fund growth has ballooned Since then, they've steadily gained market share from mutual funds

The first exchange-traded fund debuted into the early 1990s

Exchange-traded funds have steadily gained popularity among investors in recent years — a trend experts say is largely due to advantages like lower tax bills and fees relative to mutual funds.

The first ETF debuted in 1993. Since then, ETFs have captured about $9.7 trillion, according to Morningstar data through August 2024.

While mutual funds hold more investor funds, at $20.3 trillion, ETFs are gaining ground. ETF market share relative to mutual fund assets has more than doubled over the past decade, to about 32% from 14%, per Morningstar data.

"The simple fact is, the structure of an ETF is a superior fund structure to a mutual fund, especially for taxable accounts," said Michael McClary, chief investment officer at Valmark Financial Group, who uses ETFs to build financial portfolios for clients.

Here are four reasons why McClary and other experts say ETFs took off.

1. They have 'tax magic'

ETFs resemble mutual funds in many ways. They're both baskets of stocks and bonds overseen by professional money managers.

But there are a few distinctions.

At a high level, ETFs trade on a stock exchange, like the stock of a publicly traded company. Investors generally buy mutual funds directly from an investment company.

On a more micro level, many ETF investors can sidestep the fund-level capital gains taxes incurred by many investors who own mutual fund shares, experts said.

Investors generally owe capital-gains tax to the IRS on investment profits, typically from the sale of investment funds or other financial assets like individual stock and real estate.

However, mutual fund managers can also generate capital-gains taxes within a fund itself when they buy and sell securities. Those taxes then get passed along to all the fund shareholders.

In other words, these investors get a tax bill even if they personally didn't sell their holdings.

The structure of an ETF, however, allows most managers to trade a fund's underlying stocks and bonds without creating a taxable event for investors, experts said.

This is "tax magic that's unrivaled by mutual funds," Bryan Armour, director of passive strategies research for North America and editor of the ETFInvestor newsletter at Morningstar, wrote earlier this year.

In 2023, about 4% of ETFs distributed capital-gains taxes to investors relative to more than 60% of stock mutual funds, Armour said in an interview.

But the advantage depends on a fund's investment strategy and asset class. Investors who hold actively managed mutual funds that trade often are more susceptible to tax loss, whereas those with market-cap-weighted index funds and bond funds "don't benefit that much from the tax advantage of ETFs," Armour wrote.

Additionally, "the taxable argument doesn't matter in a retirement account," McClary said.  

That's because workplace retirement plans like a 401(k) plan and individual retirement accounts are tax-advantaged. Investors don't owe capital-gains taxes related to trading as they would in a taxable brokerage account.

"The 401(k) world is a place where mutual funds can still make sense," McClary said.

2. Costs are low

The first ETF was an index fund: the SPDR S&P 500 ETF Trust (SPY).

Index funds, also known as passively managed funds, track a market index like the S&P 500.

They tend to be less expensive than their actively managed counterparts, which aim to pick winning stocks to outperform a benchmark.

Investors have equated ETFs with index funds since their inception, even though there are also index mutual funds, experts said. The first actively managed ETF wasn't available until 2008.

ETFs have therefore benefited from investors' long-term gravitation toward index funds, and away from active funds, as they seek lower costs, experts said.

The average ETF costs half as much as the average mutual fund, at 0.50% versus 1.01%, respectively, according to Armour.

ETFs accounted for 80% of net money into index stock funds in the first half of 2024, Morningstar found.

"Low costs and greater tax efficiency are an easy win for investors, so I think that's the simple answer that's been so effective for ETFs," Armour said.

That said, investors shouldn't assume ETFs are always the lowest-cost option.

"You may be able to find an index mutual fund with lower costs than a comparable ETF," according to a March 2023 report by Michael Iachini, head of manager research at Charles Schwab.

3. Financial advice fee model changes

Financial advisors have also undergone a shift that's benefited ETFs, said Morningstar's Armour.

Retail brokerage firms historically earned money from commissions on the sale of funds and other investments.

However, many firms have moved toward a so-called fee-based model, whereby clients incur an annual fee — say, 1% — based on the value of the holdings in their account. A virtue of this model, according to advocates, is that it doesn't influence an advisor's investment recommendation as a commission might.

Low costs and greater tax efficiency are an easy win for investors, so I think that's the simple answer that's been so effective for ETFs.Bryan Armourdirector of passive strategies research for North America at Morningstar

The shift is "one of the most important trends in the retail brokerage industry over the past decade," according to McKinsey.

ETFs work well for fee-based advisors because they're less likely than mutual funds to carry sales-related costs like sales loads and 12b-1 fees, Armour said. The latter is an annual fee that mutual funds charge investors to cover marketing, distribution and other services.

While brokerage firms may charge a commission to buy ETFs, many large brokerages have ditched those fees.

"There was a whole generation of advisors who only used mutual funds," McClary said. "Now, it's hard to find a quality [advisor] that doesn't use ETFs to some capacity."

4. SEC rule made ETF launches easier

The Securities and Exchange Commission issued a rule in 2019 that made it easier for asset managers to launch ETFs and streamlined portfolio management for active managers, Armour said.

As a result, financial firms have been debuting more ETFs than mutual funds, increasing the number of funds available for investors.

In 2023, for example, fund companies issued 578 new ETFs, relative to 182 mutual funds, according to Morningstar.

Potential drawbacks of ETFs

That said, ETFs have drawbacks while some of their stated benefits may be oversold.

For example, while most ETFs disclose their holdings every day (unlike mutual funds), such transparency "adds little value" for investors, who have little need to check underlying securities frequently, Armour wrote.

Additionally, ETFs trade throughout the day like a stock, while investors' orders for mutual funds are only priced once a day, when the market closes.

But the ability to trade ETFs like a stock is "not much of an advantage for most investors," Armour said. That's because frequent buying and selling is generally a "losing proposition" for the average investor, he said.

Certain ETFs may also be tough to trade, a situation that could add costs for investors due to wide differences between the asking price and the bidding price, experts said. By contrast, mutual funds always trade without such "bid/ask spreads," Iachini said.

Unlike mutual funds, ETFs can't close to new investors, Armour said. If the fund gets too big, it can sometimes be difficult for certain actively managed ETFs to execute their investment strategy, he said.

This story originally appeared on: CNBC - Author:Greg Iacurci