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One of the more fascinating financial things that I’ve witnessed in recent years is the explosion of exchange traded funds (ETFs). I remember talking to a stock broker friend in the mid-2000s. It was then when he first introduced me to the concept of mutual funds losing clout to ETFs.
I was a fairly new investor. Up until that point, I thought mutual funds were the only option in terms of offering a basket of stocks.
Much later in life, I learned of Vanguard and the Boglehead movement. Anyone reading this who is under 25, feel grateful that you have greater financial information at your fingertips than I did in my 20s.
Even though my friend knew that ETFs were the wave of the future, I don’t think he anticipated how quickly they would gain popularity.
ETFs vs. Mutual Funds
Both ETFs and mutual funds are similar in that both, generally speaking, hold baskets of securities.
The main difference between them is that ETFs can be traded intraday like stocks. In contrast, mutual funds can only be priced and traded at the end of the day.
On top of that, ETFs have been a dominant player within the realm of passive index funds. Passive index funds have been gaining momentum over the years, since John Bogle introduced them in the 1970s.
On the other hand, mutual funds oftentimes have managers who actively try to beat the fund’s benchmark. This is in order to maximize the value back to the customer. However, this usually comes with hefty fees. More times than not, these active managers underperform the benchmark in which they attempt to beat.
Passive Funds
A passive fund will oftentimes mimic the performance of an underlying index, such as the S&P 500, by holding the same positions in the index. Since these positions are passive and are not traded constantly, passive index funds typically have lower fees associated with them. The draw of low fees has contributed to the popularity of passive funds over the years.
How Quickly Are ETFs Growing?
Martin Small, the head of U.S. and Canada iShares at BlackRock, in an open letter entitled, “How did we ever live without them”, said
“ETFs aren’t just having a moment. They’re creating a movement.”
Last year, 1 in 4 U.S. investors owned at least one share of an ETF. This year, experts project that the number will rise to 1 in 3 investors.
In the next two years, BlackRock projects that nearly half of all U.S. investors will have at least one position in an ETF.
Who Are the Leaders of ETFs?
The two top ETF asset managers aren’t surprising. According to Morningstar Direct, BlackRock has $1.38 trillion in ETF assets, or almost 40% of the market. Vanguard comes in second place with $872 billion in assets, or roughly 25% of the market.
Total Net Assets
Mutual funds still dwarf ETFs. However, ETFs continue to whittle down the dominant position of mutual funds. As you can see in the chart below, mutual funds account for $16.34 trillion dollars of managed funds, compared to $2.5 trillion in ETFs.
Total Net Assets of Mutual Funds in the US (1998-2016, in trillions)
Source: Statistica
Total Net Assets of ETFs in the US (2002-2016, in billions)
Source: Statistica
In 2017 alone, ETFs accounted for $692 billion amount of inflows, while mutual funds hemorrhaged $45 billion in outflows.
While mutual funds had their moment in the sun, it appears that money is now pouring into ETFs. Personally, I have a feeling that as active money managers flame out, only the best money managers will remain.
I foresee that these active money managers will gain an outsized influence, which may start to tip the scales back towards actively-managed funds in the future.
Of course, I don’t know what the future holds. But for now, I plan to keep my funds in passive index funds for the foreseeable future.
With any new investor, the first thing that we should look at is the management fees between similar ETF and mutual funds. If you do a comparison of the long term cost, you will probably ask: why should you pay thousands when you don’t have to?
In general, it’s best to try to minimize your fees so that over a long period of 20 to 30 years, you will end up with a lot more money if you go with the lower cost option.
Leo T. Ly @ isaved5k.com recently posted…The Handy Income Tax Deductions Checklist To Help You Maximize Your Refund
Great points Leo!!! Fees are so important and make a huge difference on your returns. That’s why ETFs are eating mutual funds lunches 🙂
I follow investing trends out of interest, so none of it is a surprise to me. I sometimes wonder how far passive investing can go. At some point (if passive becomes to big a piece of the market), it will create opportunity for active managers to exploit the market inefficiency. Tom
Tom @ Dividends Diversify recently posted…Southern Comfort
I totally agree with you Tom!!! At some point the star managers that outperform the market will get people to swing back against the passive index funds. I figure it’s just a vicious circle over time.
Thought experiment: 100% of the market is index ETFs. No one trades individuals company shares anymore. With no buy/sells for the individual stocks, how are the underlying shares be priced for index or the ETF? The product would become the index (not the underlying shares in the index) and bids/offers on the index ETF would drive the index and ETF price. If it is truly 100% index ETFs, the individual company stocks are not traded and one trade could move the price significantly. This leaves individual share open to manipulation. You don’t have to get all the way to 100% ETF for the volume of stock trades to be so small as invite manipulation.
Let’s ramp the experiment to more realistic levels. Let’s say we get to a point where 75% of the market is index ETFs and 25% is trades in individual stocks. Active managers will look for companies in the index that are growing faster than the index; i.e. compare index P/E ratio to company’s P/E ratio. By investing in the individual shares that have a P/E ratio less than the index P/E, the active manager is trying to beat the index. It’s debatable if that strategy has a greater or lower probability of beating the index when the index is 75% of the market vs. 10% of the market.
There will always be people who are convinced they can beat the market or at least can convince investors they can beat the market.
Here is another question. If any active investor could beat the market consistently over the long-term, why would they bother managing an ETF or mutual fund? Why carry the overhead and costs related to compliance & SEC regulations and have to deal with retail investors, etc.? Why not just invest your own money (aka Warren Buffet)? For Hedge Fund managers the 2/20 compensation says it all. With expense ratios being squeezed in mutual funds & ETFs, why would anyone who can actually beat the market do so for than kind of compensation?
Dan you always provide thought provoking questions. I would love to know why there aren’t more Warren Buffetts in the world investing their own money and letting people join along the ride. It’s also curious that Warren Buffett doesn’t have any faith in anyone either, since when he passes away his shares of stock will be liquidated into Vanguard passive index funds 🙂
Interesting data; I didn’t realize there was still so much left for mutual funds to manage. I wonder how much of it is retirement plan mutual funds that employees don’t have much control over.
SMM recently posted…Simple Stock Analysis – Walmart (WMT)
I have a feeling a ton of it has to do with 401k plans and pension funds. I’ll be interested what amount is from individual investors outside traditional retirement accounts 🙂
Yes, I’m in index fund ETFs now, as they have lower charges to hold here in the UK. I knew they were growing, as I’m not exactly an early adopter – and if I am in, loads of others must be as well.
Ms ZiYou recently posted…Growth comes from taking risks – a snowy trail adventure
I’m not an early adopter either I only wish I had jumped on the bandwagon much earlier in life 🙂