ETFs are Still Eating Mutual Funds’ Lunch

The competition between mutual funds and ETFs is lopsided.

ETFs are clobbering mutual funds in terms of asset flows.

Since the financial crisis, mutual funds have seen net outflows of $103 billion, while ETFs have net inflows of $1.5 trillion. Yes, that’s trillion with a T!

A few weeks ago, I attended “Inside ETFs” in Hollywood, Fla. This conference shed more light on this massive money shift that shows no signs of stopping anytime soon …

In its 10th year, the conference tallied 2,260 attendees (Consider that the first “Inside ETFs” event welcomed 438 people. That’s a compound annual growth rate of 20%.)

Over four days, The World’s Largest ETF Conference featured 160 speakers. Some names you may recognize:

  Richard Bernstein (CEO & CIO — Richard Bernstein Advisors)

  Bob Doll (Chief Equity Strategist — Nuveen Asset Management)

  David Kotok (CIO — Cumberland Advisors)

  Larry Kudlow (Senior Contributor — CNBC)

  Frank Luntz (CEO & Founder — Luntz Global Partners)

  Kevin O’Leary (Chairman & Founder — O’Shares Investments; Investor — ABC’s Shark Tank)

  Denise Shull (Founder & CEO — The ReThink Group)

Even Alex Rodriguez (former pro baseball player and founder of A-Rod Corp.) was a guest speaker. “A-Rod” fielded questions from Jessica Yellin (former CNN chief White House correspondent) in a 40-minute interview titled: “The Mindset of a Champion: An Interview with Alex Rodriguez.”

Beyond all the big names, there’s one presentation I look forward to every year

It’s Matt Hougan (CEO — “Inside ETFs”) and Dave Nadig’s (CEO — perennial update on the ETF industry: the past, the present and the future.

This year’s presentation was titled “The State of ETFs: Timing is Everything.” Here’s a sampling of my notes from their discussion.

The Past: $288 billion of inflows into ETFs was a record year. It was 20% more than what’s happened in any previous year. And more than twice what it was five years ago.

This trend has been pretty steady since the financial crisis …

Source: FactSet, Morningstar

If you include indexed mutual funds, some $340 billion left active ones and $505 billion went into passive ones. Roughly $845 billion changed hands.

From a numbers perspective, $1.6 million per minute, or $27,000 every second of every day (weekdays and weekends), moved from active to passive.

To add insult to injury, the No. 1 active manager last year for inflows was Vanguard (primarily a low-cost index shop).

The Present: U.S. ETF assets are at $2.6 trillion …

Source: FactSet (data through 12/31/16)

As ETFs have gained assets, they’ve gotten cheaper. In almost every asset class, there’s been a 70% to 80% decline in expenses.

ETFs are also getting better in numerous ways: more liquidity … spreads have narrowed … increased tax-efficiency … track broader indexes … and they track their benchmarks closer.

Today, ETFs make up about 30% of the market value traded daily in the U.S. In other words, nearly one out of every three trades happens with an exchange-traded product!

There are about 1,800 ETFs in existence. (Add in exchange-traded notes, and these exchange-traded products total almost 2,000.) And another 1,300 new ETFs are in registration with the SEC.

Just about everyone in asset management has entered the ETF market. The massive asset flows just can’t be ignored any longer.

ETFs are the No. 1 most-recommended product by financial advisers.

The Future: Almost everyone has caught on to the superiority of ETFs.

As Hougan said, “Even Grandma has access to greatest deal in financial history.” She can access six different asset classes via low-cost ETFs for a blended average expense ratio of 8 bps (0.08%). This portfolio gives her exposure to more than 4,000 stocks, 800 bonds, 40 countries and 20 commodities.

That means being an ETF adviser is no longer enough. Advisers need to look beyond traditional ETFs to succeed in the future. In short, they’ll want to act like institutions for their clients.

Generally, institutions use ETFs properly. They put money in for the long term and are willing to ride out lengthy cycles in factor-based investing. The problem is most investors don’t use ETFs like institutions.

In the average year, a SPY investor misses SPY’s actual return by about 5%. The typical investor misses out because of emotional mistakes: buying high and selling low … chasing the new trend after the horse is out of the barn … trying to hit a home run, etc.

Advisers are still valuable. Their primary value-add is to keep investors from making dumb mistakes. They also should try to get ahead of the curve.

For instance, the “Wealth Transfer” is coming. Over the next 25 to 30 years, a $30 trillion generational transfer of wealth will occur. Millennials stand to be the biggest beneficiaries. For the record, they love ETFs, but don’t really like financial advisers.

Related story: Gen ETF: Why Every Generation Should Love One-Click Diversification

Advisers will need to learn how communicate and work with them. You may have to text them instead of booking a tee time. And you’ll have to understand their investing interests.

What’s important to Millennials from a portfolio perspective? Environmental, social and governance (ESG) investing could be one of the answers.

A 2016 FactSet survey asked Millennials how important ESG investing is. Some 60% said they expected their wealth manager to be taking it into account in their portfolios. Actively managed ETFs, smart-beta ETFs and thematic ETFs will likely be future solutions, too.

Related stories: Impact Investing: Greater Returns for Your Portfolio and Soul, ‘Investing’ in Charities

Hougan and Nadig think ETF assets will surpass mutual fund assets (currently, about $16 trillion) by 2025, or sooner.

Others have also latched onto the enticement of cheaper index funds …

In a recent research note, Moody’s stated: “We estimate that passive investments will overtake active market shares between 2021 and 2024.”

Is it really any surprise that ETFs are taking over?

If you’re curious why ETFs are winning the asset-flow war, there are six main reasons:

1. Lower Costs

2. Tax Efficiency

3. Intraday Trading

4. Transparency

5. Better Performance

6. Access to Anything

Expect ETFs to continue eating mutual funds’ lunch for the foreseeable future.

Grant Wasylik

Originally from Pennsylvania, Grant graduated from Juniata College with an economics major and accounting minor. Since graduation, Grant has worked in the investment industry for almost two decades by serving in various roles … Prior to coming to…