The ETF structure seemed to emerge from each crisis better tested, and ready to play a bigger role in the world of advised clients, institutions and self-directed clients. As of late 2021, about 40 percent of ETF assets were with advised clients, 39 percent with individual investors, and the remaining 21 percent with wealth managers and institutional investors.
On its 30th birthday, the ETF is widely regarded as a low-cost, highly tradable vehicle that has survived and thrived in many different market environments. Even in last year’s tumultuous environment, with inflation at its highest since the launch of the first ETF and stocks and bonds falling sharply, many investors took the opportunity for a tax loss harvest and moved into ETFs.
And, while strong past inflows don’t guarantee strong future inflows, the benefits of ETFs — which include low costs, ease of access to asset classes, tradability and potential tax favorability — have become evident to investors young and old.
A MODEST BEGINNING
The first U.S. ETF launched in January 1993 at the end of the post-1980s downturn. After that downturn, some institutions and regulators were keen on designing a security that could potentially weather volatility better than individual stocks. No one thought that in 30 years, ETFs might grow to represent 25 percent of the open-end fund universe, despite a 70-year head start for mutual funds.
ETFs targeting the separate sectors in the Standard & Poor’s 500 Index followed in the late 1990s, and then, after the bursting of the dot-com bubble in 2000, came fixed-income ETFs, followed by a gold bullion ETF in 2004.
All these successful rollouts suggested that ETFs had reached parity with mutual funds in giving investors access to a variety of asset classes. But the ETF truly came of age in the wreckage of the subprime mortgage crisis of 2007–2009.
Investors and advisers, stung by two bear markets in less than a decade and frustrated that many active managers had underperformed all along, pivoted to an asset-management approach focused on low-cost ETFs.
The big stock and bond market sell-off in 2022 was, at the same time, the second-biggest year for new money coming into ETFs, suggesting that investors increasingly recognize the benefits of ETFs.
ETFs are dominating fund inflows these days as easy access to a broad range of asset classes gains new investors. Registered investment advisers have led the movement among advisers into ETFs, as have institutional clients, while self-directed personal investors are showing signs of fueling future moves into ETFs.
The increase in active ETFs now hitting the market also suggests that a vehicle once thought to be for index strategies only may have considerably broader application.
BENEFITS TO INVESTORS
Thirty years after ETFs were launched, their advantages have only become more clear.
The most obvious is costs: Given the structure of most ETFs, costs that were low to begin with have been falling as the assets in ETFs increase. By 2019, many of the large ETF trading platforms had moved to commission-free trading, which helped cement the idea that ETFs were becoming a low-cost option for investors.
ETF expense ratios have dropped industrywide over the past decade, from an average of about 0.28 percent to 0.18 percent at the end of 2020. This may not seem like a huge decline — but consider that the average asset-weighted mutual fund expense ratio was about 0.80 percent a decade ago and dropped to about 0.45 percent as of the end of 2020.
These data help explain why so many investors have opted into ETFs. Intraday trading of ETFs has added to their allure, as have their potential tax advantages.
RISING VOLUMES MEAN EASIER ACCESS
Another measure of ETFs’ success is their rising trading volume on stock exchanges over the years. According to Bloomberg, ETFs accounted for more than 30 percent of exchange volume in 2022.
This speaks to the organic rise of ETFs and their trading volume since their launch. And because ETFs trade on an exchange, that exchange volume can make determining prices of an ETF’s underlying constituents easier than on individual securities, notably for fixed-income securities.
In other words, trading an ETF can and does affect prices of underlying stocks or bonds enough to help determine the prices of those underlying securities, such as illiquid individual bonds. That can be significant when an investor is trading an ETF that has foreign holdings or even bond funds on second-tier holidays, such as Veterans Day, when bond markets are closed but stock markets where ETFs are listed remain open.
TRADABLE, BUT NOT STOCKS
So it is that investors who approach trades carefully have been able to potentially get better and better trading executions as the ETF market has grown and matured.
ETFs have sometimes been compared to individual stocks because, unlike mutual funds, they trade all day on an exchange. Also, unlike mutual funds, most ETFs have options chains attached to them and investors can buy them on margin. These features add to the tradability of ETFs and highlight differences with mutual funds.
But the similarities with individual stocks are limited, and it’s crucial to grasp the distinctions, especially to fully appreciate how ETFs can trade so smoothly.
FALLING TOTAL COSTS OF OWNERSHIP
As ETF trading volumes have ramped up over the years, bid-ask spreads that prevail on most ETFs have narrowed — even those that canvass relatively illiquid fixed-income asset classes.
That fact is one big reason why ETFs have become attractive to more investors. Investment exposures (broad and narrow) can be just a click away.
A look at how volume-weighted trading spreads have narrowed over the years highlights the question of costs. Between falling expense ratios and narrowing bid-ask spreads, the total cost of ETF ownership has edged lower over time, increasing the appeal of ETFs.
The bottom line: For those who approach trades carefully, it really is getting easier to optimize trade executions and reduce investment costs.
A BRIGHT FUTURE
It seems a fair bet that ETFs will continue on their trajectory of increased investor adoption and importance.
To be sure, mutual funds retain a secure place in the investment world. First, in the 401(k) market, mutual funds commanded $3.9 trillion in AUM at the end of 2021, or nearly 47 percent of all 401(k) assets, according to Cerulli.
Moreover, all the embedded capital gains taxation associated with exiting long-held positions in mutual funds will slow any transition to ETFs.
Such caveats aside, ETFs are where most of the new money is going these days, and they have increasingly become a hot spot of innovation.
ETF model portfolios are one such area of innovation: Because of the flexibility of ETFs, they can be used as low-cost beta funds to generate alpha, and thus can be part of a viable portfolio-construction approach.
Also, active ETFs are garnering more interest. But while more than 34 percent of U.S.-listed ETFs are actively managed, less than 5 percent of overall assets are in active strategies.
That said, active ETFs seem to be gaining investors, notably in the fixed-income realm, where lower costs are crucial given the relatively modest but steady returns of fixed income. More broadly, active ETFs that maintain a transparent structure (rather than the newer varieties of nontransparent wrappers) have gained assets. This suggests that many of the players in the ETF ecosystem are taking a wait-and-see approach to the newer, less transparent structure.
What remains clear about ETFs is that they have proven themselves a useful and efficient way to invest. And while their popularity is still growing, ETFs already play a major role in helping investors reach their financial goals.
This article was excerpted from a report written by Vanguard. Read the complete report here.