ETFs (Exchange Traded Funds) are growing in popularity with advisors across the industry. Let’s explore the unique ETF features driving this trend.
Fresh Launches and Strong Flows
ETFs (Exchange Traded Funds) have become key tools for financial advisors and retail investors alike, thus spurring new product development and tremendous inflows into ETFs. In 2022 alone, 431 new ETFs were launched.1 $604 billion was poured into U.S. ETFs last year, too, the second-highest level of annual ETF inflows on record.2 This data point indicates that the market’s 2022 downturn clearly didn’t ruin the investment community’s appetite for ETFs. In fact, the structural attributes of ETFs may be especially attractive in difficult and volatile market environments.
Now that we’ve seen the rising popularity of these funds, you’re probably wondering, “What factors are driving investors and their advisors to embrace ETFs?” That’s a great question. It’s time for us to explore the details.
Funds That Trade Like Stocks
Mutual funds only process transactions and reprice at the end of each trading day—not so with ETFs. An ETF trades continuously on an exchange throughout the day (thus explaining the “ET” in ETF), and the fund’s share price fluctuates intraday. The ETF structure enhances liquidity and ensures that you know what price will be paid or received the moment you trade. By contrast, a mutual fund trade is made with stale price information from the close of the previous trading day—the transaction is likely to be completed at a different share price than you saw when you entered the order. In volatile markets, trading with current pricing is especially imperative, and ETFs are built with this trading efficiency in mind. That’s just one potential advantage of ETFs, though.
Optimized to Manage Taxes
The ETF structure is also designed to help manage taxable gains. With a mutual fund, outflows cause the fund to sell securities, thus creating capital gains or losses that are distributed among all the fund’s shareholders. In short, Shareholder A may pay more in taxes on a mutual fund holding because Shareholder B sold a position in the same fund. ETFs don’t typically have this problem, and they rarely distribute capital gains. (Shareholder A will still owe taxes on capital gains realized from personal ETF transactions in taxable accounts, though. If Shareholder A bought ETF shares at $50/each and sold them at $65 in a non-qualified account, taxes will be owed.)
How well does the ETF structure reduce capital gains distributions at the fund level? According to data from Morningstar, the answer is “Quite well indeed.” While 60% of equity mutual funds generated taxable distributions for their shareholders last year, only 4.5% of equity ETFs did so.3 ETFs, then, can help improve tax planning by enabling investors to defer incurring most capital gains until they sell shares. Surprise tax bills are generally avoided by ETF investors, but mutual fund investors often face unwelcome taxable distributions.
ETFs continue to see strong inflows due to their liquidity, intraday pricing, tax efficiency, and lack of sales loads. The flexibility of the ETF structure also ensures that a wide array of active and passive products is available to investors and their financial advisors. The market for ETFs has the potential to see further growth in the years ahead, too. Now that we’ve discussed key ETF features, you can feel more confident when considering whether ETFs are appropriate for your clients, too.
1Heather Bell. December 30, 2022. ETF Launches Slowed in 2022 for First Time in 3 Years. Retrieved from https://www.etf.com/sections/blog/etf-launches-slowed-2022-first-time-3-years
2Elizabeth Kashner. January 26, 2023. ETF Investors Won In 2022 By Losing (And Spending) Less. Retrieved from https://insight.factset.com/etf-investors-won-in-2022-by-losing-and-spending-less
3Bryan Armour. February 17, 2023. How to Maximize the Tax Efficiency of ETFs. Retrieved from https://www.morningstar.com/articles/1138653/how-to-maximize-the-tax-efficiency-of-etfs
The information, analysis, and opinions expressed herein are for informational purposes only and represent the views of the speakers, not necessarily the views of Envestnet. The views expressed herein reflect the judgement of the writer and are subject to change at any time without notice. Information obtained from third party resources are believed to be reliable but not guaranteed. Any graphical information contained herein is for illustrative purposes only and not based on actual client data.
Exchange Traded Funds (ETFs) and mutual funds are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. Income (bond) ETFs and mutual funds are subject to interest rate risk which is the risk that debt securities in a fund´s portfolio will decline in value because of increases in market interest rates.
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