Twenty years ago when State Street introduced its broad stock market tracker, the SPDR S&P 500 (SPY, A), many investment advisors and market professionals viewed it as a fad. When the fund was launched, the SPDR only had $6.5 million in assets; today, it has become a $123 billion juggernaut and represents about 6.4% of all ETF assets worldwide [see S&P 500 Visual History].
The simple experiment of an “index fund that behaves like a stock” has completely revolutionized investing and, today, over $2 trillion in assets sit in ETF funds covering every nook and cranny of the investable market. Much of that asset gain has come at the expense of underperforming, traditional open-ended mutual funds.
For investors, ETFs are certainly here to stay and will continue to grow versus their mutual fund counterparts. Here are three charts that show why you’ll continue to invest in ETFs far into the future.
Total ETF Assets Vs. Total Mutual Fund Assets
Created just before the Great Depression, traditional open-ended mutual funds became popular after World War II as the go-to investments for the American public – at least until State Street unveiled its SPDR. Driven by lower expenses, lower taxes, intraday tradability as well as access to various non-traditional asset classes, more money managers and individual investors are making the switch over from mutual fund holdings into ETFs. Simply put, ETFs have seen growth, while mutual fund assets have started to dwindle [see 10 Questions About ETFs You've Been Too Afraid To Ask].
The growth in ETF assets will only continue as more investors realize the potential of index investing as most actively managed mutual funds fail to outperform their benchmark indexes.
Figure 1: ETF Assets Vs. Mutual Fund Assets
Average Expense Ratio of ETFs Vs. Mutual funds
One of the main reasons why investors both big and small have been flocking to ETFs to fill their portfolios is the funds’ low expenses. The difference in costs is truly striking as the average traditional mutual fund is more than one full percentage point costlier than the average ETF. These expenses grow when investors factor in some mutual funds’ front-end sales loads, 90-day redemption fees and 12B-1 marketing fees. As well, mutual funds have higher minimum investment requirements – some can top $10,000 [see Cheapskate ETFdb Portfolio].
ETFs, on the other hand, are truly low-cost investment vehicles. They gain that low-cost moniker from several factors. For starters, most ETFs are index funds and index tracking is inherently less expensive than active management. Secondly, the funds’ creation/redemption mechanisms along with the fact that investors buy/sell shares with other investors rather than the sponsoring company also help drive down costs. The average ETF has an expense ratio right above 0.43%. However, some broad stock market and bond indexes can be added to a portfolio for as little as 0.04% [see 101 ETF Lessons Every Financial Advisor Should Learn].
ETFs also win on the trading front as several brokerage firms now allow commission-free trading. ETFs also have much lower initial investment cost – technically, you can buy just one share if you wanted. This makes the fund-type perfect for smaller investors looking to get their feet wet or potentially diversify across a complete portfolio.
Figure 2. Average Expense Ratios for Mutual Funds and ETFs
The Total Number Of ETFs
The final nail in the traditional mutual fund coffin could be ETFs’ range of products. Nearly every investment theme, asset class and strategy has been tackled by ETF sponsors. Adding up all the funds across the United States, Canada, Europe and Asia–the latter three regions’ funds are available to some investors with global brokerage accounts–there are more than 4,700 different ETFs. This provides plenty of opportunities to diversify a portfolio [try our Free ETF Screener].
Think corn prices could rise because of the record drought affecting the Midwest? The futures-based Teucrium Corn ETF (CORN, A-) could be used to capitalize on that bet. What about rising smartphone adoption across the globe? The First Trust NASDAQ CEA Smartphone Index (FONE, C) could be used as a viable investment vehicle.
Aside from adding basic sectors and themes, ETFs have allowed investors to add complex strategies to their portfolios. The new AlphaClone Alternative Alpha ETF (ALFA) allows investors to tap their inner Gordon Gecko by purchasing–holding by holding–what leading hedge fund managers are buying on their publicly disclosed 13F-HR forms. The QuantShares US Market Neutral Anti-Beta ETF (BTAL) tries to deliver favorable returns when markets begin to recede by taking long positions in low beta stocks while shorting high beta stocks. Both of these concepts would be quite expensive for the average retail investor to try to replicate on their own [see Five Important ETF Lessons In Pictures].
Not every product is a hit, and the ever-expanding product roster has also led to waves of ETF closures. However, this is a normal no-sweat part of the process that other fund types–including mutual funds–have undergone during their growth years. At the end of the day, these fund closures only serve to strengthen the remaining funds. When it’s all said and done, it’s a big win for investors looking to diversify their holdings.
Figure 3. Number of U.S. ETFs Over Time
The Bottom Line
For investors, ETFs are here to stay. Driven by lower expenses, daily tradability and the ability to access almost every asset class and strategy under the sun, ETFs will continue to pop up in more and more portfolios. Overall, exchange-traded funds will continue to eat traditional mutual funds’ lunch well into the future. The previous three charts help prove just how innovative and earth shattering ETFs have been in the investment marketplace. ETFs are definitely the go-to investment of the future.
Disclosure: No positions at time of writing.
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