Exchange-traded funds are having their best year ever, thanks in part to demand from millennials.
Investors have poured more than $300 billion into ETFs this year -- breaking a record and already outpacing inflows for both 2015 and 2016 combined. Meanwhile, separate surveys by both Charles Schwab and Blackrock -- two of the largest ETF issuers -- show millennials are more likely than any other generation to purchase these investment products.
ETFs track an index, commodities, bonds or a basket of securities. However, unlike mutual funds -- which can only be traded after the market closes -- ETFs are more liquid and can be traded intraday on exchanges similar to stocks. They also tend to have lower fees than mutual funds.
In a recent Charles Schwab survey of 1,200 ETF investors, 56 percent of millennial investors (those ages 25 to 36) said ETFs were their investment vehicle of choice, in contrast with just 30 percent of baby boomers who said the same thing.
About 60 percent of millennials also said they expect to increase their investments in ETFs in the next year, and 62 percent said they would consider holding only ETFs instead of individual financial securities.
So why are ETFs so popular with Generation Y?
The younger sibling of mutual funds, ETFs have only been around since 1993 when State Street launched the first one -- the SPDR S&P 500 ETF (ticker: SPY). By the time millennials came of age, they were more likely to be familiar with ETFs and less likely than their parents' generation to have developed other investing habits.
"Millennials have grown up with ETFs, and because of this familiarity they seem to be more comfortable than other generations in embracing them as their investment vehicle of choice -- and enjoying the benefits of low costs, tax efficiency and transparency," Heather Fischer, vice president of ETF and mutual fund platforms at Charles Schwab, says in a news release.
Devon Klumb is a 25-year-old financial planner and the co-founder of RhineVest in Cincinnati. His firm uses Betterment's platform to construct portfolios of index-tracking ETFs for millennial and Generation X clients. He prefers ETFs to mutual funds or individual stocks primarily because the costs are lower after taxes and management fees.
"I'm all about cost," Klumb said. "I think ETFs do a great job of reflecting what the economy is doing as a whole. I want to have exposure to every aspect of the economy, but long term, I don't want to pay a lot in management fees. They really are the most efficient way to create a broadly diversified portfolio without cranking up the costs."
Whereas equity mutual fund expense ratios averaged 0.63 percent in 2016, expense ratios for index equity ETFs averaged only 0.23 percent, according to the Investment Company Institute.
Also appealing to millennials: There's typically no minimum required to invest in ETFs, which are purchased by the share. That's in sharp contrast to some other investments.
At Vanguard, most mutual funds require a minimum investment of $3,000. That can be a large hurdle for a beginner investor to clear.
"ETFs are a great way to start investing when you're young and don't have much money," said Mychal Eagleson, a 28-year-old financial planner and founder of An Exceptional Life Financial in Indianapolis. "Since they don't have the same initial minimum purchase requirements as mutual funds, a millennial who wants to invest, say, $1,000 in five different areas of the market can do it with ETFs, as opposed to having to be stuck buying one mutual fund with a $1,000 minimum."
Finally, millennials have grown up in a world where passive management has been widely touted over active management. Since most ETFs are passive -- meaning they track an index and minimize the frequency of buying and selling -- they've been an obvious choice, Eagleson said.
Andrew Damcevski, a 24-year-old financial planner and the other co-founder of Cincinnati-based RhineVest, agrees.
"The idea of being a Warren Buffet or Peter Lynch and beating the market by looking at fundamental analysis worked 40 or 50 years ago, but frankly that is not the environment we live in anymore," he said. "With high-frequency trading and algorithmic trading, markets are becoming more efficient and it's harder to find those price discrepancies. Millennials are more aware of that."
More From US News & World Report