The financial advisory landscape is witnessing a pivotal shift. According to a recent report by Cerulli Associates, for the first time, financial advisors are expected to allocate a larger portion of their clients’ assets to exchange-traded funds (ETFs) than to mutual funds. By 2026, it is projected that 25.4% of client assets will be invested in ETFs, surpassing mutual funds at 24%. This change signifies a transformative period for wealth managers as ETFs are on track to become the most commonly used investment vehicle, eclipsing other popular options such as individual stocks, bonds, and annuities.
Current trends show a notable gap in assets; while mutual funds hold 28.7% of client portfolios and ETFs account for 21.6%, the momentum is clearly in favor of ETFs. This article delves into the reasons behind this emerging trend and the broader implications for investors and advisors alike.
At their core, ETFs and mutual funds serve a similar purpose: enabling investors to diversify their portfolios across a spectrum of securities. However, the structural differences between the two are significant. As of now, ETFs manage approximately $10 trillion in U.S. assets—just under half the $20 trillion held by mutual funds—yet their growth trajectory has been rapid and consistent since their introduction in the early 1990s.
Jared Woodard, an investment strategist at Bank of America Securities, highlights the enduring appeal of ETFs. He notes that they offer several advantages, including tax efficiency, lower costs, and enhanced liquidity. Investors have increasingly recognized these benefits, shifting their preferences accordingly.
Tax Efficiency: A Notable Advantage
A critical differentiator between ETFs and mutual funds lies in their tax implications. Investors in mutual funds are often subject to annual capital gains distributions, a consequence of the fund manager’s trading actions. In practical terms, this means that shareholders may incur taxes on gains they have not personally realized. In contrast, most ETFs are designed to minimize such tax liabilities. In 2023, only 4% of ETFs reported capital gains distributions compared to a striking 65% of mutual funds, as reported by Bryan Armour, a director at Morningstar.
The capacity to defer these tax obligations allows ETF investors to benefit from compounding returns over time. This substantial difference in tax treatment is a driving force behind the increasing allocation of assets to ETFs, as they offer a more efficient way to manage investment earnings.
Another advantage of ETFs that cannot be overlooked is their cost structure. The average expense ratio for index ETFs stands at 0.44%, while index mutual funds average at 0.88%. For actively managed funds, the disparity is even clearer: active ETFs charge an average fee of 0.63% compared to 1.02% for their mutual fund counterparts. Lower fees translate into higher net returns for investors, a fact that advisors are increasingly taking into account when recommending investment vehicles.
Furthermore, the liquidity and transparency associated with ETFs enhance their attractiveness. Unlike mutual funds, transactions in ETFs can occur throughout the trading day, allowing investors to respond quickly to market changes. Additionally, ETFs disclose their holdings daily, offering insight into portfolio composition that mutual funds, with their quarterly disclosures, simply cannot match.
Potential Limitations of ETFs
Despite the many advantages of ETFs, there remain significant complexities and limitations to consider. For instance, while ETFs are gaining traction, mutual funds are likely to retain a stronghold within workplace retirement plans such as 401(k)s. Given the tax-advantaged nature of these accounts, the structural differences offer no substantial benefit to investors opting for ETFs over mutual funds in these scenarios.
Moreover, ETFs may face challenges regarding capacity limits, particularly for funds with focused or concentrated strategies. If an ETF becomes too popular and attracts excessive investment, the fund managers may find it difficult to execute the intended investment strategy effectively. This could potentially hinder performance and lead to frustrations for investors who entered the ETF early.
As we look ahead to 2026 and beyond, the shift towards ETFs reflects a broader evolution in wealth management. The appeal of lower costs, tax efficiencies, and greater transparency is reshaping investment strategies at an unprecedented scale. While mutual funds continue to serve a vital role, especially within retirement structures, ETFs are clearly carving out their place as the preferred investment vehicle for financial advisors and clients alike. The evolving dynamics of these two investment options will be crucial to monitor as they continue to influence the financial landscape.