The March Towards Exchange-Traded Funds

Acropolis was an early adopter of exchange-traded funds (ETFs). As the name implies, an ETF is a fund that trades on an exchange. It’s like a mutual fund in that it is generally diversified, but like a stock, it trades throughout the day.

When we got going in 2002, ETFs were about ten years old. The first version was State Streets Spyder, which still trades today with the ticker SPY. At that time, though, there were probably about 200 ETFs, and whole asset classes, like bonds or emerging markets stocks, weren’t available.

Today, there are more than 8,700 ETFs of every imaginable variety, and a slew of unimaginable ones make you wonder how they got to market. Mutual funds are still larger, with more than $27.0 trillion in assets, but ETFs now command about 20 percent of the market, with $7.2 trillion in assets.

Investors flocked to ETFs because they are generally cheaper, more liquid, and have an important tax feature: the ETF can reduce their holdings without creating a taxable event for the ETF owners. Technically speaking, when an ETF reduces its holdings, they ‘redeem’ the securities instead of selling them. I’m over-simplifying, but that’s the idea.

That means that each year, mutual funds have to distribute the gains from selling stocks in their portfolio, which they may have to do if they want to adjust the investment strategy or meet investor redemptions. ETFs can largely avoid that, although they sometimes distribute small gains.

Now, one of the big trends is mutual funds converting into ETFs. Over three dozen occurred since early 2021, representing about $60 billion. Dimensional Fund Advisors (DFA), a fund complex that we use in our client portfolios, is the big player in this trend.

That’s somewhat ironic because we detoured from our exclusive use of ETFs in 2010 (or 2012, I can’t quite remember) when we started using a DFA mutual fund that invested in microcaps stocks.

Although some clients may still have this fund for tax or other reasons, we largely stopped using it a few years ago.

It is not a bad fund, but we weren’t putting enough into microcap stocks to make a difference to a portfolio. Instead of adding enough to make a difference, which we thought would make our overall portfolios too volatile, we exited the asset class altogether.

After we opened the door to mutual funds eight or ten years ago, we started to use a handful of others. They had strategies that weren’t available in the ETF format, were relatively inexpensive, and relatively tax-efficient strategies.

Unfortunately, even if the strategies were tax-efficient, we were stuck with the decisions of our co-investors; when they sold for some reason, that impacted the tax bill for us and our clients.

So, last year, we decided to stop using mutual funds almost altogether. Because of ETF proliferation, we could find similar strategies to what we had in mutual funds, almost always at a lower cost.

Some clients will still have mutual funds, like the microcap fund, for tax or other reasons. But, for the most part, we’re back to being an ETF-based firm. We still have one bond mutual fund on our Approved List, but the capital gains issues are relatively small in bonds (especially after last year).

Although you still have to pay taxes when you sell an ETF, we are back in charge of the timing and size of the capital gains, and it doesn’t matter what other ETF shareholders we own are doing. That doesn’t make ETFs cheaper taxwise upon the sale, but it can mean more years when there are no tax distributions, which means tax-deferral.

And, if you die without selling, you did save on taxes because you deferred them until the point that the cost basis stepped up. That may not seem like the best news since you’re dead, but it does mean more money for your kids or charity.

The shift from mutual funds to ETFs was probably one of the most significant all-time transformations in the financial services industry. It coincided with the transition from active management to passive management, but now active managers are moving into ETFs too.

There will probably always be a place for mutual funds – I prefer them inside employer-sponsored retirement plans, like 401ks. I don’t want the record-keepers or third-party administrators trading ETFs during the day, and the taxes don’t matter since taxes are deferred for money in the plans anyway.

Other than that, I’ll be curious to see the ETF market share in another ten years. We weren’t sizeable mutual fund investors (outside our retirement plan business), but we’ll have even fewer from here.