An exchange-traded fund, or ETF, is a financial instrument that offers investors flexibility in trading, cost savings compared to mutual funds, tax efficiency and broad diversification of an investor’s portfolio. In the United States, these factors have spurred continued expansive growth in the popularity of ETFs since their introduction in 1993.

Mutual Funds Vs. ETFs

An investor considering two investment options, an actively managed mutual fund or a similar ETF, is likely well-advised to choose the latter. The primary reason is profitability, which is one of the major contributing factors to the growth of the ETF industry. First of all, in terms of overall returns, most actively managed mutual funds do not outperform most benchmark indexes, even over a substantial period of time. Second, and perhaps more importantly, ETFs generally have substantially lower expense ratios than mutual funds. An average equity mutual fund charges somewhere between 1 to 1.5% in expenses. An average equity ETF typically charges less than 0.6%. A lower expense ratio means a higher total return to investors. A difference of 1% in expense ratios, for an investor with $10,000 invested in mutual funds or ETFs, can mean a much larger differential in profitability. Assuming a 5% annual return in a mutual fund or ETF, a 1.5% expense ratio versus a 0.5% ratio, reduces an investor's net profits by an additional 20%.

ETFs also offer greater flexibility and liquidity than mutual funds since they are traded like stocks throughout the trading day, as opposed to mutual fund shares that can only be bought or sold at their end of day net asset value (NAV). With trading days where the S&P 500 surges or falls by as much as 1 to 2%, having the ability to act early in the day rather than waiting until the end of the day to realign one's investments is a huge advantage.

ETFs also offer the advantage of easier access to a wider variety of investments. Mutual funds were created solely for the purpose of assembling a diversified portfolio of stocks. ETFs reflect the changing global investment market, offering investors exposure to emerging market economies, commodities, currencies and various derivative investments.

The U.S. Market

In the U.S. market alone, there are more than 1,500 ETFs trading. Deutsche Bank released a report in 2013 stating that global ETF assets had grown by over 28% for the year. The U.S. market was responsible for leading this surge in growth. In 2013, the ETF market in the United States saw an unprecedented inflow of approximately $210 billion in investment capital. By the end of the year, ETF assets were up nearly 30% from the previous year, with total ETF assets totaling nearly $2 trillion. ETF growth has continued to outpace that of mutual funds. Since the year 2000, the percentage increase in assets committed to ETFs has grown by over 2,500%, compared to an increase of only 120% for mutual funds.

However, total investment capital committed to mutual funds still dwarfs, by more than tenfold, the total amount committed to ETFs, suggesting ETFs can continue to experience substantial growth, at 15 to 30% per year, for the next five to 10 years. As of 2015, there are more than 7,000 mutual funds available, compared to less than 2,000 ETFs, indicating the ETF market still has room for massive expansion.

The global ETF space is dominated by the U.S. market. Approximately 75% of the world’s total ETF assets belong to ETFs traded in the U.S. As of 2014, three corporations are the predominant issuers in the country’s ETF market: BlackRock, State Street Corp. and Vanguard. Combined, these three issuers are in command of more than 80% of the market. iShares funds, issued by BlackRock, have particularly made substantial advancements with retail investors. Retail investors were responsible for nearly $17 million of the total $40 billion the firm saw in inflows in the last quarter of 2014.

The fact that only a few issuers dominate the ETF market simply means there is still a vast amount of room for additional ETFs to be created as other issuers increase their number of offerings.

The earnings and continued growth of the ETF market, along with the success of the dominant issuers, prompted global asset managers such as JPMorgan Chase & Company, Wells Fargo Corporation and Goldman Sachs to enter the ETF game fairly early on. Goldman Sachs laid its foundation for actively managed ETFs by filing with the Securities and Exchange Commission (SEC) for permission to issue a series of active ETFs, with its initial fund being the Goldman Sachs Equity Dividend Fund.

The major reasoning behind the interest of large investment banks in ETFs is as simple as being able to offer wealthy clients additional investment products. Large institutional investors have continued to drive the growth in assets committed to ETFs.

The Future of ETFs

There is nearly universal consensus that the ETF industry will continue to grow at double-digit rates for several years to come. Many analysts predict the ETF industry will surpass the hedge fund industry in assets under management (AUM) in the very near future. Growth in both the users and uses of ETFs is expected. Increasing competition between fund issuers likely drives continued development of new ETF products, as does the desire to more precisely tailor ETFs to suit the investment goals of different investors.

The ETF market in the U.S. is arguably the most mature. Europe’s market is somewhat fragmented geographically and burdened by substantial regulations. Changes in the regulations governing ETFs that enable the creation of a more uniform ETF market could lead to explosive growth in the European ETF market. The rapid development of the Asian ETF market suggests it may surpass the European market within the next decade.

Greenwich Associates conducted a survey to determine how institutional investors are typically utilizing ETFs. There seems to be a relatively equal divide among institutions, with some reporting ETF usage as strategic and the remainder reporting usage as tactical. The most commonly reported use of ETFs by institutional investors is for passive exposure as part of core strategies, and almost half of the participants in the survey reported they employ ETFs to round out and diversify portfolios.

A survey of financial advisors found that those who do not use exchange-traded products indicated the primary reason is merely a lack of knowledge. As the ETF industry continues to grow, more financial professionals will become familiar with ETFs, and therefore, more will offer exchange-traded products to their clients. Additionally, increasing numbers of issuers and ETFs will continue to draw more interest and assets from retail investors.

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