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

Basically, an ETF provides investors with a basket of securities, and are offered on any kind of asset class. This means they can give investors access to traditional investments or even alternative assets such as commodities or even currencies. They are sold through brokerage firms on a stock exchange. 

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. According to the most recent data from the Investment Company Institute, the average equity mutual fund charged 0.59% in expenses in 2017. The expense for the average equity ETF was much lower in the same year, falling at 0.21%. 

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. ETF Market

More than 1,700 ETFs were trading in the United States alone by the end of 2016, according to the most recent data from Statista. Growth in global ETF assets, according to a report from Ernst & Young, showed a cumulative average growth rate of 21% since 2005. The report predicted asset growth of about 15% per year for the succeeding three to five years. 

The U.S. market was responsible for leading the surge in ETF growth. According to Statista, the value of the ETF market in the U.S. grew to approximately $2.47 trillion by the end of 2016. 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.

In 2016, there were more than 9,500 mutual funds available, compared to the 5,000 ETFs, indicating the ETF market still has room for 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 the end of 2017, five corporations are the predominant issuers in the country’s ETF market: BlackRock — the largest ETF provider in the country, State Street Corp., Vanguard, Invesco and Charles Schwab. Combined, these issuers are in command of more than 80% of the market. iShares funds, issued by BlackRock, have particularly made substantial advancements with retail investors. By the end of December 2017, BlackRock had more than 800 ETFs globally, with more than $1 trillion in assets under management. 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 the 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.

The Bottom Line

ETFs have been providing investors with another avenue to various asset classes since 1993. Growth in the ETF market has been outpacing mutual funds for some time now — and that growth is likely to continue, especially in the United States. Unlike mutual funds, these investments offer lower fees, making them a much more attractive option.