Why ETFs are Taking Over the World

Over the past several years, we’ve seen ETF inflows increasing dramatically while mutual fund outflows seem to continue unabated. This has been driven by several factors ranging from better fee structures to lower tax liabilities to bad press on actively managed mutual fund performance and other factors. Here are some observations I’ve had in the past few years as I’ve watched this phenomena unfold:

• ETF Criticism – No financial innovation goes without the seedy side, bubbles, exploitation and ultimately, unintended consequences. Just like collateralized debt obligations were not necessarily a bad thing for the mortgage and banking system until sub-prime lending caused a crash, ETFs were meant to provide a more simple, cost-effective investment vehicle for investors. What we’ve ended up with over the years has been a spate of ETFs investors don’t understand (leveraged ETFs, futures ETNs, volatility ETFs, etc.) and many ETFs that are more like gimmicks than investment vehicles (like water ETFs that barely profit from water shortages around the globe). ETFs are not perfect and the ones that are heavily criticized are often deserving of some criticism. The free market usually takes care of that by forcing issuers to eventually close funds due to lack of interest (hence, lack of fees generated) like some leveraged ETFs, religious-based themed ETFs, and many others over the years.
• ETF Benefits – Aside from some of the benefits I listed above, with key attributes like lower fees, more liquidity and better tax treatment, many ETFs are simply providing a better net return on investment. At the end of the day, that’s what matters most to the common investor. When you consider that most actively managed mutual funds can’t match their benchmark, while ETFs can virtually match most benchmarks minus a few basis points for fees, that’s a win right there. Then, there’s a the diverse sectors and hedging available through various ETFs.

What I’m really waiting for is when ETFs take over mutual funds in 401(k) and other retirement plans. I’ve called the death of the mutual fund in the past and aside from further inroads with retail investors and some regulatory changes, I don’t see what’s stopping the further encroachment of ETFs into mutual fund market share.