ETFs vs. Mutual Funds: Three Keys To Winning The War

by on May 3, 2010

When exchange-traded funds burst onto the scene  roughly 15 years ago they were heralded as a new alternative to mutual funds, offering investors diversified exposure for a minimal cost while providing the added benefit of enhanced liquidity and tax efficiency. As the universe of asset classes available through ETFs has expanded, these products have steadily eaten into the market share of traditional mutual funds, reflecting a trend towards indexing as an investment strategy. Many mutual fund companies have recognized that the exchange-traded structure are here to stay by expanding their product offerings to include ETFs, hoping to tap into a still rapidly-expanding market. 

Despite increased participation from investors and record cash flows, ETFs still trail their mutual fund counterparts by a wide margin in terms of total assets under management. In 2008, for every $100 invested in the market, mutual funds captured nearly $81.50 compared to just $9 for ETFs. However, this is up sharply from 2001, when ETFs only managed to secure a paltry $2 for every $90 that went to mutual funds. Clearly ETFs have managed to make significant inroads over the past decade, but they still have a long way to go in order to match mutual funds’ impressive asset totals. How can ETFs finally break through and beat their entrenched competition? It’s no easy task, but there are three tasks that must be accomplished is ETFs are ever to overtake mutual funds.

1. Get Into 401(k)s And Other Retirement Plans

Arguably the single biggest roadblock to ETFs dominance is their lack of availability within most retirement plans. Many company retirement plans restrict investors’ options solely to mutual funds either to cut down on costs by striking a deal with a mutual fund company or to make things easier for the employees. Some also cite that the technology is not available to record and manage ETFs in a 401(k) plan cheaply. Slowly but surely, this roadblock is being chipped away; companies such as Invest n Retire have developed the technology to make the ETF record-keeping easy and affordable. Without widespread adoption in the 401(k) space, ETFs will never surpass mutual funds (see ETFs vs. Mutual Funds: The Ultimate Guide).

2. Increase The Investing Public’s Knowledge

Many people still have no idea what an ETF is and how it can be used (many well-known publications occasionally refer to them as “EFTs”. What is perhaps more shocking is that many financial advisors are blissfully unaware of the ETF revolution, clinging to antiquated tools and investment vehicles when constructing portfolios. According to a recent study, just 14% of U.S. pension funds, endowments and foundations surveyed reporting using ETFs. When asked why this rate is so low, many in the industry simply respond “education.” The sales pitch for ETFs is a relatively easy one to make, and those who have been enlightened are usually quick to make the switch.

The ETF industry needs to continue its aggressive marketing campaign in order to further promote their products and make “ETF” a household phrase (also see a recent study that shows that Half Of Mutual Funds Will Be Gone By 2015 And Replaced By ETFs).

3. Stick To The Numbers

Many investors who are just starting out are drawn to mutual funds by the presence of an expert fund manager, which  alleviates concerns of most beginners. However, many investors would do just fine by buying simple market tracking ETFs such as SPY. Statistics show that over time nearly 80% of mutual funds will underperform the market and that the average mutual fund returns roughly 2% less to is shareholders than if an investor was able to invest in the broad market. Furthermore, there are a variety of ETFs that fall under the Target Retirement Date ETFdb Category and can offer compelling alternatives to target retirement date mutual funds. These funds offer investors exposure to a variety of asset classes that rebalances over time as investors near retirement. In other words, they can offer the same exposure and asset allocation that mutual funds do at a fraction of the cost (also see The True Cost Of Active Management).

These tasks are obviously easier typed than accomplished, and mutual funds won’t concede ground to ETFs without a fight. With all of their inherent advantages, it seems only logical that ETFs will one day overtake mutual funds as the investment vehicle of choice. But that day may be decades off, as significant obstacles still remain. For more thoughts on the world of ETFs, make sure to sign up for our free ETF newsletter.

Disclosure: No positions at time of writing.