The growth of exchange-traded funds has surged due to these 4 reasons.

• The first exchange-traded fund was launched in the early 1990s.
• ETFs have steadily gained market share relative to mutual funds.
• ETFs offer tax savings and low costs, making them attractive for investors, experts said. However, mutual funds may still be a better option in specific situations.

The popularity of exchange-traded funds (ETFs) among investors has been increasing steadily in recent years, with experts attributing this trend to several benefits, including lower tax bills and fees compared to mutual funds.

ETFs have amassed approximately $9.7 trillion in assets under management since their inception in 1993, according to Morningstar data through August 2024.

ETFs are gaining ground on mutual funds, with their market share relative to mutual fund assets more than doubling over the past decade, to about 32% from 14%, according to Morningstar data.

According to Michael McClary, chief investment officer at Valmark Financial Group, ETFs are a better fund structure than mutual funds, particularly for taxable accounts.

Here are four reasons why McClary and other experts say ETFs took off.

1. They have 'tax magic'

Mutual funds and ETFs share similarities as both are managed by professionals and comprise a mix of stocks and bonds.

But there are a few distinctions.

ETFs are traded on a stock exchange, while mutual funds are bought directly from an investment company.

ETF investors can avoid fund-level capital gains taxes by owning mutual fund shares, according to experts.

Generally, investors are required to pay capital-gains tax to the IRS on profits earned from the sale of investment funds or other financial assets, such as individual stocks and real estate.

Capital-gains taxes can be generated by mutual fund managers when they buy and sell securities within a fund, which are then passed on to all shareholders.

Even if they didn't sell their holdings, these investors still receive a tax bill.

Experts stated that most ETF managers can trade the fund's underlying stocks and bonds without triggering a taxable event for investors due to the structure of an ETF.

ETFInvestor newsletter editor Bryan Armour, a director of passive strategies research for North America, stated earlier this year that the tax benefits of ETFs are unmatched by mutual funds.

In 2023, more than 60% of stock mutual funds distributed capital-gains taxes to investors, while only about 4% of ETFs did the same, according to Armour's interview.

The tax advantage of ETFs is not as significant for investors who hold actively managed mutual funds that frequently trade, as opposed to those who invest in market-cap-weighted index funds and bond funds.

In a retirement account, the taxable argument is irrelevant, according to McClary.

Tax-advantaged retirement plans like 401(k)s and individual retirement accounts allow investors to avoid capital-gains taxes on trades.

McClary stated that mutual funds can still be beneficial in the 401(k) world.

2. Costs are low

The SPDR S&P 500 ETF Trust was the first ETF to be an index fund.

Passively managed funds, commonly referred to as index funds, mimic the performance of a market index such as the S&P 500.

Passive funds are generally less expensive than actively managed funds, which strive to select top-performing stocks to surpass a benchmark.

Although ETFs and index funds are often considered interchangeable, there are also index mutual funds. Experts noted that the first actively managed ETF wasn't introduced until 2008.

As investors shift their focus to index funds and away from active funds, ETFs have gained popularity due to their lower costs, experts noted.

According to Armour, the average ETF costs half as much as the average mutual fund, with ETFs priced at 0.50% and mutual funds at 1.01%.

In the first half of 2024, 80% of net money invested in index stock funds came from ETFs, according to Morningstar.

ETFs have been successful because they offer low costs and increased tax efficiency, which is an attractive option for investors, according to Armour.

That said, investors shouldn't assume ETFs are always the lowest-cost option.

According to a March 2023 report by Michael Iachini, head of manager research at Charles Schwab, you may be able to find an index mutual fund with lower costs than a comparable ETF.

3. Financial advice fee model changes

Morningstar's Armour stated that financial advisors have undergone a shift that has benefited ETFs.

Historically, retail brokerage firms generated revenue through the form of commissions on the sale of funds and other investments.

Advocates of the fee-based model argue that it has the advantage of not affecting an advisor's investment recommendation, as a commission might, since clients pay an annual fee based on the value of their account holdings.

Over the past decade, one of the most significant developments in the retail brokerage sector has been a trend, as stated by McKinsey.

ETFs are advantageous for fee-based advisors as they typically do not have sales-related expenses such as sales loads and 12b-1 fees, which are annual fees that mutual funds charge investors to cover marketing, distribution, and other services.

Brokerage firms may charge a commission to buy ETFs, but many large brokerages have eliminated those fees.

""Nowadays, it's challenging to find a skilled advisor who doesn't incorporate ETFs into their investment strategy," McClary stated."

4. SEC rule made ETF launches easier

In 2019, the Securities and Exchange Commission introduced a rule that facilitated the launch of ETFs by asset managers and simplified active portfolio management, according to Armour.

The number of ETFs introduced by financial firms has surpassed that of mutual funds, giving investors more options.

In 2023, ETFs outnumbered mutual funds by 396 to 182, according to Morningstar.

Potential drawbacks of ETFs

While ETFs have their advantages, some of their advertised benefits may be exaggerated, and they also come with drawbacks.

While ETFs disclose their holdings daily, such transparency provides little value to investors who rarely need to check underlying securities, according to Armour.

ETFs are traded like stocks, while mutual fund orders are priced only once a day, at market close.

According to Armour, the ability to trade ETFs like a stock is not much of an advantage for most investors because frequent buying and selling is generally a losing proposition for the average investor.

Experts noted that certain ETFs can be difficult to trade due to wide bid/ask spreads, which can increase costs for investors. However, mutual funds do not experience such spreads, Iachini said.

ETFs cannot close to new investors, as opposed to mutual funds, Armour stated. If an ETF grows too large, it can sometimes hinder actively managed ETFs from executing their investment strategy, he added.