It’s no secret that ETFs are steadily gaining popularity in today’s market. Since 2005, global ETF assets have grown to heights of three trillion dollars. This figure is still smaller than the assets under management of ETFs’ older cousin — mutual funds. But the tides are beginning to turn. ETFs have now surpassed mutual funds in net cash inflows since 2013. And ETFs are poised to surpass mutual funds in total assets under management by 2025.
What makes ETFs so popular
The general answer is that ETFS are more affordable, more tax efficient, and more liquid than mutual funds, while still achieving the benefit of economies of scale. Digging deeper into these characteristics, we start to see how the fundamental structure of an ETF contributes to its likeable qualities.
How ETFs work
There are two main players in the structure of the ETF: The ETF Company and the Authorized Participant (AP). The ETF Company owns the stock of companies represented in the ETF and trades shares of the ETF Company with the AP. The AP buys and sells stock of individual companies in exchange for shares of the ETF Company.
Here’s how these two players interact during a typical trading day:
- At the beginning of each day, an ETF Company publishes a buy list of certain companies whose stock is represented in the ETF
- The AP then buys the shares listed on the ETF company’s stock list
- The AP puts these individual shares into a “basket” and sends the basket of stocks to the ETF company
- In exchange, the ETF company gives the AP shares of the ETF Company
- The AP then sells these shares on the open market to you and me
Because of this unique structure, ETFs are fundamentally cheaper to operate than a mutual fund. And because shares of the ETF are traded on an exchange, the ETF Company does not have to be involved in every trade that investors make. This reduces administrative costs within the ETF Company that would ultimately be passed down to investors as part of the expense ratio.
Furthermore, there are no 12b-1 fees associated with ETFs. “12b-1 fees” are the annual marketing expenses of mutual funds that the mutual fund company generally passes on to its investors. Ouch.
Because of this efficient operating structure, investors have been attracted to ETFs since their inception. Now that ETFs have achieved massive economies of scale, they are becoming even more cost efficient with average expense ratios declining by 80% in the last ten years.
ETFs also save investors money because their structure makes them tax efficient. When an AP redeems shares of the ETF, the ETF Company does an in-kind redemption; so the ETF is constantly cleansing its portfolio of capital gain potential and kicking capital gains out to the AP. This means that ETF equity funds almost never pay out capital gains distributions, (unlike mutual funds).
Transparency & Liquidity
Besides its lower cost and tax efficient structure, ETFs are increasingly popular due to their transparency: ETF companies disclose their entire stock holdings and trading everyday.
Like an individual company’s stock, an ETF share can be traded at its intra-day price at any time during market hours. This makes them much more liquid than mutual funds. Their intra-day price is calculated by an exchange (i.e. the NYSE, Nasdaq) and updated every 15 seconds. This price generally represents the ETFs net asset value (NAV) and fluctuates throughout the trading day.
In contrast, if you wanted to trade a share of a mutual fund during market hours, you would not know the price of the share until the fund’s NAV was calculated at the end of the trading day.