A recent report by ISS Market Intelligence shows a significant shift in investment preferences among US-based financial advisors. The study, part of the ISS MI Advisor Pulse Series, surveyed over 800 advisors in July 2024 and revealed a growing preference for exchange-traded funds (ETFs) over traditional open-end mutual funds. As ETFs offer tax efficiency, liquidity, and active management options, ETFs are quickly becoming a portfolio mainstay for financial advisors and their clients.
The rise of ETFs
ETFs have become the preferred investment vehicle for many advisors, with 60% expressing a preference for ETFs over mutual funds when presented with the same strategy from a top asset manager.
A 2022 report by Cerulli & Associates showed that retail clients’ share of total ETF assets rose from 61% to 80% between 2012 and 2022. Retail financial advisor intermediary channels owned the majority by the end of 2022, and within this group, wirehouses and independent RIAs held the most ETF assets, with $1.2 trillion and $1.1 trillion respectively.
This evolution is largely attributed to the cost advantages and tax efficiencies ETFs offer. ETFs are liquid and traded intra-day, offering transparency and flexibility for investors that need to remain liquid and distribute capital gains effectively.
Active ETFs: A rising star
Passive ETFs continue to dominate net new ETF assets, but there is a notable increase in interest for actively managed ETFs. Active ETFs have emerged as one of the most favored investment vehicles among advisors. In fact, 53% of advisors plan to increase their use of active ETFs over the next year. Ashley Wood, managing director at ISS Market Intelligence notes that this trend reflects advisors’ focus on vehicle appropriateness and cost containment rather than a strict commitment to active over passive investing philosophies. This preference for active ETFs surpasses that for any other investment vehicle, as advisors look to capitalize on the portfolio wrapper.
ETF providers have contributed to the rise in active ETFs by providing more actively managed funds to the market. Since 2019, the number of active ETFs has increased fivefold, according to Morningstar.
The appeal of active ETFs lies in their ability to combine the flexibility and liquidity of traditional ETFs with the potential for outperformance through active management. This hybrid approach allows advisors to tailor their investment choices to specific client goals and market conditions.
Moreover, the wrapper has become particularly useful in model portfolios. Model portfolios and their use by RIA channels continue to grow, and active ETF wrappers have grown along with them. Cerulli estimates that the percentage of advisors relying primarily on model portfolios is expected to grow, and active ETFs are playing a major role in this trend. Both mutual funds and ETFs count themselves as building blocks of model portfolios, but active ETFs tend to distribute fewer capital gains than mutual funds, allowing for more frequent tax-loss harvesting. Active ETFs also complement passive, index-based strategies within a larger portfolio or model to pursue alpha returns or other specific outcomes.
In addition, there are a growing number of active ETFs designed to deliver specific outcomes such as tax optimization or income generation. The wrapper allows for customization within a portfolio without compromising other strategies, and advisors are quickly catching on.
Passive ETFs remain the dominant vehicle
While active ETFs are gaining traction, passive ETFs remain a staple in the investment strategies of many advisors. The ISS report indicates that 45% of RIA-only advisors and 38% of hybrid advisors plan to increase their use of passive ETFs. Cost effectiveness and broad market exposure allow for low expense ratios and transparency. Passive ETFs remain a mainstay in large portfolios and still hold the lion’s share of ETF assets. Out of the $9.5 trillion of investor money in ETFs, less than 8% is in active strategies, reports Morningstar. That gap may narrow quickly. Throughout all of 2023, 418 new active ETF launches were listed on US exchanges, and in the first nine months of 2024 alone, 331 more active ETFs were introduced in the US.
Implications for the wealth management industry
The increasing adoption of ETFs present opportunities and challenges for asset and wealth managers. Asset managers must adapt their product strategies to accommodate the growing demand for ETFs, moving away from traditional mutual fund models. Meanwhile, wealth managers need to equip their advisor platforms with scalable personalization tools to support advisors in delivering customized solutions and reinforcing their value propositions.
Further, many question the increased ETF usage among advisors as a bid to net more profit from unassuming clients. ETFs typically have lower expense ratios than mutual funds. As advisors move from transaction-based brokerage fees to a percentage-of assets advisory model, advisors could net more fees simply by moving out of mutual funds and into cheaper, more efficient ETFs while maintaining the same fee.
Nonetheless, the benefits of ETFs are compelling. ETFs are nimble and flexible enough for use in pursuing an array of investment objectives, and active wrappers give advisors the broad range of tools they need to create a portfolio tailored to their client’s or board’s investment goals. As the industry continues to evolve, and model portfolios are increasingly used by wirehouses and RIAs, ETFs and their active counterparts will increasingly offer differentiated value.
