The slow, inexorable decline of mutual funds

More investors each year are discovering the advantages of exchange-traded funds over traditional mutual funds.

Exchange-traded funds offer similar or equal diversification at a lower cost and are more tax friendly than traditional mutual funds. But mutual funds still comprise two-thirds of all fund assets due to institutional inertia in retirement plans and compensation structures for brokers selling them.

That dynamic is changing. Exchange-traded funds are gaining assets, while mutual funds are bleeding. In 2024, exchange-traded fund assets increased by over $1 trillion, while $380 billion leaked away from mutual funds. As it gets more difficult to defend a higher-cost model, the shift toward exchange-traded funds will pick up speed.

The year 1924 was a seminal one for individual investors. That year, a former cookware salesman turned stockbroker named Edward Leffler had a brainstorm. His idea was to pool the modest capital of smaller investors to purchase a common portfolio of stocks, allowing average households access to the market for the first time. The Massachusetts Investor Trust was the very first mutual fund and still exists today, the flagship of the fund giant MFS. Others soon followed, sparking the evolution of today’s multi-trillion dollar industry.

But as the venerable mutual fund celebrates its 100th birthday, its aches and pains are taking a toll. Meanwhile, there’s a younger, nimbler, smarter challenger on the scene. The superiority of exchange-traded funds over mutual funds derives from the difference in their structures, which gives exchange-traded funds a big advantage in cost and tax efficiency. The expanding panoply of exchange-traded fund offerings will ultimately capture the lion’s share of assets.

While costs have declined to compete with exchange-traded funds, mutual funds remain more expensive. Commissions, sales charges and marketing expenses impose a drag on returns approximately double that of the average exchange-traded fund. Some mutual fund companies do offer passive index funds with more competitive fees.

For the 30% of fund assets held in taxable accounts, mutual funds often generate higher tax bills since they are required to distribute capital gains each year, even if no shares were sold. Exchange-traded funds are structured differently and typically have minimal taxable distributions unless the investor sells shares.

One major driver behind the popularity of exchange-traded funds is the massive shift toward passive investment in index funds that track broad markets rather than active stock picking attempting to beat the market. According to Standard and Poor’s, 95% of active U.S. large cap equity managers fail to beat their benchmarks over 20 years after fees, and investors are catching on. No wonder inexpensive passive indexing overtook active funds in total assets under management last year.

Still, passive index investing does not appeal to everyone, and, until fairly recently, investors seeking active management had few choices other than mutual funds. But in 2019, the Securities and Exchange Commission approved rule changes that spawned over 2,000 new actively managed exchange-traded funds, with more coming each year. This shift is not lost on the traditional fund companies, many of whom have introduced cheaper ETF versions of their existing active mutual funds.

So how do mutual funds maintain their grip? One reason is their dominant role in defined contribution retirement plans like 401(k) and 403(b) plans. Mutual funds can share marketing fee revenues to offset expenses for administration, record keeping and broker commissions, keeping employer cost down but obscuring the true cost to participants.

Also, many 401(k) providers argue that the technology built around mutual funds is difficult to modify to accommodate exchange-traded funds. Yet some custodians now even allow cryptocurrency in retirement accounts. The fund giants have a vested interest in protecting the mutual fund infrastructure, but the camel’s nose is already under the tent, with many plans already offering a limited exchange-traded fund menu.

The other driver of mutual fund persistence is the legacy commission structure for broker dealers. While competition has reduced marketing compensation on new fund sales at many brokers, funds purchased previously continue to pay trailing commissions. Broker dealers must ensure that new sales are in their clients’ best interest but are not subject to the same standard on an ongoing basis once the sale is complete. This could create a disincentive to recommend switching to more cost-effective alternatives.

Registered investment advisors are bound by a higher standard called a fiduciary duty, which requires the advisor to act in the client’s best interest at all times. As the universe of actively managed exchange-traded funds continues to expand into strategies previously occupied by mutual funds, it may become problematic for advisors to meet their fiduciary duty with mutual funds if equivalent exchange-traded funds are available.

Traditional brokerage firms are paying attention. Assets (and brokers) have been leaving in favor of registered investment advisors for several years, and the trend is accelerating. Industry data firm Cerulli Associates predicts that over the next three years, the total share of assets held by broker dealer firms will decline from 34.1% to 27.7%, almost all of which will transition to registered investment advisors as more clients recognize the impact of fees and expenses on long term performance.

Innovation has been central to the development of the dynamic U.S. financial market. A century ago, mutual funds opened the door for millions of investors. Exchange traded funds represent the next iteration of innovation to increase access and efficiency, leading to better long term returns. It’s just a matter of time.

Christopher A. Hopkins, CFA, is co-founder of Apogee Wealth Partners in Chattanooga.