Americans are piling into a hot new type of ETF investing

The popularity of exchange-traded funds has skyrocketed over the past decade as more Americans have opted for them over mutual funds.

Although the two vehicles are structured similarly, the appeal of ETFs has long been lower fees and the ability to be actively traded like stocks. This dynamic was reflected in fund-flows data for 2023, which saw net inflows for mutual funds fall $462 billion as ETFs absorbed a net $539 billion, according to JPMorgan.

Further, between 2014 and 2024, assets under management in ETFs were at 16%, versus 84% for mutual funds. As of June 2024, it was 32% for ETFs to 68% for mutual funds.

It’s a trend that’s expected to continue.

“It is becoming pretty clear that a lot of investors are now viewing ETFs as their vehicle of choice,” says Matt Barry, head of capital markets at Touchstone Investments, a firm that manages mutual funds and ETFs. He added that their structural benefits, including tax efficiency, transparency, and liquidity, have been driving that popularity.

A new ETF strategy

Within the ETF space, institutional interest has grown over time, and a popular new strategy has emerged.

An increased number of money managers are choosing to offer so-called model portfolios using ETFs as the main vehicles. The overall goal of a model portfolio is to match a client’s collection of assets with a predetermined objective — anything from growth to income to capital preservation.

Rather than pick a collection of funds themselves, the clients of the model portfolios leave the mix of ETFs up to professional investment advisors, depending on what they want to achieve.

Jon Maier, chief ETF strategist at JPMorgan, outlined a few more advantages. Instead of deploying a large team of analysts to scour through stocks and fixed-income products or paying hefty hedge fund fees, they use an ETF that does something similar, he said.

It’s also a more user-friendly and efficient way to manage assets, said Maier. For one, scalability is easier since management teams aren’t directly responsible for overseeing every asset in the portfolio. Instead, they can leverage the expertise of the investment management teams of each specialized ETF, he noted.

And it works well since there is now an ETF for just about anything: from those that passively track a broad index to those that actively manage a strategy or grouping of securities. They can be built around a theme like AI or a sector like healthcare. They can also be focused on types of stocks like growth, value, or dividend-payers. And if you want to balance or hedge a portfolio, there are ETFs that manage fixed income or employ options strategies.

“What we’ve seen over the past five or so years since the ETF level came up, is a lot of active managers getting into the ETF space”, Barry said, who has witnessed active funds go from a small sliver of the ETF universe to making up a quarter of net inflows coming into the space. This means managers opting for the ETF model portfolios have a range of active funds and expertise to choose from.

Word seems to have gotten out in recent years. Between 2016 to 2023, assets under management in model portfolios more than doubled, going from $2.1 trillion to $5.1 trillion, according to JPMorgan’s report.

The inflow to model portfolios isn’t purely ETFs, Maier said. It’s a combination of ETFs, mutual funds, and separate accounts that are merged into a strategy. He acknowledged that it’s difficult to parse out how much of it is purely ETFs. However, since the US’s compounded annual growth rate of assets piling into ETFs is at 17%, from a trend and anecdotal perspective, he assumes much of it is.

Maier, who once ran Merrill Lynch’s model portfolios, says that most firms that chose to employ this structure aren’t just buying up ETFs with the appropriate exposure. There’s still a bottom-up approach that requires them to look under the hood and assess the allocation of the securities while navigating macroeconomic trends.

For example, in the context of a traditional 60-40 stock-to-bond portfolio, a money manager could use various ETFs to satisfy each division. In equities, they can balance passive and active funds with exposure to growth or value depending on an investor’s risk appetite. They could overweight a sector based on the business cycle or pick funds with an international component, Maier noted. A similar approach can be employed for the fixed-income side by picking ETFs that target a particular duration or credit quality and shifting that allocation over time, he added.

Maier noted that the tax efficiency of ETFs is another benefit since managers don’t have to worry about capital gains every time they turn over a position. As for fees, while each fund will vary, it’s typically a layer of those charged by the underlying ETFs and a management or wrapper fee that could range between 0.5% to 1%, he noted.