A Once Rocky Romance

How advisors slowly fell in love with ETFs.

Reviewed by: Heather Bell
Edited by: Heather Bell

The relationship between advisors and ETFs over the years has been a sort of “When Harry Met Sally”-style rom-com, with animosity eventually evolving into a passionate love affair.

In the very early days, there were concerns about ETFs encroaching on advisor territory, and about how advisors would recoup the commissions they would miss out on from selling mutual funds to their clients. Many said there was no compelling reason for advisors to use ETFs in their client portfolios, considering this.

But that way of thinking has changed, and while not every advisor is a fan, the number of advisors using ETFs has increased exponentially in the last decade or so. Today roughly 85% incorporate the wrapper into their client portfolios, by most estimates.

The reasons for this evolution in the relationship between advisors and ETFs are pretty clear cut and indisputably compelling.

Tax Efficiency
Tax efficiency is probably the biggest reason for advisors to embrace ETFs. If you’re not an RIA, give one a call and ask them why they like ETFs. And if they’re not still smarting over the ding to their mutual fund fee collection, the odds are high they’ll wax rhapsodic over the tax blessings that come with ETFs.

There’s little in the way of capital gains thanks to the creation/redemption mechanism and in-kind transactions. The ETF structure also sidesteps another key pitfall faced by mutual funds: When someone wants to enter or exit an ETF, they simply trade shares of the fund on the stock market any time of day.

Meanwhile, if someone wants to enter or exit a mutual fund, the related trading and transaction costs are spread across the entire pool of shareholders.

In fact, the advisory firm 6 Meridian entered the ETF space a little more than a year ago, specifically because of its devotion to tax management. It offers several strategies it had previously operated as separately managed accounts in ETF form simply because the tax advantages are so strong. Its five ETFs currently have roughly $620 million in assets under management.

Low Costs
Advisors also know you really can’t beat ETF costs. There are several that don’t even have an expense ratio. Zip. Zero. Nada. Yes, there are trading costs, but if you’re using a brokerage platform that doesn’t charge to trade ETFs, and you’re planning to hold the fund for the long term, they become a nonissue.

ETFs are a large part of the reason mutual funds have seen their expense ratios compress over the past few years—and no small reason for mutual funds’ pretty drastic recent outflows. But even with that pressure, a mutual fund is still pricier than an ETF. On average, a mutual fund costs roughly three to four times the price of an average ETF. 

Meanwhile, nearly 200 ETFs (mostly covering broad asset classes) have expense ratios of less than 0.10%. The 10 largest actively managed ETFs currently trading have expense ratios ranging between 0.18% and 0.75%. Despite the pricing pressure, the cost gap between ETFs and mutual funds remains pretty glaring.

An Assist
Between those two crucial considerations—cost and tax efficiency—most advisors couldn’t resist the siren call of ETFs. They miss out on the mutual fund fees they used to get, but the trade-off was simply too compelling. ETFs help advisors do their job better and provide their clients with better outcomes.

To borrow (and warp) an old catchphrase from my home state: “Advisors and ETFs, perfect together.”

Heather Bell is a former managing editor of etf.com. She has also held editorial positions at Dow Jones Indexes and Lehman Brothers. Bell is a graduate of Dartmouth college and resides in the Denver area with her two dogs.