5 ways to enhance your portfolio with ETFs
Exchange-traded funds (ETFs) have grown considerably in popularity and net investment flows due to their low cost, tax efficiency and simplicity. Investors can use ETFs to build globally diversified portfolios that are easier to evaluate.
Help your clients stay the course—even amid market volatility—and meet their long-term investment goals by incorporating transparent, potentially tax-efficient ETFs at an attractive cost. Explore five reasons why you should consider using ETFs in your portfolio decisions.
- Potentially lower your client’s expenses with ETFs; they may reduce costs, particularly relative to active mutual funds, by closely tracking an underlying index and avoiding high-expense manager activity.
- ETFs offer potential tax efficiency by taking advantage of a unique rebalancing and redemption process.
- Give your clients greater transparency into what they own—most ETFs report their holdings daily, rather than quarterly like most mutual funds.
- Increase broad-based exposure to virtually all liquid asset classes and diversify across different investment styles with ETFs.
- Tailor portfolio exposures across geography, asset class and investment style by taking advantage of the numerous options provided by the dramatic growth of the ETF space in recent year.
#1 Lower overall portfolio expenses
Actively managed mutual fund portfolio managers conduct research seeking to identify securities that will collectively outperform a given benchmark. This expensive process is one of the reasons actively managed mutual funds generally have higher costs than index ETFs and mutual funds. Investors are increasingly unwilling to pay that higher price, especially if an actively managed mutual fund fails to provide either a track record of outperformance or significantly different underlying securities. Over the past decade investments in ETFs have grown substantially as investors have elected to gain broad-based exposures to a benchmark. These investment flows have helped lead to a wide availability of low-cost ETFs across asset classes.
As it turns out, in many cases the underlying holdings of actively managed mutual funds and index ETFs are largely the same. If your clients are invested in an actively managed mutual fund that has a substantially higher cost than an ETF (such as in Exhibit 1) with comparable broad-based exposure, consider whether they are receiving commensurately greater value.
Exhibit 1: Expense comparison between actively managed mutual funds and index ETFs
See how the annual expense ratio of a blended actively managed mutual fund portfolio compares to a blended ETF portfolio.
Source: Morningstar Direct as of 12/31/2021. Cost refers to “Annual Report Net Expense Ratio” data point. Blended portfolio of Schwab ETFs is a blend of equity and fixed income found within Schwab Asset Management’s Portfolio Construction framework.
#2 Can help improve your clients’ tax experience
Potential tax efficiency is one of the most significant benefits of the ETF structure. Exhibit 2 shows that the tax bill on ETFs that track the S&P 500 is significantly lower than that of mutual funds that track the S&P 500. That’s because, unlike mutual funds, transaction activity within ETFs is relatively low, which helps mitigate taxation on capital gains.
Exhibit 2: Taxable distributions between ETFs and mutual funds that track the S&P 500
Below is a comparison of taxable distributions between ETFs and mutual funds that track the S&P 500.
Source: Morningstar as of 12/31/2021.
Both mutual funds and ETFs must distribute their annual net gains and income to investors to avoid paying corporate income taxes. A high turnover ratio, or the percentage of a fund’s holdings that have been replaced in a given year, typically can result in higher tax exposure. Transactions within ETFs are often limited to rebalancing in accordance with changes to the underlying index an ETF tracks. In comparison, active mutual fund managers continually evaluate and select securities they believe will help the fund outperform while adhering to the fund’s mandate set forth in its prospectus. This means that actively managed mutual funds may have a higher turnover ratio, which is correlated with higher potential capital gains.
The way in which ETFs handle redemptions and rebalancing trades also helps their tax efficiency over mutual funds. When a mutual fund investor wants to sell their shares, they redeem them directly to the fund manager or intermediary, who then sells securities to raise cash to meet the redemption, contributing to a higher portfolio turnover ratio. By contrast, when ETF investors want to sell shares, they can simply sell to another investor in the secondary market (as they would with a stock or bond). These trades directly between buyers and sellers lower the turnover of assets with the ETF, thus lowering the potential capital gains within the ETF. Finally, ETFs also offer the fund managers flexibility to rebalance the fund using in-kind exchanges rather than outright sales of securities, which can generate taxable gains.
#3 Provide investor-friendly transparency
For clients to understand what a typical ETF is invested in, they can look directly at the index it tracks. Passive ETFs, by nature, tend to maintain a low tracking error against their benchmark.1 Additionally, as illustrated in Exhibit 3, investors can see most ETF holdings on a daily basis, while mutual funds typically only report their holdings quarterly. ETF transparency can contribute to a straightforward investment approach that is easily explained and evaluated, offering peace of mind to clients who want to better understand their portfolio.
Exhibit 3: Knowing what you own
The sample calendar below shows how investors have greater transparency into ETFs, which typically report holdings daily—as opposed to most mutual funds, which report holdings quarterly.
Holdings are reported:
Source: SEC Investor Bulletin, Exchange traded funds (ETFs), Investopedia.com.
ETF transparency is also beneficial from a behavioral standpoint. Advisors know that their clients’ behavior can impact investment outcomes and they are more likely to stick with a strategy if they understand what they are invested in. The daily reporting of most ETF holdings affords investors the opportunity to fully understand what they own in real time. In turn, this insight can help them to react more knowledgeably to market volatility. After all, we believe time in the market is more important than timing the market. This can help your clients stay the course and maintain focus on long-term goals, especially during bouts of market turbulence.
#4 Diversify across investment styles with ETFs
As discussed, passive ETFs are traditionally known for offering low-cost exposure to an index. Many of these indices, such as the S&P 500, while offering diversified exposure, are market cap-weighted, which means holdings with the highest market value receive the heaviest weighting. ETFs have evolved to offer diversification in additional ways.
Not only can ETF investors diversify their portfolios across numerous geographies and asset classes, they can also diversify across investment styles, including various strategic or “smart” beta† categories. These strategies methodically weigh specific dimensions such as growth, dividend, value, risk-oriented and multi-factor (see Exhibit 4). These ETFs are based on indices that seek to improve the strategies’ return profile, risk profile or both. Pursuit of these objectives used to be only possible through individual stock, bond and mutual fund selection. However, due to the dramatic growth of AUM and choices available among ETFs, investors can now use ETFs to diversify their portfolios in ways beyond simple market-cap weightings.
Exhibit 4: Top strategic beta categories by AUM and number of ETFs
The pie chart illustrates the 11 strategic beta ETF categories that Morningstar recognizes, ordered by AUM and the table next to it shows the number of ETFs available in each category.
Source: Strategic beta classification based on Morningstar as of 12/31/2021.
#5 Tailor exposure for the long term
The number of ETFs globally available has risen dramatically over the past decade. Exhibit 5 shows that in 2021, more than 2,900 ETFs were available for purchase, with a total of approximately $7.3 trillion in assets under management in the U.S. alone.2 Access to large numbers of sector-specific ETFs now allows for more granular portfolio customization that, in decades prior, could only be achieved through individual security or mutual fund selection.
Exhibit 5: ETF availability and AUM on the rise since 2000
You can see the increasing number of available ETFs, as well as their growth in AUM from 2000 through 2021.
Source: Morningstar Direct 12/31/2021.
The availability of asset-class specific ETFs (see Exhibit 6) also helps to create efficiency in the portfolio construction process. You can tailor portfolios by dialing in specific investment exposures based on your clients’ needs. Because of the growing availability of ETFs in various asset categories including U.S. equity, international equity, taxable bond, municipal bond, alternatives, etc., using just two to three specific low-cost ETFs can result in a more efficient portfolio construction process.
Exhibit 6: ETF availability and expenses by sector
The chart shows the number of available ETFs by sector and average operating expense ratio.
|Sector||Number of ETFs||Average OER (%)*|
*Operating expense ratio
Source: Morningstar Direct 12/31/2021
An effective tool for long-term goals
For your clients looking to add more precise, diversified or transparent exposure to their portfolios while keeping expenses low, think about ETFs. Compared with actively managed mutual funds, index ETFs offer a lower-cost option. Due to lower turnover and a more efficient redemption process, ETFs may help increase a portfolio's tax efficiency. Additionally, your clients can gain greater transparency into what they own by adding ETFs. The numerous and widespread availability among ETFs across asset classes can help provide a more efficient investment management process for you and a better overall experience for your clients. We encourage you to consider harnessing the potential benefits that ETFs can add to your clients' portfolios while helping them stay invested toward their long-term goals.