Are Traditional Mutual Funds Going the Way of the Eight-Track Tape?

Aug 2, 2021
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Exchange-traded funds (ETFs) are surging in popularity — on pace to take in more money in just seven months this year than in any previous full year.

ETFs are not exactly new kids on the investment products block, having been created more than 30 years ago. So what’s fueling their popularity right now? Eric Balchunas, a Bloomberg Intelligence ETF analyst described it for the Wall Street Journal as a simple format change: “In the same way that people went from buying CDs to using streaming or digital music, or from using cabs to Uber.”

Of course, new formats gain popularity by offering features and benefits that people prefer over the old formats. ETFs offer all the diversification of a traditional mutual fund, but at a lower cost, higher tax efficiency, and the freedom to trade throughout the day just like stocks. However, none of that is new.

What is new is commission-free trading and the flexibility at an increasing number of brokers (including Fidelity) to trade ETFs in fractional shares. A money-flow analysis shows ETF inflows outpacing those of traditional mutual funds beginning 2011, with the disparity widening pretty much ever since.

With ETFs’ rapid growth in popularity, more and more traditional mutual fund companies are jumping on the ETF bandwagon, offering ETF versions of many of their traditional mutual funds. Almost all of the 25 largest U.S. money managers either now offer ETFs or plan to in the near future.

One of the most noteworthy changes is the introduction of more actively managed ETFs. While they still represent just a small segment of the total ETF market, it’s a fast-growing segment.

Impact on SMI strategies

The growing availability of ETFs has put more such funds on our momentum-monitoring radar screen, so it’s no surprise to see them showing up more frequently on our recommended funds lists. Four of the seven stock funds currently recommended in Fund Upgrading are ETFs. In Sector Rotation, 11 of the 35 funds in August’s top quartile are ETFs. All six of the funds used in Dynamic Asset Allocation have always been ETFs.

Just-the-Basics can be implemented with ETFs or traditional mutual funds. At all of our recommended brokers other than Fidelity, the decision comes down to whether you prefer the flexibility of buying in the exact dollar amounts that traditional mutual funds offer. At Fidelity, you can buy either type in exact dollar amounts.

Risky business?

Some market analysts are concerned that the freedom to make no-commission ETF trades throughout the day, just like stocks, along with the availability of fractional share trading, will prompt more frequent trading of ETFs, especially among newer, less experienced investors. The worry is that with less friction in the buying and selling process to slow people down, long-term “investing” will be replaced by short-term “trading.”

However, for those following SMI’s strategies, the ability to trade ETFs throughout the day should be irrelevant, while the lack of commissions along with fractional share trading are helpful new benefits. A growing universe of ETFs to choose from will only enhance those benefits.

Whether ETFs will ever completely replace traditional mutual funds is anyone’s guess. One roadblock is the preference among 401(k) plan administrators for traditional mutual funds. The tax efficiency of ETFs isn’t seen as a benefit since workplace plans are already tax-advantaged. And the ability to trade ETFs during the day may be seen as a hindrance to employee productivity. Still, it’s clear that the fund landscape is changing in significant ways.

Written by

Matt Bell

Matt Bell

Matt Bell is Sound Mind Investing's Managing Editor. He is the author of five biblical money management books and the teacher or co-teacher on three video-based small group resources. His latest book, Trusted: Preparing Your Kids for a Lifetime of God-Honoring Money Management, was published by Focus on the Family in 2023. Matt has spoken at churches, universities, and conferences throughout the country and has been quoted in USA TODAY, U.S. News & World Report, and many other media outlets.

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