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Portfolio > ETFs

Why RIAs and IBDs Favor ETFs Over Actively Managed Funds 4 to 1

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It’s well known that ETFs have been growing in popularity, increasing market share at the expense of mutual funds, and that financial advisors are increasingly investing in ETFs on behalf of clients.  But the extent of that usage may surprise you.

According to a new report from Broadridge’s Fund Distribution Intelligence, which compiles data on ETFs and mutual funds, the use of ETFs among RIAs is undergoing a dramatic shift. While currently held assets are split 30% passive – largely ETFs – vs. 70% active (primarily actively managed mutual funds), 80% of net new cash flows are invested in passive assets vs. 20% in active assets.

Broadridge reported a similar shift in the IBD channel. Seventy-seven percent of new cash flows in that channel are invested in passive instruments versus 20% in actively managed funds.

“This has been the trend over the past couple of years but now it has accelerated,” says Frank Polefrone, senior vice president of product development at Broadridge. “It’s not just because of the DOL fiduciary rule,” which requires that advisors act in the best interest of their clients. “Even if it’s done away with or watered down, I don’t think that will change the trend.”

Underlying the trend toward passive investment, especially ETFs, and away from active investments are the lower costs, increased transparency and tax-efficiency.

But the DOL fiduciary rule, which is scheduled to take effect starting April 10 if there are no delays or a repeal under President-elect Donald Trump, has RIAs and IBDs looking at their accounts and considering what lower-cost products to switch to in order to serve the best interest of their clients. Actively traded products that cost more and underperform passive investments could be subject to class-action lawsuits under the DOL rule, explains Polefrone.

“The DOL rule hasn’t even taken effect, but it’s getting everyone’s attention.”

Lower-cost products could also potentially leave more money in the pocket of fee-based advisors. They don’t charge more for higher priced products, and since few actively managed funds consistently outperform their benchmark indexes, their clients are likely to have more assets on which to base their  fees.

“The monthly data we see is consistent with these trends,” says Todd Rosenbluth, director of ETF Research at CFRA. “”RIAs and IBDs are increasingly using ETFs for their asset allocation needs, and various iShares core product ETFs and Vanguard core products ETFs are among the biggest asset gatherers. We see inflows into IVV [iShares Core S&P 500 ETF]and VOO [Vanguard S&P 500 ETF] even when SPY [SPDR S&P 500 ETF Trust] has outflows.”

Although all three ETFs are based on the S&P 500 index, the expense ratios of IVV and VOO are about half that of SPY, just four and five basis points, respectively.

Increasingly advisors are focused on lower expense ratios,” says Rosenbluth.

They’re also increasingly looking toward what Rosenbluth calls the “second wave of ETFs” –  funds that are tilted toward lower volatility or quality or another attribute that falls under the “smart beta” umbrella. “There isn’t such a wide array of choices among mutual funds,” says Rosenbluth.

Rather than use funds that are actively managed ,advisors themselves can actively adjust asset allocations using “easy-to-understand ETFs,” says Rosenbluth.

“The fee-based RIA channel has been ahead of this [ETF] trend,” says Polefrone. “The wirehouses are behind it, moving slower but also away from products with commissions and loads. “They’re trying to play catchup.”

Despite the growing popularity of ETFs mutual funds continue to dominate the fund universe – accounting for over $16 trillion in fund assets compared to about $2.1 trillion in passive assets, primarily ETFs – and that’s still the case for RIAs and IBDs.

According to Broadridge, through the third quarter of 2016, RIAs held $1.63 trillion in long-term mutual funds – more than twice the $656.5 billion in ETFs. IBDs had $1.78 trillion in long-term mutual funds — about four times the $488.4 billion in ETFs.

But fund flows clearly favor ETFs.  Flows into ETFs through the third quarter rose 13.6% for RIAs and 22.1% for IBDs while flows into long-term mutual funds increased just 1.3% among RIAs and fell 0.8% among IBDs.

Rosenbluth doesn’t expect to see parity between ETF assets and mutual fund assets for many years, in large part because employer-based retirement plans continue to favor mutual funds. “It’s rare to find 401(k) plans and pension plans investing in anything other than mutual funds.”

He expects the use of ETFs will continue to grow in 2017 among RIAs, IBDs, institutions and individual investors, not just in equities but fixed income as well. “As yields rise, investors are going to look to rotate within the fixed income market,” says Rosenbluth. “The  low-cost structure of ETFs compared to funds make that all the more appealing. Paying 10 to 15 basis points for low yields and low returns is a lot better than paying 60, 70, or 90 basis points for it.”

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