Exchange-traded funds are bringing a surprising twist to America's favorite investment, hands-off indexing

The future of ETFs: What you need to know

January 24, 2022 4:16 PM

The tsunami of exchange-traded funds that has surged into retirement portfolios over the past decade is only going to get bigger — and more complex for investors, financial advisors and regulators.

With low costs and stellar long-term returns, ETFs lock in broad exposure to the market or specific industries, disclose their holdings daily and trade like regular stocks. They’re unusually beneficial on the tax front, thanks to their use of a decades-old loophole that avoids triggering capital gains taxes on their profits.

The majority of ETFs track U.S. equity indexes, like the S&P 500, and seek to replicate the performance of a specific benchmark. By contrast, mutual funds involve a manager trying to beat the market by picking winning stocks through proprietary trading strategies, a more costly way to invest. They disclose their holdings quarterly and don’t trade like stocks — investors who sell them have to go through the fund itself or a broker.

ETFs are devouring the world

Investors fleeing mutual funds for ETFs is like a slow-motion trainwreck. Mutual funds still held nearly five times as much money, or almost $24 trillion, compared to ETFs in 2020, according to ICI. But the balance is about to tip.

U.S. ETFs managed nearly $7.3 trillion dollars in 2021, more than double 2017’s level, according to Morningstar and Statista. ETFGI, a research and consulting firm in London, predicts that ETF assets will surpass those of mutual funds before 2026.

Passive devours active

ETFs use the same technique as another massive investing trend, index funds: Both mirror a benchmark or other factor, “passively" reproducing a measure’s performance by proportionally owning the same securities. While index funds started out as mutual funds in the 1970s, the emergence of lower-cost index ETFs in the early 1990s has chomped out market share.

Which points to the big picture: Passive investing, driven by ETFs, has the mutual fund industry on the run. Index funds invested in U.S. equity benchmarks first overtook actively-managed funds in terms of assets under management in August 2019, according to Morningstar. The big news right now in the industry concerns a new breed of ETFs that seeks to beat benchmarks or other factors, such as those for sustainability, by operating as actively-managed funds. It’s bringing scrutiny from some financial industry professionals, academics, regulators and lawmakers over their tax benefits and costs to investors.

One decade, a revolution in investing

The vast majority of ETFs mirror U.S. stock indexes. Those that are actively managed favor bonds. A tiny slice is in commodities or currency funds. ETFs focused not on indexes but on measurable themes, such as growth or sustainability, and managed by a fund manager who is actively picking their holdings will become more prevalent this year, according to Cerulli Associates.

Asset managers love ETFs

The biggest ETFs, led by State Street's $450 billion SPDR S&P 500 ETF Trust, are linked to the S&P 500 index of the largest US companies. Investors love them because they can get exposure to the biggest American corporations through only one fund. But with their low fees, they're not as profitable for asset management companies as actively-managed ETFs. Having a well-paid fund manager pick stocks, bonds or other assets in an attempt to beat the market costs money.

Passive gets aggressive

In 2008, the SEC greenlit a form of ETF that’s actively managed by a fund manager. Like other ETFs, such funds are typically invested in bonds and must disclose their holdings daily. There aren’t many of those funds, because their trading strategies are an open secret that’s ripe for others to copy while avoiding the management fees.

A decade later, a major change came when asset managers got regulatory approval in 2019 to issue partly-transparent and opaque actively-managed ETFs. Unlike traditional ETFs, those funds aren’t required to lift the veil daily on their holdings and can keep their trading strategies secret as they try to beat the market. The development threatens to make the new breed of ETFs resemble the very industry — mutual funds — that the entire ETF industry originally set itself against when it first emerged in 1993. The main issue with the partly- and non-transparent ETFs is that the secrecy around holdings makes it impossible for an investor to know whether its share price reflects the underlying value of its holdings.

Boston research firm Cerulli Associates said in a Jan. 13 report that the new active funds are “poised for a pivotal year” of growth. But given their black box nature, they also require “additional diligence from advisors and home offices,” Cerulli said.

Controversial tax loophole

Mutual funds generate capital gains taxes each time they sell an underlying holding that has appreciated, even if an individual investor holds on to her fund. So that cost is passed on to her. By contrast, ETFs use an obscure tax loophole to cash in on appreciated holdings by swapping assets with a buyer — in this case, major banks.

For example, a fund sells an appreciated stock in its “basket” of shares to a bank and immediately buys back “substantially similar” shares. Because no cash has traded hands, there’s no capital gains tax on those profits. Or an ETF can sell a losing stock, deduct the loss, then buy back similar stock. The deduction boosts the returns of the fund. Of course, when an investor sells her ETF, she owes capital gains tax on the profits. But until she does, the capital gains taxes on internal trades made to keep the fund in line with its benchmark are “washed away.”

With active trading strategies, the tax perk for the new semi-transparent and opaque ETFs is even more significant. As well as potentially more prone to scrutiny. Sen. Ron Wyden, who heads the Senate Finance Committee, called in Sept. 2020 for an end to ETFs’ use of “in-kind” transactions to avoid triggering capital-gains taxes.

Vanguard's secret sauce

In 2001, Vanguard, the world’s second-largest asset manager, acquired a patent for a novel, tax-efficient fund structure that blends a mutual fund and an ETF by bolting on an ETF share class to its existing stock mutual funds. The patent expires in May 2023, which could open the flood gates to lookalike funds from competitors — and to greater scrutiny by regulators and critics, who argue that the structure’s tax benefits are controversial.

Vanguard’s secret sauce has several benefits.

Ordinarily, investors in a mutual fund owe capital gains taxes when that fund sells stock. The Vanguard patent uses an obscure, decades-old tax loophole to eliminate those levies both in a mutual fund and an ETF.

The loophole says that when withdrawals from a fund are paid with stock, not with cash, there’s no capital gains hit for the investor. For withdrawals, Vanguard uses rapid trades to whisk appreciated stock out of both a mutual fund and its sister ETF, then rapidly injects stock back in. A 2019 Bloomberg investigation detailed how those so-called “heartbeat” trades are fueled by big banks.

Investors can swap their mutual fund shares for shares in a “sister” ETF, all without owing taxes on the profits. The tax erasure not only reduces taxes on paper profits but also allows investors to defer paying taxes on their profits until they ultimately sell their mutual fund.

Because the patented structure involves two classes of shares, it gives investors the choice of holding a single investing strategy as a mutual fund or as an ETF. Vanguard’s secret method bolts an ETF onto an existing mutual fund, in contrast to competitors that issue stand-alone ETFs. While the entire investment holds the same securities, the ETF portion has a separate class of shares. The structure allows Vanguard “to have an ETF product that is almost identical to its mutual fund counterpart, which gives investors a wider range of product choice,” Shapiro said. “One fund, two share classes — that is unique.”

Prior Cerulli research cited in the firm’s U.S. Exchange-Traded Fund Markets 2021 report showed that nearly four in 10, or 38%, of ETF issuers were considering adopting the Vanguard model once its patent expires. “Managers considering launching active ETFs should also keep an eye on the dual-share-class structure used by Vanguard, which comes off patent in 2023,” the Cerulli ETF report said.

The benefit to financial advisors is that they “wouldn’t have to dig into specific differences between what’s in the mutual fund and what’s in the ETF,” Shapiro said. Still, he added that “it’s an open question” whether the new breed of active ETFs will get a green light to use the Vanguard recipe, given the controversy over its tax benefits. “It’s not clear that the SEC would approve it,” he said.

Fidelity's bespoke method

When the SEC relaxed its rules on ETFs in 2019, it opened the door to the creation of bespoke fund models with secret trading strategies run by portfolio managers picking stocks, bonds and other securities. Six asset management companies — Fidelity Investments, Invesco, Precidian, Blue Tractor, T. Rowe Price and Easton Vance — plus the New York Stock Exchange now license their “secret sauce” methods to asset management companies that issue ETFs.

Who’s in the pole position so far? Fidelity. More than four in 10 companies that issue or plan to launch ETFs are very likely or somewhat likely to use Fidelity’s proprietary method, according to Cerulli Associates.

The economics of indexing

Funds that passively mirror an index by investing proportionally in the stocks making up the benchmark are synonymous with low-cost investing. Because there are no specific stocks to “pick,” the benchmark itself does the work, not a highly-paid fund manager.

But an academic paper in July 2021 showed that companies that provide indexes for funds to track wield strong market power and charge large markups to ETFs. Those costs are passed on to investors through management fees.

The paper, by researchers at the University of Washington, University of California, Berkeley and Johns Hopkins Carey School of Business, said that around one-third of all ETF management fees are paid as index licensing fees to index providers. For example, it estimated that one-third of the 0.09% total expense ratio charged by the $420 billion SPDR S&P 500 ETF Trust, the world’s largest ETF, could be attributed to the licensing cost charged by S&P Dow Jones Indices. The study estimated that 60% of licensing fees constitute markups charged by index providers and said that eliminating index providers’ “market power” could lower ETF management fees by 30%. It’s an issue that the SEC has flagged for scrutiny.

A handful of companies dominate the index providing business, including S&P Global, which oversees the S&P 500 and Dow Jones indexes, MCSI, Bloomberg and the London Stock Exchange, provider of the Russell indices.