In 1993 State Street Global Advisors revolutionized the investment industry by launching the first ETF: The State Street S&P 500 Index (SPY). The primary goal was to provide a mutual fund like vehicle that could be traded intra-day, as opposed to just at market close like traditional mutual funds. SPY offered very low-cost access to the popular S&P 500 Index, a widely accepted market benchmark for stock market investors popularized by the Vanguard S&P 500 Index fund.

Since that time SPY has been joined by more than 3,100 ETFs representing various investment categories, including U.S., developed international, bonds, commodities and emerging markets. As a result of exponential growth, combined ETF assets reached $8.24 trillion in January 2024.

In the early years ETFs were mainly known for their low investment expenses as investors became educated that investment costs are a critical component to the total return of an investment. Most ETFs were passively managed index portfolios with expenses about the same as traditional index mutual funds, but much lower than mutual funds on average—most of which are actively managed.

As ETF assets have grown many managers have continued to drop their management fees even further. Additionally, since ETFs were traded like stocks, trading commissions were much lower than charges assessed to trade most mutual funds. Eventually, many custodians (e.g., Fidelity, Schwab), reduced commissions on ETF trades to zero, further increasing their cost advantages over standard mutual funds.

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Taxes matter has been the mantra for CPAs as for long as CPAs have been around. One of the key tax benefits of mutual funds is there is no entity level taxation if the mutual fund annually distributes both investment income and realized capital gains to the investors. But the flip side is that many taxable mutual investors do not like having no control over capital gain realizations. What often frustrates investors is a situation where the return of a mutual fund is negative for a given year—yet capital gain taxes are due. It can add insult to injury.

The realized capital gains in a mutual fund can be driven by the investment manager selling specific stocks to change the investment strategy or just needing to sell stocks at a gain to meet redemption requests. Also, stock liquidations may be forced due to a corporation action, such as the company is acquired for cash in a taxable acquisition.

All of these realized taxable transactions are recognized as taxable capital gains in the mutual fund structure and passed through to the investors of record at the capital gain dividend record date.

These sorts of non-investor controlled realized tax events can be eliminated by the ETF structure. Unknown to the ETF creators in 1993, the creation and in-kind redemption structure of the ETF allowed investment managers to eliminate the annual capital gains distribution. ETFs will issue and redeem shares based on trading activity. Done properly, this process, along with the use of tactical “heartbeat trades,” can eliminate all recognized capital gains at the ETF entity level.

While a mutual fund investing in the S&P 500 would have annual capital gain distribution, an ETF investing in the S&P 500 would not. The ETF investors delay all capital gains recognition events until they sell their ETF.

As noted earlier, the first ETFs were passive portfolios tracking publicly available indexes. The advantages of index investing are well known. Namely, passive strategies have low expenses, no dependence upon the skill of an investment manager and a good performance track record against actively managed portfolios.

The downside of most index strategies is that they are “capitalization weighted.” Under this construct the larger the market capitalization of a stock, the greater its weight in the portfolio. The S&P Index for example has 503 stocks, yet the largest 10 stocks comprise 30 percent of the portfolio. This has a way of actually reducing diversification as individual stocks and sectors become overweighted compared to their role in the overall economy.

To help alleviate the need for investment managers to follow a passive index and allow active managers to offer active ETFs, the SEC adopted the “ETF” rule (Rule 6c-11 under the Investment Company of 1940) in September 2019. The new rule allowed active managers to offer ETFs that followed a “fully active transparent” investment structure to alleviate inherent problems with a passive index structure. This new rule was the impetus for many active managers to convert existing mutual funds to fully active transparent ETFs, as well as offer new active ETFs for investors.

By converting to ETF structures, fund companies were able to reduce expenses and solve the uncontrolled realized gain realization problem with standard mutual funds.

In some cases, traditional mutual funds can still be a rational choice for a portfolio. In qualified accounts the capital gains distributions are a non-issue and many mutual funds have expenses just as low as comparable ETFs. Also, some investment managers maintain that they can generate better performance with the less fluid nature of a non-ETF strategy.

Other ETF issues include small asset bases, which can lead to fund liquidation as well as low trading volumes that can result in large bid/ask spreads. So due diligence is really important and in some parts of a portfolio. traditional mutual funds may be a better choice. The ETF explosion, along with the growth of fee-based investment advisers acting as fiduciaries, has resulted in better investment outcomes for millions of Americans. As your clients consider using an independent adviser it is important that the adviser understand the potential advantages of ETFs for your clients’ portfolios, has done the due diligence needed to choose those ETFs and can skillfully orchestrate their use.