Why ETFs Are The Future

Why ETFs are the future

Key Takeaways

  • The last 10 years have seen an accelerated growth in ETFs led by retail investors and thematic ETFs.
  • ETFs are favored over mutual funds due to their flexibility and lower fund fees. 
  • As of Q3 2022, retail investors have invested $40 billion into thematic healthcare ETFs.

Whether you are a new or seasoned public market investor, it’s important to understand the range of investment options available. Broadly, there are two pathways to consider. Investors can purchase shares of individual companies (i.e., stocks) or choose to invest in diversified funds, such as mutual funds or exchange-traded funds (ETFs).

A general rule of thumb for retail investors is to invest in what you know. In the industry today, it appears that retail investors are gravitating toward diversified funds, specifically ETFs.

Why is all of this happening?

ETFs have been around for almost 30 years, and in the last 10 years, they have experienced an accelerated ~5x growth in their total assets under management (AUM). This is due to thematic investment philosophies and retail investors now being able to invest easily through their mobile devices.

To understand the drivers behind this growth, we must first understand diversified funds and how each type of fund differs.

What Does it Mean to Invest in a Fund?

A fund is a collection of an individual company’s shares. The number of companies within a fund can range from hundreds to thousands. Purchasing one share of a fund will get you a small fraction of each company. The amount of money allocated to each company is determined by the company’s weight within the fund.  

A company’s weight within the fund and the rules controlling those weights can range from simple to complex. A fund’s design can lead to tax implications, alter investment returns, and change how much you can invest. 

Let’s break this down. Table 1 illustrates how a $100 investment is split within a fund and allocated to each underlying company based on their respective weights. 

weighted company comparison

Advantages Of Funds 

Funds can help investors manage risk by diversifying their portfolio across hundreds or several thousand companies.

As per Table 1, instead of investing $100 into each company, you can invest $100 into a single fund and own a piece of every company in the fund. If one company’s stock declines and the others don’t, your $100 investment is hedged.

Disadvantages Of Funds

Funds are operated by asset managers, which costs money. To offset this cost and to be paid for their time, a fund charges investors an expense ratio or fund fees. The higher the fees, the lower your (or the fund’s) potential returns. It’s important for investors to realize that this cost will compound over time. For example, take the two funds in Table 2.

comparison of fund fees

Even though the contributions and returns are identical, Fund B investors lost $1,090,436 due to a higher expense ratio.

In addition, proper distribution of your investment within the fund is contingent upon how its holdings are weighted and if the fund manager continuously updates the fund based on evolving market dynamics.

ETFs vs. Mutual Funds

There are two main types of funds available to investors for public market investing, ETFs and mutual funds. Each fund gives access to hundreds or thousands of companies while mitigating risk. To further complicate matters, there are thousands of ETFs and mutual funds investors can choose for investment.

Table 3 compares and contrasts these two funds.

ETFs vs Mutual funds

While both are investment vehicles for gaining access to different companies, ETFs have been gaining more popularity due to their tax efficiency and ability to invest in real-time. Plus, thematic ETFs are now available for those interested in covering a specific investing area (more on that below). 

Types of ETFs

Passively-managed ETFs

Passively-managed funds track an Index (such as the S&P 500 or Nasdaq Healthcare Index) and obey the rules set by that Index. Once companies are bundled into the fund, that’s it. The fund is left alone to follow the rules of the Index. As an investor, the advantage is that there is stability – you know what you’re getting when you invest – and typically low volatility. 

The downside with passively-managed funds is that they are updated based on the basic rules they follow. If the updates are favorable, the fund does well. If not, you may suffer a loss.  

Actively-managed ETFs

Actively-managed funds aim to beat an industry benchmark. Fund managers are actively updating companies within the fund and/or altering their weight. The advantage for the investor is that if a company isn’t doing well, the fund manager will likely adjust or remove those shares. Doing this eliminates the risk of investing in that company and increases the chances of earning higher returns from the fund.  

The downside with actively-managed funds is if the fund manager gets it wrong, your investment returns may not beat an index as intended. In addition, these funds have higher volatility due to frequent trading and higher fund fees because someone is doing the work on the backend.

Diversified vs. Non-Diversified Funds

An additional feature of ETFs and mutual funds is that they are labeled as diversified or non-diversified. This classification depends on how their holdings are weighted. To qualify as diversified, a fund must pass the 75-5-10 test. This test states that 75% of a fund’s total weight must be spread across other holdings, the fund may not invest more than 5% in a single company, and the fund cannot own 10% of a single company’s total outstanding shares. 

Typically, passively-managed ETFs tracking an entire industry contain upper limit caps on a company’s weight so that the fund obeys the 75-5-10 rule and can be labeled as diversified. On the other hand, actively-managed ETFs that focus on a specific sector and/or are thematic are non-diversified. This allows investors to gain additional exposure to specific companies in an attempt to have outsized performance relative to benchmarks. 

Compared To Mutual Funds

Overall, actively-managed ETFs are similar to mutual funds. Both have fund managers and higher fees than passively-managed ETFs. Passively-managed ETFs operate by their own set of rules without interference from a fund manager.

ETF Growth Over the Years

In 2003 there were only 276 ETFs worldwide (123 in the U.S.). In 2021, that number grew to over 8,000 worldwide (2,952 in the U.S.). As of Q3 2022, AUM is now over $5.9 trillion ($10 trillion worldwide).

ETF growth

The Rise of Thematic ETFs

Thematic ETFs are funds that contain companies within a specific niche or sector. Their advantage is that you can concentrate on a specific sector to diversify and increase the overall exposure of your portfolio. They also help to isolate the risk from niche investments from the rest of your portfolio’s investments. 

In Q3 2022, there were 319 new ETFs, and over 150 thematic ETFs saw cash inflows of more than $50M each. During this time, 50 thematic healthcare funds held over $99 billion in AUM, with approximately 41% of investments ($40.5 billion) coming from retail investors*.

Here’s the rub. ETFs classified within a particular niche may not exclusively contain companies within that industry. 

Take, for example, the healthcare ETFs on U.S. exchanges. Some of them contain Walmart, Inc. and CVS Pharmacy, Inc., which you could argue are healthcare companies due to their pharmacies and primary care clinics; however, the majority of their revenue doesn’t come from direct patient care. 

There are other healthcare ETFs that include companies that own the land hospitals/clinics rest upon. In other words, they are real-estate companies that respond differently to market dynamics than actual healthcare companies. 

Investors need to understand these differences when managing their portfolio. 

In Summary

“ETFs will be the delivery system for investment management in the future”

Kip Meadows (CEO, Nottingham)

There are a plethora of investment options to choose from depending on the level of risk you’re willing to take. ETFs, especially thematic funds, are ushering in a unique take on diversifying your portfolio.

*Data analysis by Kirubel Asfaw.

Sanjana Vig, MD, MBA
Sanjana Vig MD, MBA
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