Exchange-traded funds are totally ubiquitous so this might come as a surprise: A substantial portion of financial advisors still don’t use them. More than one quarter, or 27%, did not invest any client money in ETFs in 2019. Their primary objection to ETFs was that clients were worried about the cost, according to Cerulli Associates, a Boston-based research and consulting firm.
“As more mutual fund assets went to institutional share classes, without the upfront sales charges of an A-share, and without a 12b-1 fee, this cost advantage for mutual funds had been a key selling point; advisors could purchase these products without incurring any upfront costs to clients. In the past, this represented a major advantage for advisors interacting with fee-conscious clients,” according to Cerulli.
One advisor told Cerulli: “We have $3 million clients, and make trades for them totaling tens of thousands of dollars, and they’ll complain about $150 in transaction fees.” For clients like that, it might be easier to simply buy an S&P 500 index mutual fund, rather than justify the commission on an S&P 500 ETF.
But circumstances have changed.
To be sure, investors have been increasingly favoring ETFs over mutual funds. ETF flows outpaced mutual fund flows last year, mutual fund managers have reduced fees, and it’s rumored even Dimensional Fund Advisors might begin offering ETFs. Only 11% of advisors make no allocations to mutual funds.
However, a new ripple from a splashy move last fall is upon the wealth management industry and could accelerate their adoption.
Schwab’s decision in October to eliminate commissions to trade stocks, ETFs, and options was a moment of upheaval in financial services. Interactive Brokers was the first big, legacy discount brokerage to eliminate commissions on the same securities. But Schwab stole the spotlight when it did the same the following week. In response, after some of their own stock prices plummeted, TD Ameritrade, E*Trade, and Fidelity Investments also eliminated commissions.
Along with self-directed investors, some clients and wealth management firms stood to save significant money if they no longer had to pay to trade stocks and ETFs.
After the flurry of price changes, deals followed. In November, Schwab agreed to acquire TD Ameritrade for $26 billion. In February, Morgan Stanley bought E*Trade for $12 billion.
Now, one of the lasting effects of the so-called race to zero will begin taking place.
“Zero-fee trading has quickly become the norm, impacting both direct investors and financial advisors who are increasingly using ETFs as the building blocks for client portfolios,” according to a Cerulli report published last week.
The adoption and use of ETFs and “advisors abandoning mutual funds” will only accelerate as a result, according to the researcher.
Over the next two years, financial advisors plan to increase allocations to ETFs from 15% of client portfolios in 2019 to 18% in 2021. Meanwhile, they plan to lower mutual fund allocations from 33% in 2019 to 29% by the end of next year, according to a 2019 survey of advisors by Cerulli.
Other forces at work are pushing advisors to ETFs, too. More advisor compensation is coming from asset management fees rather than commissions, decreasing the influence compensation might have on their security selection. Currently, 69% of compensation is asset-based and 25% comes from commissions. But during the next two years asset-based fee compensation is estimated to climb to 75% and commission-based is expected to lower to 17%, according to Cerulli.
Advisors also like the tax efficiency of ETFs, which can limit capital gains exposure. The report noted that 51% of advisors said tax planning is one of their key service offerings.