ETF insights
February 27, 2023
The ETF turns 30 this year and upward of $6.5 trillion1 is now invested in U.S. ETFs. As with so much innovation in history, ETF innovation has manifested in waves, each wave bigger than the last and each preceded by a crisis.
The ETF structure seemed to emerge from each crisis better tested, and ready to play a bigger role in the world of advised clients, institutions, and self-directed clients. As of late 2021, about 40% of ETF assets were with advised clients, 39% with individual investors, and the remaining 21% with wealth managers and institutional investors.2
On its 30th birthday, the ETF is widely regarded as a low-cost, highly tradable vehicle that has survived and thrived in many different market environments. Even in last year’s tumultuous environment, with inflation at its highest since the launch of the first ETF and stocks and bonds falling sharply, many investors took the opportunity for a tax loss harvest and moved into ETFs.
And, while strong past inflows don’t guarantee strong future inflows, the benefits of ETFs―which include low costs, ease of access to asset classes, tradability, and potential tax favorability―have become evident to investors young and old.
Industry mutual fund and ETF assets and net cash flows, 2013−2022
Sources: Vanguard, based on Morningstar, Inc., data as of December 31, 2022.
The first U.S. ETF launched in January 1993 at the end of the post-1980s downturn. After that downturn, some institutions and regulators were keen on designing a security that could potentially weather volatility better than individual stocks.3 No one thought that in 30 years, ETFs might grow to represent 25% of the open-end fund universe, despite a 70-year head start for mutual funds.4
ETFs targeting the separate sectors in the Standard & Poor’s 500 Index followed in the late 1990s and then, after the bursting of the dot-com bubble in 2000, came fixed income ETFs, followed by a gold bullion ETF in 2004.
All these successful rollouts suggested that ETFs had reached parity with mutual funds in giving investors access to a variety of asset classes. But the ETF truly came of age in the wreckage of the subprime mortgage crisis of 2007–2009.
Investors and advisors, stung by two bear markets in less than a decade and frustrated that many active managers had underperformed all along, pivoted to an asset-management approach focused on low-cost ETFs.
The big stock and bond market sell-off in 2022 was, at the same time, the second-biggest year for new money coming into ETFs5, suggesting that investors increasingly recognize the benefits of ETFs.
As the chart above shows, ETFs are dominating fund inflows these days as easy access to a broad range of asset classes gains new investors. Registered investment advisors have led the movement among advisors into ETFs, as have institutional clients, while self-directed personal investors are showing signs of fueling future moves into ETFs.
The increase in active ETFs now hitting the market also suggests that a vehicle once thought to be for index strategies only may have considerably broader application.
Thirty years after ETFs were launched, their advantages have only become more clear.
The most obvious is costs: Given the structure of most ETFs, costs that were low to begin with have been falling as the assets in ETFs increase. By 2019, many of the large ETF trading platforms had moved to commission-free trading, which helped cement the idea that ETFs were becoming a low-cost option for investors.
As the chart below shows, ETF expense ratios have dropped industrywide over the last decade, from an average of about 0.28% to 0.18% at the end of 2020. This may not seem like a huge decline—but consider that the average asset-weighted mutual fund expense ratio was about 0.80% a decade ago and dropped to about 0.45% as of the end of 2020.6
Over the same 10-year period, the average expense ratio of Vanguard ETFs® dropped to 0.06% from about 0.14%. These data help explain why so many investors have opted into ETFs. Intraday trading of ETFs has added to their allure, as have their potential tax advantages.
Another measure of ETFs’ success is their rising trading volume on stock exchanges over the years.
According to Bloomberg, ETFs accounted for more than 30% of exchange volume in 2022.
This speaks to the organic rise of ETFs and their trading volume since their launch. And because ETFs trade on an exchange, that exchange volume can make determining prices of an ETF’s underlying constituents easier than on individual securities, notably for fixed income securities.
ETFs are lowering the cost of investing year by year
Note: Estimated asset-weighted expense ratios are per end of each calendar year and are derived using end-of-year ETF AUM and most recently published annual reports per year.
Sources: Vanguard calculations, based on expense ratio data from Morningstar, Inc., as of December 31, 2022.
In other words, trading an ETF can and does affect prices of underlying stocks or bonds enough to help determine the prices of those underlying securities, such as illiquid individual bonds. That can be significant when an investor is trading an ETF that has foreign holdings or even bond funds on second-tier holidays, such as Veterans Day, when bond markets are closed but stock markets where ETFs are listed remain open.
So it is that investors who approach trades carefully have been able to potentially get better and better trading executions as the ETF market has grown and matured.
ETFs have sometimes been compared to individual stocks because, unlike mutual funds, they trade all day on an exchange. Also, unlike mutual funds, most ETFs have options chains attached to them and investors can buy them on margin. These features add to the tradability of ETFs and highlight differences with mutual funds.
But the similarities with individual stocks are limited, and it’s crucial to grasp the distinctions, especially to fully appreciate how ETFs can trade so smoothly.
Rising average daily volume of Vanguard S&P 500 ETF (VOO)
Sources: Vanguard, based on FactSet data from January 1, 2012, through December 31, 2022.
As ETF trading volumes have ramped up over the years, bid-ask spreads that prevail on most ETFs have narrowed—even those that canvass relatively illiquid fixed income asset classes.
Crucially, bid-ask spreads on most Vanguard ETFs —the difference between what buyers are willing to pay and what sellers are offering—are narrower than the average bid-ask spreads on the individual underlying securities that make up that ETF.7 That fact is one big reason why ETFs have become attractive to more investors. Investment exposures—broad and narrow―can be just a click away.
A look at how volume-weighted trading spreads have narrowed over the years highlights the question of costs. Between falling expense ratios and narrowing bid-ask spreads, the total cost of ETF ownership has edged lower over time, increasing the appeal of ETFs.
For a more comprehensive examination of how ETF trading has come of age, see our deep dive on the history of ETF trading. The bottom line: For those who approach trades carefully, it really is getting easier to optimize trade executions and reduce investment costs.
It seems a fair bet that ETFs will continue on their trajectory of increased investor adoption and importance.
To be sure, mutual funds retain a secure place in the investment world. First, in the 401(k) market, mutual funds commanded $3.9 trillion in AUM at the end of 2021, or nearly 47% of all 401(k) assets, according to Cerulli.
Moreover, all the embedded capital gains taxation associated with exiting long-held positions in mutual funds will slow any transition to ETFs.
Such caveats aside, ETFs are where most of the new money is going these days and they have increasingly become a hot spot of innovation.
ETF model portfolios are one such area of innovation: Because of the flexibility of ETFs, they can be used as low-cost beta funds to generate alpha, and thus can be part of a viable portfolio-construction approach.
Also, active ETFs are garnering more interest. But while more than 34% of U.S.-listed ETFs are actively managed, less than 5% of overall assets are in active strategies.8
That said, active ETFs seem to be gaining investors, notably in the fixed income realm, where lower costs are crucial given the relatively modest but steady returns of fixed income. More broadly, active ETFs that maintain a transparent structure (rather than the newer varieties of nontransparent wrappers) have gained assets. This suggests that many of the players in the ETF ecosystem are taking a wait-and-see approach to the newer, less transparent structure.
What remains clear about ETFs is that they have proven themselves a useful and efficient way to invest. And while their popularity is still growing, ETFs already play a major role in helping investors reach their financial goals.
Vanguard offers 81 ETFs in the U.S. that are designed with the goal to give investors the best chance for investment success. When you invest with us, we invest with you. That’s the Value of Ownership.9
1 Morningstar, Inc., as of December 31, 2022.
2 Source: Financial Times reporting on Citigroup data, as of September 30, 2021.
3 SPY@20: ‘SPDR Woman’ Still Surprised, ETF.com, January 29, 2013.
4 That first U.S. ETF, SPDR S&P 500 ETF (SPY), launched on January 29, 1993. For the record, the world’s first ETF was listed in 1990 on the Toronto Stock Exchange, where it remains listed today. As of February 1996, SPY’s AUM was at $1.15 billion, according to Morningstar. According to Morningstar, AUM in SPY had shot up to $353 billion as of January 6, 2023, making it the biggest U.S.-listed ETF.
5 According to Morningstar, Inc., a total of $590 billion flowed into U.S.-listed ETFs in 2022, making it the second-biggest year of inflows.
6 Using Morningstar, Inc., data, all mutual fund and ETF expense ratios are calculated as asset-weighted averages, using all available share classes and their net assets as of each year-end, as of December 31, 2011, and December 31, 2020.
7 Vanguard, based on Bloomberg data as of December 31, 2022.
8 Vanguard, based on Morningstar, Inc., data, as of December 31, 2022.
9 Vanguard is investor-owned, meaning the fund shareholders own the funds, which in turn own Vanguard.
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