Will ETFs Continue Their Surge in 2022?

Exchange traded funds (ETFs) are expected to continue their surge in 2022 following their massive growth last year. Statistics reveal that in 2021, ETFs have taken in over $1 trillion in global inflows through November 2021, pushing total global ETF assets under management over $9.5 trillion.¹

Since ETFs were first introduced in 1993, they have always been viewed as the little sister to the mutual fund industry, and seemed to live in the shadow of their older and bigger sibling. ETFs may still be dwarfed by the number of mutual funds and their assets under management (AUM), but ETFs have significantly closed the gap over the past decade and continue to gain in popularity. At the end of 2010, there were 950 ETFs offered by U.S. financial service companies; by the end of 2020 there were 2,296, an increase of 142%. During the same timeframe, the number of mutual funds increased by just shy of 6% (8,523 in 2010 versus 9,027 in 2020),² and while mutual fund net assets roughly doubled in size over that same timespan, ETF net assets grew an astounding 449%.³

ETFs Overview

For those who may not be familiar with ETFs, let’s explore the characteristics of an ETF and how they operate.

Similar to mutual funds, ETFs are pooled investment vehicles that invest primarily in liquid securities. ETFs are organized as open-end management investment companies registered with and regulated by the SEC under the Investment Company Act of 1940 (40 Act).⁴ Under the 40 Act, both mutual funds and ETFs are subject to the same requirements such as:

• Leverage limitations;
• Daily valuation;
• Liquidity requirements;
• Prohibitions on affiliate transactions; and
• Having their advisor be a registered investment advisor (RIA).

Both vehicles also typically elect to be treated as Regulated Investment Companies (RICs) for tax purposes under Subchapter M of the Internal Revenue Code.

Unique Features of ETFs

The key area where mutual funds and ETFs differ is in how shares of the funds are transacted with retail investors. Mutual fund shares are bought and sold at the net asset value (NAV) per share computed at the end of a trading day through a variety of different distribution channels or directly with the fund. ETF shares are listed on national security exchanges and trade throughout the day at the market price versus the NAV of the ETF. Retail investors would buy and sell shares of an ETF through a broker-dealer in the same fashion they would purchase or sell any other stock.

One other unique feature of an ETF is the use of authorized participants (APs). An AP must be a licensed broker-dealer and have the ability to clear securities with the Depository Trust & Clearing Corporation (DTCC). Typically, large financial institutions fill this role and enter into agreements with the ETFs to act as APs. Only APs have the ability to purchase blocks of shares (typically 25,000 at a minimum) known as “creation units” directly from an ETF. APs will typically deliver a basket of securities similar to the securities held by the ETF in exchange for shares of the ETF. When an AP redeems shares from an ETF, the ETF delivers a basket of securities to the AP in exchange for the ETF shares being redeemed. Cash purchases and redemptions are possible but in-kind exchanges are preferable as that transaction assists with the ETF not having to incur the costs of executing buys or sells of the underlying securities, as well as the tax advantages described below. The DTCC helps ensure that both the ETF and the AP deliver the promised shares in a transaction.

This distinctive feature allows ETFs to be very tax-efficient products for their shareholders. In general, corporations making distributions of appreciated property are required to recognize gains as if such property were sold. However, ETFs electing to be taxed as RICs are exempt from recognizing any unrealized gains on securities redeemed in-kind per IRC Sec. 852(b)(6). Since ETFs have the option of tax-free in-kind redemptions versus recognizing gains upon the sale of appreciated securities, the ETF limits the amount of taxable capital gain distributions passed through to its shareholders.

Having the ETF shares available on a national exchange gives investors the flexibility to trade shares intraday at market value. It also allows smaller investors the ability to purchase smaller quantities of ETFs as opposed to some mutual funds, which have certain minimum investment amounts.

In the early years of ETFs, most were formed to track particular indexes. Since the portfolio turnover is relatively low on index-based funds, this resulted in lower trading costs to the ETF, helping to keep the fund’s expense ratio on the lower side. In more recent years, there has been an increase in actively managed ETFs, where the advisor has discretion over the trading activity based upon its investment objective, similar to mutual funds. At the end of 2020 there were 467 actively managed ETFs.⁵ According to the New York Stock Exchange (NYSE), there were 207 actively managed ETFs launched through September 30, 2021 with $276 billion in AUM so the trend toward actively managed ETFs is still going strong.

The ETF Rule

One hindrance that ETFs faced for years was the requirement for each individual ETF to obtain exemptive relief from certain provisions of the 40 Act from the SEC prior to launching. In September 2019, the SEC adopted the “ETF Rule” (Rule 6c-11 under the 40 Act), which allows ETFs that meet certain conditions (e.g., daily disclosure of portfolio holdings, disclosure on its website regarding premium, discount and bid-ask spread information, as well as written policies and procedures regarding basket construction and the process of accepting baskets) to begin operations without first obtaining the specific 40 Act exemptive relief previously required.⁶ The adoption of the ETF Rule facilitates ETF sponsors in getting their products to market much more quickly and without the added expense of filing for exemptive relief from the SEC. The adoption of Rule 6c-11 is undoubtedly a driving factor in the approximately 23% increase in ETFs from the end of 2019 through the 3rd quarter of 2021.⁷

Non-Transparent and Semi-Transparent ETFs

Beginning in 2019, the SEC began granting exemptive relief to certain ETF sponsors seeking to launch ETFs which only report their portfolio holdings on a quarterly or monthly basis instead of daily. These are known as non-transparent and semi-transparent ETFs. Still in their infancy, through April of 2021 there were only 25 of these types of funds in existence with assets of approximately $1.5 billion.⁸ Because of the less frequent transparency of their portfolio holdings, they cannot take advantage of the “ETF Rule” so it remains to be seen how many ETF sponsors will incur the additional cost and wait time or if there is a substantial market for less transparent funds.

What Does the Future Hold?

A comparison of the net cash flows between ETFs and mutual funds over the last several years would seem to indicate that ETFs are currently the vehicles of choice for most investors in non-retirement accounts. This is most likely due to a combination of the key factors discussed earlier, lower expense ratios, intra-day trading availability, lower tax exposure, etc. Only time will tell but the SEC’s adoption of the ETF Rule might have been the last key piece on making ETFs the slightly more optimal vehicle for both advisors and investors.

¹Wall Street Journal “Annual ETF inflows top $1 trillion for first time” December 13, 2021
²2021 Investment Company Fact Book
³2021 Investment Company Fact Book
⁴There are a small % of ETFs which invest in other assets, such as physical commodities or commodity futures, which are not registered under the 40 Act. These funds are not addressed in this discussion.
⁵2021 Investment Company Fact Book
⁶Exchange-Traded Funds, Inv. Co. Act Rel. No. IC-33646 (Sept. 25, 2019)
⁷Percentage increase derived from the 2,683 ETFs as of 9/30/21 reported by the NYSE and the 2,176 funds as of 12/31/19 reported in the 2021 Investment Company Fact Book
⁸Semi-Transparent ETFs: Nascent Product Opportunity for Managers, August 2021, UMB Fund Services

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