What it means for investors

Market experts say asset managers are increasingly debuting mutual fund strategies as exchange-traded funds, a move that capitalizes on the popularity of ETFs in recent years and also benefits many individual investors.

Asset managers have taken several approaches.

Many convert certain mutual funds into ETFs. According to Morningstar data, 56 mutual funds were converted to ETFs in 2024, a steady increase from 15 in 2021. This year, 40 more people did so.

Some companies open ETF “clones” of specific mutual funds, allowing investors to choose between a mutual fund or ETF version of an investment strategy.

Additionally, more than 80 asset managers have asked the Securities and Exchange Commission for permission to launch ETF share classes for existing mutual fund portfolios, said Brian Armor, director of North American ETF and passive strategies research at Morningstar.

This is a slightly different strategy than the others. Mutual funds are typically available in a variety of share classes. In this case, the ETF becomes a separate share class and shares the same portfolio as mutual fund investors.

“This is one of the biggest trends in the fund market right now,” Armer said. “We expect a number of ETF stock classes to see heavy use over the next two years.”

The SEC gave the green light to Dimensional Fund Advisors’ first application on September 29th.

“We’re kind of waiting for the next shoe to come out, and my guess is that would have been the case had there not been a government shutdown,” Armor said in reference to the SEC’s approval of more filings.

ETFs and mutual funds are largely similar. ETFs are relatively liquid baskets of stocks, bonds, and other assets overseen by professional asset managers that help investors diversify their portfolios.

Investors have shown a strong preference for ETFs in recent years.

Investors poured about $1.1 trillion into U.S. ETFs in 2024, a record high, according to Morningstar. Meanwhile, investors withdrew $388 billion from U.S. mutual funds.

ETF assets still account for only about one-third of the total U.S. fund market, but their status is increasing. For example, ETFs had a 14% market share versus mutual funds at the end of 2014, compared to 5% in 2004, according to Morningstar.

The main reason for their popularity is due to important differences that many financial advisors argue make ETFs generally a better financial option for individual investors.

Exchange-traded funds are generally tax efficient, allowing investors to avoid unexpected annual tax bills on capital gain distributions, and tend to have lower annual fees than mutual funds, says certified financial planner Blake Pignan, senior financial planner and tax manager at Anchor Bay Capital in Carlsbad, California.

Armor said there is also increased transparency in ETF holdings for investors. Asset managers are required to disclose their ETF holdings on a daily basis, while mutual funds typically do so on a monthly or quarterly basis.

“ETFs have become very prominent in the market,” Armor said. “Bigger picture, asset managers are looking to take advantage of demand,” he added.

Pinyan said investors with taxable brokerage accounts should generally aim to hold ETFs in such accounts for tax efficiency considerations.

“Avoid mutual funds in taxable accounts,” said Pignan, a member of CNBC’s Financial Advisory Council. “Holding mutual funds in a taxable brokerage account can result in investors paying more taxes. It’s very tax-inefficient.”

However, experts point out that exchange-traded funds are not necessarily better in all situations.

For example, experts say the tax benefits of ETFs are meaningless for tax-advantaged accounts such as IRAs or 401(k) plans.

Additionally, investors should pay attention to whether ETF “clones” of actively managed mutual fund strategies are “identical twins” or “cousins,” writes Greg Wolper, senior manager research analyst for equity strategies at Morningstar Research Services.

In other words, “cousin” ETF portfolios may be similar to mutual funds from the same manager, but they are not identical and may not be suitable for all investors, depending on their preferences, he writes.

There could be potential downsides for some ETF investors if the SEC approves further applications by asset managers to launch mutual funds with ETF stocks, according to a Morningstar analysis published in October. The idea is to share the tax burden with mutual fund shareholders.

This could reduce some of the relative tax benefits for ETF investors, but this would be rare, the report said.

“In certain circumstances, often caused by the actions of investors in mutual funds, investors in ETF share classes may be at risk of capital gain distributions,” the report said.