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Will ETFs ever surpass mutual funds as the investment vehicle of choice for individual investors?

Despite 30 years of amazing growth for ETFs, from zero assets in 1989 to US$5.5 trillion globally today, some industry observers have been disappointed.

ETFs’ value proposition is compelling: all the benefits of mutual funds at a fraction of their cost plus better transparency, tax efficiency and continuous intraday trading. If ETFs are so much better than mutual funds, why have they not yet replaced them?

They may still. Importantly, ETFs have just gone past the tipping point.

Adopting new ideas

Everett Rogers introduced the “diffusion of innovations” theory in 1962 while pondering why hybrid corn seed adoption took 13 years, despite the 20% yield improvement it offered. Rogers described the stages from introduction to acceptance: awareness, interest, evaluation, trial and adoption.

The same has been true for ETFs. Usually, product adoption begins with innovators, moves to early and late adopters, and then reaches the laggards.

Laggards are described by author Simon Sinek as those who purchase a touch-tone telephone only because they can’t buy a rotary phone anymore. Early adopters, on the other hand, evaluate new products and ideas, see benefits and take the risk to incorporate them into their lives.

A “tipping point” or critical mass occurs at 15% to 18% adoption. Once achieved, the early and late majority — comprising 68% of the population — will follow in short order. Bridging this critical 15% to 18% has been described as “crossing the chasm” by venture capitalist and author Geoffrey Moore.

In 2015, on the 25th anniversary of the first ETF, ETFs had only 11.8% of U.S. market share versus mutual funds. The industry wondered if ETFs would cross the chasm into broad acceptance or remain a subset of retail investing. Almost five years later, we may have an answer.

Charging across the chasm

By summer 2019, ETFs made up 16.5% of U.S. investment fund assets, up 0.5% from year-end 2018, passing the tipping point and accelerating through Moore’s chasm. Consider the following:

  • regulators in the U.S. and Canada are making ETF issuance easier;
  • passive investing increased from 18% of U.S. assets in 2008 to 36% in 2018;
  • ETF net sales in Canada exceeded those of mutual funds in 2018 (though ETFs made up less than 11% of Canadian investment fund assets as of Sept. 30, if holdings by Canadians of U.S. traded assets are not considered);
  • 13 of the 20 largest mutual fund companies in Canada now offer ETFs;
  • Canadian banks, which dominate mutual fund distribution, all sponsor ETFs now;
  • mutual fund dealers in Canada were approved to use ETFs in 2017;
  • the number of ETF sponsors in Canada has tripled from 12 to 36 since 2015;
  • increasingly popular robo-advisors use ETFs almost exclusively;
  • commissions to trade ETFs, a cost mutual funds don’t have, are being eliminated by leading U.S. discount brokers, while commissions on ETF purchases in Canada have been waived by some discount brokerage firms for years;
  • balanced funds, which account for more than half of Canadian mutual fund assets, must now compete with multi-asset ETFs that have much lower management expense ratios.

Changing compensation systems

Eliminating trailing commissions in the U.K. and Australia aligned advisor compensation with their clients’ interests by promoting fee-based relationships that promote ETF use. In Australia, ETF assets doubled in a year following the change.

A proposal by Canadian regulators to ban deferred sales charges and limit trailing commissions has stalled amid industry pressure and the Ontario government not supporting the reforms.

But compensation systems should reinforce advice — not compromise it. Investors and progressive advisors already realize that fee-based practices strengthen confidence in advice by unifying interests, and that ETFs are a preferred vehicle because of low costs and diversification.

Assault on the summit

The internet took 20 years to hit its tipping point because computer and web access costs slowed adoption. Advisor acceptance of ETFs is important, but not essential, in moving across the chasm for the assault on the summit.

Millennials, influenced by the internet and robo-advisors, recognize the importance of low fees in reaching their goals. Baby boomers, still controlling most of the wealth, will gravitate to low-cost options such as robos and ETFs to preserve capital and avoid running out of money.

Advisors prepared with comprehensive ETF solutions as the market accelerates through the tipping point will win big.

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.