ETFs could seize half of current US mutual fund assets, says Citi

The rapidly growing exchange traded funds industry could seize half of the money currently held by long-term US mutual funds in the coming decade, according to estimates by Citi.

US investors have gradually been switching from mutual funds to ETFs for at least the past decade, attracted by lower costs, better liquidity and greater tax efficiency. Mutual funds, excluding money market funds, have seen net outflows in nine of the past 10 years in the US, according to data from the Investment Company Institute, even as ETFs have seen constant inflows.

Despite this, however, the mutual fund industry remains far larger, with $19.6tn in long-term funds at the end of 2023, according to the ICI, dwarfing the $8.1tn in US-listed ETFs.  

This could reverse in the coming decade, though, according to Citi, which believes $6tn to $10tn of the remaining money in long-term mutual funds is at risk of capture by ETFs.

“The US asset management industry is clearly in an ongoing paradigm shift,” said Scott Chronert, global head of ETF research at Citi. “The flow trends speak for themselves.

“All told, we project that an additional $6tn to $10tn in mutual fund AUM is at potential risk of ETF replacement or cannibalisation,” he added.

Most vulnerable to predation are mutual funds held outside of tax-exempt retirement accounts, which are unable to compete with the ability of many ETFs to defer capital gains tax liabilities that accumulate within a fund.

Citi estimates that between half and all of the $2.4tn currently held by retail investors in non tax-exempt mutual funds is a potential target for replacement by ETFs.

In addition, between a quarter and a half of the $4.1tn of equivalent money held by institutional investors, and up to a fifth of the $1.3tn non-taxable variable annuity market is also up for grabs.

Chronert pointed to the rising use of model portfolios, which are typically built using ETFs, as a key factor driving this trend.

The $11.9tn worth of mutual funds held within tax-exempt retirement structures, such as 401k defined contribution schemes and individual retirement accounts, are likely to prove stickier, as ETFs do not have any tax advantage here.

Nevertheless, Citi argued that there were a number of trends in place that would allow ETFs to chip away at mutual funds’ dominance in this arena.

Firstly, IRAs are accounting for a rising share of US retirement assets, having risen from below 20 per cent in 1995 to around 35 per cent now.

This is relevant because while “historically, ETFs have not had a place on the 401k menu”, IRAs “are typically much more open architecture in nature than a set menu of funds” meaning that ETFs “certainly have a large, and growing, opportunity here”, Chronert said.

Mutual funds’ share of IRA assets has already fallen by about 10 percentage points to 40-45 per cent since 2005, Citi found.  

Secondly, even within 401ks, more schemes are now offering a self-directed brokerage option, allowing savers to access a much wider range of investments. ETFs now account for 23 per cent of self-directed assets, up from 12 per cent a decade ago.

Other opportunities abound. The vast majority of 401k savers aged under 35 simply invest in a target-date fund, designed to adopt a level of risk appropriate for their age. Research by FactSet suggests many of these target-date funds in turn use ETFs to manage this glide path.

Finally, Citi believes demographics will play a part as younger generations — which exhibit clearer preferences for ETFs — build assets.   

Tying this together, Citi estimates that 50-60 per cent of the $7.4tn held by retail investors in retirement accounts could be seized by ETFs, along with a small slice of the $4.5tn of institutional and variable annuity rate money.

Combined with its estimates for non tax-exempt investments, this would mean $6.3tn to $10tn of the $19.6tn currently held by US-domiciled mutual funds is a potential target for ETFs.

Others saw things a little differently, though.

Bryan Armour, director of passive strategies research, North America at Morningstar, noted that during 2022 and 2023 “something like $1.6tn flowed out of mutual funds and a big chunk of that went to ETFs”, adding “I don’t know that there’s a natural point where [that flow] stops”.

However, Armour believed mutual funds had some advantages over ETFs, such as the ability to close to new investors if a fund gets too large. He also saw use cases for assets such as private credit, which mutual funds can hold but ETFs cannot.

“The 800lb gorilla in the room,” Armour said, is the chance that the Securities and Exchange Commission could approve the many applications by asset managers to copy the “ETF as a share class” structure that has helped propel Vanguard’s rapid expansion, the patent for which has now expired.

Gaining approval would potentially render the relevant pre-existing mutual funds more tax efficient, softening the pressure for investors to flee to an ETF.

However, when it comes to retirement plans, Armour believed mutual funds are “more under attack from collective investment trusts than they are from ETFs”.

CITs, which account for 38 per cent of 401k assets, according to the ICI and BrightScope, “are cheaper to run [than mutual funds] and they can have variable fees [meaning] they can negotiate fees lower for bigger plans”, Armour said.

Research house Cerulli Associates agreed with Armour on this, arguing that the growing adoption of CITs in the DC market “has raised questions about whether mutual funds are heading towards obsolescence.

“CITs have gained market share and are overtaking mutual funds in 401ks,” said Adam Barnett, senior analyst at Cerulli. “CITs, on aggregate, have far lower management fees than mutual funds of a similar composition.”