Key Questions: Active ETFs or Mutual Funds: Which Belongs in Your Portfolio?

Exchange-Traded Funds (ETFs) have experienced explosive growth in recent years, as investors increasingly favor their tax efficiency, transparency, real-time pricing, and lower costs relative to mutual funds. Goldman Sachs Asset Management reports that U.S.-listed ETFs have attracted over $3 trillion in net inflows since 2021, with the market size quadrupling over the past decade to over $12 trillion.

Originally designed as passive, low-cost investment vehicles, ETFs have evolved significantly. Asset managers are now launching actively managed ETFs across new asset classes and even within categories where they already offer mutual funds, such as traditional large-cap equities or bond funds. The widespread adoption by retail and institutional investors signals a broader shift in capital allocation — from traditional 1940 Act mutual fund structures toward ETFs. This raises an important question: Is there room for active ETFs and mutual funds in the future investment landscape?

ETFs and their Evolution

An ETF is an investment vehicle that pools money from investors to buy a diversified portfolio of assets (such as stocks, bonds, or commodities) and trades on stock exchanges like a single security. ETFs have been structured to track the performance of a specific index, sector, or strategy. More recently, ETFs have expanded, and many are now actively managed with the objective to outperform a stated benchmark.

ETFs allow investors to buy and sell shares at market prices throughout the trading day, similar to individual stocks. This intraday liquidity is made possible through a creation and redemption mechanism involving authorized participants, which also helps maintain the ETF’s price close to its net asset value (NAV).

The first ETF was launched on the Toronto Stock Exchange in 1990, and the U.S. market followed shortly after with the introduction of the SPDR S&P 500 ETF (SPY) by State Street Global Advisors — the largest ETF today. While other firms began launching ETFs in the years that followed, they initially gained little traction among retail and institutional investors during the 1990s and early 2000s. Over time, however, the ETF landscape began to evolve beyond simple index-tracking products. More specialized offerings, such as leveraged and inverse ETFs (strategies we don’t condone), challenged the original blueprint and introduced new ways for investors to access niche strategies and market exposures.

The first actively managed ETF, Bear Stearns’ Current Yield ETF, launched in 2008. Since then, active ETFs have steadily gained traction, accumulating a growing share of total ETF assets. Today, the ETF landscape has evolved significantly — with active ETFs now outnumbering passive ones. U.S.-listed ETFs hold over $12 trillion in assets, and a notable portion of new flows is going into actively managed strategies.

This trend reflects investors’ increasing preference for flexible, cost-effective access to professional management and diversified portfolios. Beyond benefits such as lower costs, real-time pricing, and transparency, active ETFs also avoid the capacity constraints typical of mutual funds. ETFs use a creation and redemption process where large investors, called authorized participants, trade baskets of securities for ETF shares, helping keep the ETF’s price close to its actual value. Their creation/redemption mechanism enables hypothetically unlimited capacity, as authorized participants adjust share supply based on market demand. 

ETFs vs. Mutual Funds: Why Capacity Matters

Mutual funds have the flexibility to manage capacity by implementing soft closures — allowing existing investors to continue adding capital — or hard closures, which block all new investments. Fund managers monitor capacity closely, especially in concentrated strategies targeting niche or less liquid markets, where large positions can influence pricing and move markets.

Unlike traditional funds, ETFs benefit from an open-end structure that allows for theoretically unlimited inflows, offering significant scalability. While this flexibility can be advantageous, it also introduces potential risks — particularly in less liquid or more concentrated markets. When large ETFs allocate capital to areas like frontier markets or small/micro-cap stocks, heavy inflows can disrupt pricing, crowd trades, widen bid-ask spreads, and dilute investor returns. Additionally, ETFs with lower trading volumes may experience wider gaps between bid and ask prices, making them more expensive to trade. During periods of market stress, this can lead to unfavorable execution prices and reduced liquidity for investors looking to exit positions.

Tax Efficiency Differences

ETFs are generally more tax efficient than mutual funds, largely due to their unique structure. The key advantage lies in the in-kind creation and redemption process, which allows ETFs to exchange securities with authorized participants without triggering capital gains. This mechanism helps ETFs avoid realizing gains when investors buy or sell shares, resulting in fewer taxable distributions. Additionally, because ETFs trade on exchanges, individual investor transactions don’t affect the fund’s tax position, further reducing the likelihood of capital gains passed on to shareholders.

Mutual funds, however, are more likely to generate taxable events. When investors redeem shares, the fund may need to sell securities to raise cash, potentially realizing capital gains that are distributed to all shareholders. This can lead to unexpected tax liabilities, especially in actively managed mutual funds with high turnover or concentrated positions. While mutual fund managers can use strategies like tax-loss harvesting to mitigate some impact, these funds lack the structural advantages ETFs offer, making mutual funds generally less tax efficient for investors.

Should Investors Abandon Mutual Funds?

The simple answer is, “No. Or at least, not now.” Mutual funds continue to play an important role depending on the investor’s needs and circumstances. While the industry is clearly shifting — asset managers are launching more ETFs than mutual funds — the transition is still in its early stages. Like any new product, widespread adoption takes time, and there are still some structural and operational hurdles to overcome. One of the biggest headwinds slowing ETF market share growth is their limited integration into retirement plans.

Retirement plans, particularly 401(k)s and other employer-sponsored accounts, remain a cornerstone of the mutual fund industry. These plans are deeply embedded with mutual fund infrastructure, and recordkeeping platforms have long-standing systems and relationships built around mutual fund trading, compliance, and reporting. ETFs, despite their growing popularity, face challenges in these environments because of their intraday trading, brokerage requirements, and lack of fractional share support.

Most retirement platforms are built around mutual fund infrastructure, which does not support intraday trading or brokerage-based transactions. Additionally, while fractional ETF shares are becoming more common, many retirement systems still lack the capability to process them efficiently, limiting seamless integration. Until those issues are resolved, mutual funds will continue to dominate retirement accounts, maintaining their relevance in the broader investment landscape.

Conclusion

The rise of active ETFs marks a pivotal moment in the evolution of investment vehicles, offering investors a compelling blend of tax efficiency, transparency, real-time pricing, and lower costs. While mutual funds remain deeply embedded in key areas such as retirement planning — where their infrastructure and operational familiarity continue to provide value — the growing momentum behind active ETFs suggests a shift in investor preferences.

Rather than viewing active ETFs and mutual funds as mutually exclusive, investors should consider them complementary tools — each with distinct strengths suited to different goals and contexts. As the industry continues to progress, we are preparing for a future where active ETFs play a central role in portfolio construction, driven by their alignment with current investor needs, tax efficiency, and long-term investment objectives. 

For more information, please contact your advisor.