Mutual funds are no longer the go-to investment for financial advisors. Their new favorite? Exchange-traded funds (ETFs).
A recent survey shows that, for the first time, advisors are embracing ETFs more than any other investment option, including traditional mutual funds.
"I think [ETF popularity] speaks overall to what investors want," said Valerie Chaillé, a certified financial planner and director of practice management for the Financial Planning Association (FPA). "They like low cost, transparency and liquidity."
Chaillé also said the stock market environment might play a role in the appeal of ETFs.
"When the market is performing well overall—which it has been—passive management is more popular than active management," she said.
The 2015 Trends in Investing Survey, conducted by the FPA Research and Practice Institute and the Journal of Financial Planning, shows that 81 percent of advisors use or recommend ETFs, compared with 78 percent for mutual funds.
In 2006, according to the FPA survey, 40 percent of advisors used ETFs. By 2014 that had grown to 79 percent, which was just a tad behind mutual funds, at 82 percent.
Additionally, the survey shows that 51 percent of advisors plan to increase their use or recommendation of ETFs over the next year, compared with 20 percent for mutual funds.
ETFs can be traded throughout the day, like stocks. Most are passively managed, meaning that the investing portfolio tracks an index.
In contrast, mutual funds can only be bought or sold once daily, and many of the largest mutual fund companies remain focused on actively managed portfolios where performance depends on the stock-picking skills of portfolio managers.
The expense ratios of index ETFs are typically lower than those of actively managed mutual funds, though that is also the case with traditional index mutual funds.
ETFs do offer tax benefits over all traditional mutual funds.
"We use ETFs because there is a tax advantage for our clients," said Avani Ramnani, a CFP and director of financial planning and investment management for Francis Financial. "Mutual funds [commonly] pass on capital gains to investors, and there can be lots of complexities to that."
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Those capital gains can be unpredictable, which makes tax planning tricky for investors who have assets in a taxable mutual fund. Capital gains with ETFs are less likely, simply because of their makeup and how they are traded.
Nevertheless, Ramnani said her firm uses actively managed mutual funds for bonds and international investments, because both asset classes benefit from management expertise regardless of what the market is doing.
"In general, when the equity market is going up, [actively managed] mutual funds tend not to do as well compared to indexes," Ramnani said. "But when things aren't going as well, actively managed funds might do better."
According to investment research firm Morningstar, ETFs hold an estimated $2.1 trillion of investor assets. While mutual funds are far ahead with $12.6 trillion, ETFs are experiencing a faster rate of growth. In 2014. For instance, assets in ETFs grew at a 14.2 percent clip. That compares with growth in mutual funds of just over 2 percent.
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But mutual funds are more mature: The first one, launched before the Great Depression, started in 1929. In 1940, there were 68 mutual funds. Today there are more than 10,000, including funds that invest in other mutual funds.
By comparison, the first ETF was launched in 1993. Now more than 1,400 ETFs are on the market.
I wouldn't be surprised if in 10 years, virtually all mutual funds become traded in some form of how ETFs are traded.Ben Tobiaspresident of Tobias Financial Advisors
"When advisors do due diligence on funds, whether for an ETF or [traditional] mutual fund, they need to understand how both work and then make a decision," said Ben Tobias, a CFP and president of Tobias Financial Advisors.
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The survey also shows that the use of so-called smart-beta ETFs remains low. Roughly 22 percent of advisors use smart-beta ETFs for client portfolios. In simple terms, smart-beta ETFs combine passive investing (tracking an index) with active management (changing the weightings of the index's individual holdings to hopefully maximize returns).
Regardless of the growth of ETFs, advisors doubt actively managed mutual funds will go by the wayside. However, it's possible that ETFs are a harbinger of what's to come.
"I wouldn't be surprised if in 10 years, virtually all mutual funds become traded in some form of how ETFs are traded," Tobias said.
—By Sarah O'Brien, special to CNBC.com
