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Millennials prefer ETFs, and it's all about cost

60 percent of millennials say ETFs will be their primary investment in the future. For baby boomers it's just 19 percent.

Millennials working
Ariel Skelley | Getty Images

Millennials and exchange-traded funds have grown up together.

Investors plunked down $66 billion in U.S. ETFs in 2000, according to the Investment Company Institute. Now U.S. ETFs hold more than $2.2 trillion in assets.

The rise of ETFs has coincided with millennials, people age 18 to 35, becoming investors.

"Millennials are more amped up about ETFs than any other generation," said Heather Fischer, Charles Schwab's vice president of ETF platform management.

She based her assertion on data from Schwab's 2016 ETF Investor Survey, released at the Morningstar ETF conference last week in Chicago. Schwab is the fifth-largest ETF provider in the United States, with $52 billion in ETF assets, according to ETF.com, and has been an intense fee war in recent years with other big ETF companies, including BlackRock's iShares ($929 billion), State Street Global Advisors ($461 billion) and index fund giant Vanguard Group ($579 billion).

Individual investor adoption of ETFs continues to steadily rise among millennials, Generation X and baby boomers, according to the Schwab survey, which polled more than 1,000 investors between the ages of 25 and 75 with at least $25,000 in investable assets. But the biggest move to ETFs has been among millennials.

Investors now allocate 22.5 percent of their total portfolios to the ETFs, compared to 16 percent in 2012. Among millennials, the average ETF allocation is 35.8 percent.

Three out of four investors surveyed by Schwab said that ETFs have had a positive impact on the way they invest their money. Among millennials, 86 percent said ETFs have a positive impact on the way they invest.

In the past year, 44 percent of investors said they've raised investments in ETFs and 10 percent of those investors said those increases were substantial. Meanwhile, 63 percent of millennials boosted their ETFs investments and 21 percent made ETF purchases they deemed as substantial.

In the year ahead, 43 percent of all investors say they plan to increase their investments in ETFs. For millennials, 66 percent expect to boost their exposure to ETFs.

Sixty percent of millennials said they expect ETFs will be the primary investment vehicle for their portfolio in the future. Only 38 percent of Gen Xers and 19 percent of baby boomers said the same thing.

Why the millennial attraction to ETFs? Lower costs than traditional mutual funds seem to be the top reason.

"Newer investors are more sensitive to cost," said Andrew Chanin, CEO of PureFunds, which sponsors eight thematic ETFs.

Feeling the fee pressure

Driven by the success of — and pressure from — ETFs and traditional index mutual funds, the average expense ratio of mutual funds hit a two-decade low at the end of 2015, at 68 basis points (0.68 percent of assets), according to the Investment Company Institute. The average expense ratio of an actively managed equity fund was 108 basis points in 1996. While active managers have reduced fees for six straight years, the average expense ratio of an indexed equity fund is now 11 basis points. Schwab, iShares and Vanguard all offer total U.S. stock market ETFs at expense ratios ranging from three to five basis points (0.03–0.05 percent).

In the Schwab survey, a lower total operating expense ratio was the most important reason to choose an ETF for investors across all generations — ETF experts advise investors to not only look at the management fee but other costs that go into the expense ratio, including trading costs.

"Investors are choosing low-cost funds period, whether they are mutual funds or ETFs," said Ben Johnson, global director of ETF Research at Morningstar. "Over the past decade, 95 percent of all flows have gone into funds in the lowest-cost quintile."

Morningstar research has shown that expense ratio is so important, it is the best predictor of mutual fund success. According to new data from S&P Dow Jones Indices, more than 90 percent of active U.S. equity fund managers lagged their benchmarks over the past five-year period through the end of June.

Vanguard Group founder Jack Bogle published a 2014 research paper showing that an investor age 30 who is saving for retirement could over four decades see an increase in index fund portfolio value that is 65 percent greater than for an actively managed fund portfolio. "These numbers may be scary and almost unbelievable, but the data do not lie," Bogle wrote.