In recent years, asset managers have increasingly turned their attention to the exchange-traded fund (ETF) market, reshaping how traditional mutual fund strategies reach investors. This shift marks a significant evolution in the investment industry as managers aim to capture the growing popularity of ETFs while offering retail investors more efficient and flexible options.

The New Wave of Conversions

Money managers are employing several methods to integrate mutual fund strategies into ETFs. One of the most common approaches has been converting existing mutual funds directly into ETFs. Data from Morningstar shows that 56 mutual funds made the transition to ETFs in 2024, a dramatic rise from only 15 in 2021. So far this year, another 40 conversions have taken place, underscoring the momentum behind this trend.

Another emerging method involves creating an ETF “clone” of an existing mutual fund. This approach allows investors to select either the traditional mutual fund or the ETF version of a given strategy, depending on their tax situation and investment goals.

A third, and increasingly talked-about, development involves the introduction of ETF share classes within existing mutual fund portfolios. According to Bryan Armour, Morningstar’s director of ETF and passive strategies research for North America, more than 80 asset managers have requested permission from the Securities and Exchange Commission (SEC) to launch ETF share classes. Unlike full conversions, these ETFs would share the same portfolio as the mutual fund, operating as another share class within the same structure.

“This is one of the biggest trends in the fund market right now,” Armour said. “Over the next two years, we expect to see a large number of ETF share classes being widely adopted.”

The SEC gave its first approval for this model to Dimensional Fund Advisors on September 29. Armour noted that further approvals were likely delayed by the recent government shutdown but are expected to resume soon.

Why ETFs Are Winning Over Investors

Both mutual funds and ETFs provide diversified portfolios of stocks, bonds, and other assets, managed by professionals. However, investors have shown a clear and accelerating preference for ETFs. Morningstar reported that investors poured a record $1.1 trillion into U.S. ETFs in 2024, while withdrawing $388 billion from mutual funds during the same period.

Although ETFs currently represent about one-third of the total U.S. fund market, their growth trajectory has been remarkable. In 2004, ETFs held only about 5% of the market share compared to mutual funds; by 2014, that share had climbed to 14%. Today, they continue to gain ground rapidly.

One major reason for this shift is the structural advantages ETFs offer to retail investors. According to financial planner and tax manager Blake Pinyan of Anchor Bay Capital, ETFs are generally more tax-efficient than mutual funds. Their design minimizes the distribution of capital gains, sparing investors from unexpected tax liabilities. ETFs also tend to have lower expense ratios, which can make them more cost-effective over time.

Transparency is another significant advantage. ETF holdings must be disclosed daily, allowing investors to see exactly what assets they own. Mutual funds, by contrast, typically release their holdings only once a month or even quarterly. “ETFs have become so much more prominent in the market,” Armour explained. “At a high level, asset managers are simply responding to investor demand.”

ETFs vs. Mutual Funds: What Should Investors Choose?

When deciding between ETFs and mutual funds, tax considerations play a key role. For investors with taxable brokerage accounts, ETFs are often the smarter choice due to their tax efficiency. “Avoid mutual funds in taxable accounts,” said Pinyan, who also serves on CNBC’s Financial Advisor Council. “Holding a mutual fund in a taxable brokerage account can lead to significantly higher tax liabilities. They’re very tax-inefficient.”

However, ETFs are not always the better option in every situation. In tax-advantaged accounts such as IRAs or 401(k) plans, where taxes on capital gains are deferred, the ETF’s tax benefits are largely irrelevant. In those cases, investors may prioritize other factors such as performance, strategy, or management style.

Experts also caution investors to look closely at ETF “clones” of mutual funds. Not all ETFs are exact replicas of their mutual fund counterparts. As Morningstar analyst Gregg Wolper wrote, some are “identical twins,” sharing the same holdings and strategy, while others are more like “cousins,” with differences that could lead to varied outcomes. For investors, understanding whether an ETF mirrors or merely resembles its mutual fund version is crucial.

The Future of ETF Share Classes

If the SEC continues approving applications for ETF share classes within mutual fund structures, it could open a new chapter in fund management. However, analysts warn that such a development may also bring potential challenges. According to a recent Morningstar analysis, ETF investors in these hybrid structures might share certain tax exposures with mutual fund investors. In rare cases, actions taken by mutual fund shareholders—such as large redemptions—could trigger capital gains distributions that affect ETF holders as well.

While these scenarios are expected to be uncommon, they highlight the complexity of merging mutual fund and ETF structures. Still, the growing integration between the two signals a broader trend in the industry: the pursuit of efficiency, transparency, and accessibility for investors.

A Market in Transition

The ongoing evolution of the ETF landscape reflects a fundamental shift in how investors access and manage their portfolios. As traditional mutual funds adapt to meet modern investor expectations, the boundaries between fund types are becoming increasingly blurred. What remains clear is that ETFs have captured the imagination—and the capital—of a new generation of investors seeking smarter, leaner, and more transparent investment vehicles.

With regulatory changes on the horizon and more asset managers preparing to enter the ETF space, the coming years could see an unprecedented expansion of ETF offerings—reshaping not just portfolios, but the very structure of the investment industry itself.