Buying on the FACTS: Investors choices between ETFs and mutual funds

Buying on the FACTS: Investors choices between ETFs and mutual funds Vanguard research June 213 Executive summary. Over the past decade, exchange-traded funds have generated significant attention and gathered assets at a more rapid pace than similar investment offerings. Why are ETFs gaining such traction? To address this question, we analyze the purchase decisions of a set of selfdirected investors who, for a new investment purchase, could have chosen either an ETF or a mutual fund to achieve the same exposure. Our analysis finds that the decision to buy the ETF share class is largely driven by a set of factors we have dubbed the FACTS : familiarity, access, costs, trading flexibility, and stocks. Authors Joel M. Dickson, Ph.D. Stephen M. Weber, CFP David T. Kwon John Ameriks, Ph.D. Foremost among them is familiarity: Investors who have purchased ETFs before are much more likely to do so again the next time they face a decision between a mutual fund and an ETF. Access is also a key determinant, as investors must have a brokerage account to buy an ETF, and the lack of one appears to be a significant barrier to entry to ETF Note: The authors thank Chris Vaul of Vanguard s Client Insight team for his immense help in gathering the client transaction data. Connect with Vanguard > vanguard.com

adoption. Costs also play an important role, as investors are more likely to choose an ETF over a mutual fund if no commission is charged, if the mutual fund has a purchase fee, or if the ETF offers a lower expense ratio. Furthermore, active traders as well as equity investors are more inclined to choose ETFs. Taken as a whole, this framework can be useful for understanding the growth of ETFs among retail investors and suggests that such growth may continue as ETF adoption begets ETF adoption. Assets in exchange-traded funds (ETFs) have been growing considerably over the past decade, at a pace faster than mutual funds. In prior research (Ameriks et al., 212), we analyzed the behavior of investors after they purchased an ETF or a mutual fund. Here, we examine the considerations that investors weigh before deciding to purchase one vehicle over the other. 1 Our analysis shows that investors who have brokerage access and have made prior ETF purchases are much more likely to choose ETFs. Low costs, trading features, and asset class considerations also influence the decision. We have dubbed these considerations the FACTS familiarity, access, costs, trading flexibility, and stocks and it is clear that investors consider the FACTS when they make their investment choices. The growth of ETFs Although traditional mutual funds remain the dominant form of pooled investing in the United States, ETFs have grown rapidly and become the investment of choice for many investors. As shown in Figure 1, assets in U.S.-listed ETFs grew from $12 billion in 22 to $1.3 trillion in 212 an impressive compound annual growth rate of roughly 3%. 2 During this period, ETF assets grew as a percentage of total U.S. fund assets from 3% to 13%. 3 ETFs rapid growth relative to traditional funds is somewhat surprising considering the similarities between the two products. Although introduced roughly 7 years after the first mutual fund was created in 1924, ETFs serve much the same purpose: to give investors exposure to a diversified portfolio of assets. As pooled investment vehicles, Notes on risk: All investing is subject to risk, including the possible loss of the money you invest. Vanguard ETFs are a share class of Vanguard fund portfolios. Vanguard ETF Shares are not redeemable with the issuing fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling. Trading limits, fund expenses, and minimum investments may apply. See the Vanguard Brokerage Services Commission and Fee Schedules on vanguard.com for full details. 1 In some cases, we examined subsequent trading behavior to act as a proxy for unobservable prior trading inclinations. 2 This compares with roughly 12% annual growth for traditional mutual funds. As of December 31, 212, U.S. mutual funds (excluding money market funds) held $9.3 trillion in assets, according to Morningstar, Inc. 3 Fund assets include ETFs and mutual funds. Although some ETF growth may be attributable to increasing use by institutional investors, roughly half of ETF assets are held by retail investors (Lan et al., 212); this suggests that individuals are increasingly buying ETFs. Nonetheless, ETF penetration rates among U.S. households remain modest; only about 3% own an ETF, compared with 44% that own traditional mutual funds (Investment Company Institute, 213). Among the roughly 53.8 million U.S. households that owned mutual funds in 212, 6% also owned ETFs. 2

Figure 1. U.S.-listed ETFs have grown rapidly over the past decade, 22 212 ETF assets (in billions) $1,4 1,2 1, 8 6 4 2 22 23 24 25 26 27 28 29 21 211 212 14% 12 1 8 6 4 2 ETF assets as percentage of total fund assets (ETFs and mutual funds) ETF assets ETF assets as percentage of total fund assets Notes: As of December 31, 212. Data include exchange-traded notes and other legal structures. Source: Morningstar, Inc. ETFs and mutual funds gather money from many investors and use it to acquire stocks, bonds, or other assets. Therefore, investors can use both ETFs and mutual funds to gain access to a particular investment exposure whether broad market or niche, large-capitalization or small-cap, value or growth, U.S. Treasuries or corporate bonds. Although ETFs and mutual funds perform essentially the same investment function, the growth rate of ETFs has outstripped that of mutual funds over the past decade. What explains their rapid growth? ETFs offer distinctive features such as greater trading flexibility and possibly lower costs than mutual funds, and many believe that these factors, along with others, have contributed to ETFs widespread success. Our research aimed to shed light on this question by examining the factors that influence investors decisions to purchase an ETF or a mutual fund when given the choice between the two. Insights drawn from this study may give us a better idea of how sustainable the growth of ETFs is. The data Our data set comprised 554,76 self-directed retail investors who, during the five years from January 1, 28, to December 31, 212, initially invested in one of 22 Vanguard index funds that, as of January 1, 28, offered both a traditional mutual fund share class and an ETF share class. 4 For some analyses, we narrowed the data set to the 154,39 investors who owned a Vanguard brokerage account at the time of purchase, because a brokerage account is required at Vanguard to purchase an ETF and we wished to analyze investors who had an equal opportunity to purchase either an ETF or a mutual fund at Vanguard. 4 The 22 index funds (with their respective ETF share classes) analyzed in this paper are: Vanguard Dividend Appreciation Index Fund, Vanguard Emerging Markets Stock Index Fund, Vanguard European Stock Index Fund, Vanguard Extended Market Index Fund, Vanguard FTSE All-World ex-us Index Fund, Vanguard Growth Index Fund, Vanguard High Dividend Yield Index Fund, Vanguard Intermediate-Term Bond Index Fund, Vanguard Large-Cap Index Fund, Vanguard Long-Term Bond Index Fund, Vanguard Mid-Cap Index Fund, Vanguard Mid-Cap Growth Index Fund, Vanguard Mid-Cap Value Index Fund, Vanguard Pacific Stock Index Fund, Vanguard REIT Index Fund, Vanguard Short-Term Bond Index Fund, Vanguard Small-Cap Index Fund, Vanguard Small-Cap Growth Index Fund, Vanguard Small-Cap Value Index Fund, Vanguard Total Bond Market Index Fund, Vanguard Total Stock Market Index Fund, and Vanguard Value Index Fund. 3

What are the FACTS? Familiarity Investors are more likely to buy ETFs when they have bought them before. Access Investors without a brokerage account are unlikely to open one to buy an ETF. Costs Investors are more likely to choose ETFs when the ETFs offer lower costs. Trading flexibility Investors who prefer a more hands-on approach are more likely to choose ETFs. Stocks Investors are more likely to buy ETFs in a stock fund than in a fixed income fund. Vanguard s share-class structure provides a unique opportunity to study the purchase decision. The sample of Vanguard investors we analyzed had already chosen indexing as an investment strategy and were choosing between two products, ETFs and mutual funds, that are share classes stemming from the same index portfolio. 5 Because our share-class structure allowed us to control for the investment strategy, we could then compare investors purchases in both share classes to determine the FACTS (see the box above). The factors we examined were: Trading behavior Whether the investor, after the initial purchase, subsequently engaged in active or buy-and-hold trading behavior. We used this trading characteristic to gauge an investor s preference for the intraday trading and pricing flexibility offered by the ETF. Expense ratio advantage for the ETF For each purchase transaction, the expense ratio advantage, if any, offered by the ETF over the equivalent mutual fund share class. The expense ratio is a key component of total costs for investors. Fees and commissions Whether the applicable mutual fund share class would have charged a purchase fee, or whether a transaction in the equivalent ETF share class would have incurred a brokerage commission. 6 These transaction costs are another key component of total costs. Patterns of regular investing Whether the investor, after the initial purchase, engaged in a pattern of frequent, evenly spaced purchases or withdrawals. We used this variable to capture an investor s preference for automatic investing programs, which are available for traditional mutual funds but not readily available for ETFs. Familiarity with ETFs Whether the investor had ever purchased ETFs before at Vanguard. We used this variable as a proxy for whether an investor was familiar with ETFs. Account type Whether the transaction occurred in a taxable account, a traditional IRA, or a Roth IRA. The type of account may affect the purchase decision. Investors basic demographic information Age, gender, wealth, and website logon behavior, among other characteristics, may also influence the purchase decision. 7 See the Appendix, on pages 12 13, for a more complete breakdown of these characteristics in our data set. 5 Vanguard is currently the only firm to offer this multi-share-class structure of ETFs and mutual funds. Other ETF structures include a stand-alone portfolio and a master-feeder structure, in which multiple types of portfolios, including an ETF, feed into a common investment portfolio. 6 Transactions made before May 4, 21, were assumed to be commission-free for Vanguard Flagship Services clients, who were entitled to a fixed number of commission-free trades. We made exceptions to this assumption when a paid commission was recorded. Since May 4, 21, trades for all Vanguard clients in Vanguard ETFs have been commission-free. 7 Estimates of household wealth were provided by WealthComplete from Equifax. Estimated household wealth and vanguard.com logon behavior had a negligible impact on our results and therefore are not presented in this paper. 4

The FACTS Our analysis suggests that five key factors played an important role in investors decision to choose between the ETF share class and the traditional mutual fund share class. Figure 2. 8% Investors familiar with ETFs are more than three times as likely to purchase ETFs 72% Familiarity We found that those who had previously purchased ETFs at Vanguard whom we deemed familiar with ETFs were significantly more likely to choose them again for their initial purchase in our data set than those who had never purchased ETFs before. To examine this effect, we narrowed our original data set to 154,39 investors who owned a brokerage account at the time of purchase, to ensure that each investor had an equal opportunity to purchase an ETF or a mutual fund. As shown in Figure 2, 72% of those who had purchased ETFs before at Vanguard chose them again, compared with 23% of brokerage investors who had never purchased ETFs before. In other words, investors familiar with ETFs were more than three times as likely to choose the ETF as those who were not. Our finding that prior ETF buyers are much more likely to purchase ETFs again may seem obvious, like saying that a population of coffee drinkers is composed mostly of people who have drunk coffee before. Nonetheless, this result has important implications for the future of ETFs. Despite their rapid growth over the past decade, ETFs remain a small footprint in the overall U.S. fund industry: They constitute just 13% of overall fund assets, and recent surveys indicate that many investors remain unaware of and have not yet used them. 8 As the large numbers of investors who are unfamiliar with ETFs cross the ETF Rubicon, the familiarity effect suggests they will be inclined to purchase ETFs again, which would bode well for continued ETF growth. Percentage of investors choosing ETF share class 6 4 2 23% Unfamiliar (has not purchased ETFs before) Familiar (has purchased ETFs before) Notes: Data cover January 1, 28, to December 31, 212, and include only those investors with a Vanguard brokerage account at the time of purchase. Source: Vanguard. Other results from our analysis also suggest that familiarity is indeed a strong point of consideration for Vanguard investors. For example, we found that younger investors are more likely to choose ETFs than older investors. 9 This may reflect a greater familiarity with ETFs among younger investors, who may have started investing when ETFs were already on the brokerage investment menu. We also found a higher proportion of ETF investors, compared with mutual fund investors, choosing a purchase in a taxable account as opposed to a retirement account. This may indicate that investors are more willing to experiment with less familiar investments, such as ETFs, in their taxable accounts than in their IRA nest eggs. 8 For example, a quarter of advisors surveyed by WealthManagement.com did not use ETFs at all, primarily because the advisors didn t know enough about them (Britton, 213). Also, roughly 37% of retail investors surveyed by Charles Schwab (212) had never used ETFs. And Greenwich Associates (213) found that only 18% of U.S. institutional investors it surveyed used ETFs. 9 Among investors with a brokerage account and no prior experience buying ETFs. 5

Figure 3. Percentage of investors choosing ETF share class 14% 12 1 8 6 4 2 Brokerage account requirement poses a significant barrier to purchasing an ETF 1% 12% Figure 3, only 1% of investors without a brokerage account elected to open one to purchase an ETF. Among investors with an established brokerage account, 12% chose to purchase an ETF. We note that this brokerage access barrier is not the industry norm. At many companies, investors open a brokerage account for their investing activities; it can house any number of vehicles, including ETFs and mutual funds. Because a brokerage account is the default option and not an additional hurdle in these cases, one might expect the proportion of investments directed to ETFs to be higher at some other companies. Investors with no preestablished brokerage account Investors with preestablished brokerage account Notes: Data cover January 1, 28, to December 31, 212, and include only investors who had never purchased ETFs before. For this analysis, we classified an investor who opened a Vanguard brokerage account at least 14 days before the initial purchase as one who owned a brokerage account. An investor without a Vanguard brokerage account who wished to purchase a Vanguard ETF would first have had to open such an account a process that can take a number of days and then make the purchase. Source: Vanguard. Access At Vanguard, a significant barrier to purchasing an ETF is that a brokerage account is required. All Vanguard investors already own a mutual fund account that allows them to purchase mutual fund shares. Those who wish to purchase an ETF, however, must open a separate brokerage account as well. Our data show that investors are generally unwilling to go through the additional effort of opening a brokerage account to purchase an ETF when they can readily purchase a comparable mutual fund in their existing mutual fund account. To examine the effect of the brokerage barrier on ETF purchases, we first removed from the original data set any investors who were familiar with ETFs, because by definition they already owned a brokerage account and would be more likely to choose an ETF. As shown in Costs The third factor that influences the share-class decision is costs. Our analysis shows that Vanguard clients who own a brokerage account consider the impact of costs brokerage commissions, purchase fees, and expense ratios when deciding on their purchase. Brokerage commissions. A relevant cost for many ETF investors is a brokerage commission a sales charge that pays the broker who executes your transaction. For much of our sampled period, investors paid commissions on all Vanguard ETFs but not on Vanguard mutual funds (because they are no-load funds). One might expect that the prospect of a brokerage commission on an ETF would encourage investors to choose the equivalent mutual fund share class instead, especially given that at Vanguard, the underlying investments are identical. Figure 4 illustrates the effect of brokerage commissions on ETF purchase decisions. On May 4, 21, Vanguard began offering its ETFs commissionfree, and this announcement was immediately followed by a large uptick in the percentage of ETF share class purchases by investors who had never purchased ETFs before. This effect suggests that commissions had, in fact, previously been a significant deterrent for Vanguard investors who were considering buying an ETF. It also suggests that the ongoing industrywide cutback on commissions for many investors may lead more of them to adopt ETFs. 1 1 Since 29, a number of brokerage firms in addition to Vanguard, including Charles Schwab, Fidelity, TD Ameritrade, and E*Trade, have begun offering commission-free trading of certain ETFs. 6

Figure 4. Impact of Vanguard s commission-free announcement on first-time ETF investors 45% Monthly percentage of investors choosing ETF share class 4 35 3 25 2 15 1 5 Vanguard announces commission-free ETFs May 4, 21 Jan. 28 July 28 Jan. 29 July 29 Jan. 21 July 21 Jan. 211 July 211 Jan. 212 July 212 Jan. 213 Note: Data cover January 1, 28, to December 31, 212, and include only those investors who had a Vanguard brokerage account at the time of purchase and had never purchased ETFs before. Source: Vanguard. Although Figure 4 points to a clear commission effect on ETF purchases, we acknowledge that other dynamics may also be at play. News coverage and marketing efforts surrounding Vanguard s commission-free announcement may have induced even those who already benefited from commissionfree trading of ETFs (such as Vanguard s Flagship clients, who were already allowed a fixed yearly number of commission-free brokerage trades) to buy more ETFs. Nonetheless, our commission effect is consistent with prior academic research, which found that fund investors strongly consider the impact of one-time fees such as commissions. 11 Purchase fees. Mutual fund purchase fees are another type of transaction cost that influences the ETF purchase decision. Unlike brokerage commissions, which apply to ETFs, purchase fees on mutual fund share classes are paid directly to the fund to offset the transaction costs of buying securities. Several mutual fund share classes in our data set charged purchase fees, and one would expect that in those instances (akin to the impact of brokerage commissions), such fees would encourage investors to choose the equivalent ETF share class, especially since the underlying investments are identical. In fact, as shown in Figure 5, on page 8, the percentage of brokerage investors choosing the ETF share class increased from 3% to 47% when investors faced a mutual fund purchase fee. 12 Expense ratios. Our data suggest that expense ratios are yet another cost that Vanguard investors take into account when choosing between ETFs and mutual funds. 13 Unlike fees and commissions, which are transaction costs, expense ratios represent the ongoing operating expenses incurred by a mutual fund or ETF and are deducted gradually from the fund s value. 11 For example, Barber, Odean, and Zheng (25) found that when buying a mutual fund, investors are more sensitive to the more obvious and salient costs such as front-end loads and commissions than they are to more gradual costs such as expense ratios, which are incurred daily. 12 Two mutual funds Vanguard Emerging Markets Stock Index Fund and Vanguard FTSE All-World ex-us Index Fund charged purchase fees during our sampled time period. Those fees were between.25% and.5% of the purchase amount. Mutual funds that charge purchase fees typically face high costs in transacting in the underlying securities. 13 Expense ratios include the impact of management fees, legal and auditing fees, registration fees, and administrative fees. 7

Figure 5. Purchase fees on mutual funds encourage investors to choose ETFs Figure 6. ETF expense ratio advantage encourages investors to choose ETFs 5% 47% 6% Percentage of investors choosing ETF share class 45 4 35 3 25 2 15 1 5 3% Mutual fund share class charges no purchase fee Mutual fund share class charges purchase fee Percentage of investors choosing ETF share class 5 4 3 2 1 24% 37% Overall 11% 29% Before Admiral share class minimums were reduced 27% 48% After Admiral share class minimums were reduced Note: Data cover January 1, 28, to December 31, 212, and include only those investors with a Vanguard brokerage account at the time of purchase. Source: Vanguard. In our data set, Vanguard ETFs offered expense ratios that were generally lower than or equal to those of the equivalent mutual fund share classes. We found that just as investors tended to avoid the vehicle with purchase fees and commissions to minimize costs, they were drawn to the vehicle with a lower expense ratio. Figure 6 shows that when the ETF provided no expense ratio advantage, brokerage investors purchased the ETF 24% of the time, but when its advantage was 1 basis points (1 bp equals 1/1 of 1 percentage point) or more, the investors chose the ETF 37% of the time. The expense ratio effect is even clearer when we divide the sample into two periods: purchases made before and after October 6, 21, the date when Vanguard lowered its $1, minimum investment to $1, on many funds Admiral TM Shares, which typically have the same expense ratio as the ETF. The timing of that reduction came just a few months after Vanguard announced commission-free ETFs. By dividing the sample in this way, we could control for No expense ratio advantage ETF expense ratio advantage is 1 bps or greater Notes: Data cover January 1, 28, to December 31, 212, and include only those investors with a Vanguard brokerage account at the time of purchase. The minimum investment amount for Admiral Shares of many Vanguard funds was reduced on October 6, 21. Source: Vanguard. the fact that many more opportunities arose to choose an ETF with no expense ratio advantage when the general likelihood of buying the ETF was already higher, because of the commission-free policy. In both periods, the percentage of investors purchasing the ETF increased considerably when its expense ratio was at least 1 basis points lower. It is important, however, to recognize that our data set of investors may not be ideal for measuring the impact of this cost. Investors in our sample faced relatively small expense ratio differentials between Vanguard s ETF and mutual fund share classes; as a result, they may have viewed other factors as more important when making their decision. We might expect to find a greater expense ratio impact if we were to compare low-cost ETFs with higher-cost mutual funds elsewhere in the industry. 14 14 As of March 31, 213, the industry average expense ratio was 1.28% for mutual funds and.62% for ETFs, according to Morningstar, Inc. For Vanguard, the average was.18% for mutual fund share classes and.14% for ETF share classes. In addition, the effect of expense ratios on the purchase decision reflects broader trends in the fund universe. As prior Vanguard research (Kinniry, Bennyhoff, and Zilbering, 213) found, the majority of industry investor cash flows over the decade ended December 31, 212, poured into ETFs and mutual funds with the lowest expense ratios in their categories. 8

Trading flexibility The once-a-day-trading (at net asset value) feature of mutual funds is sufficient trading flexibility for most investors. However, some desire greater flexibility. These investors may prefer ETFs, which trade throughout the day on a stock exchange at marketdetermined prices and do not restrict frequent trading of shares, as many mutual funds do. Our analysis of brokerage investors found that an inclination to trade encourages investors to choose the ETF share class. To analyze the impact of trading preference on the ETF purchase decision, we examined trading behavior after the initial purchase transaction for each brokerage investor in our data set who bought shares between January 1, 28, and December 31, 211. 15 We observed the length of time each investment was held and the number of investment reversals the investor executed during the subsequent holding period. We considered such reversals the first buy after a previous sell or the first sell after a previous buy to measure an investor s change in attitude toward an investment. We then assigned each investment position to one of three mutually exclusive behavioral categories: the most conservative one, buy-and-hold, and the more active hands-on and short-term groups of investors. These categories are based on a combination of holding period and number of reversals. We classified buy-and-hold investments as those that were owned for at least one year and experienced either one investment reversal or none in any rolling one-year period. Hands-on investments were those that were held for at least one year and experienced two or more reversals during at least one rolling one-year period. Short-term investments were those sold entirely within one year. Percentage of investors choosing ETF share class Figure 7. 45% 4 35 3 25 2 15 1 5 Investors who prefer a more active trading approach are more likely to choose the ETF share class 29% 36% Buy-and-hold Short-term Hands-on Trading behavior 41% Notes: Data include only those investors with a Vanguard brokerage account at the time of purchase. For this analysis, we restricted the data set to purchases made between January 1, 28, and December 31, 211. Source: Vanguard. As shown in Figure 7, a greater inclination to trade was associated with a greater preference for ETFs. Although the majority of brokerage investors chose the mutual fund share class over the ETF in each of the three trading categories, a larger proportion of active investors (36% of short-term and 41% of hands-on investors) chose the ETF share class than did buy-and-hold investors (29%), suggesting that a preference for trading affects the ETF purchase decision. This is consistent with our previous research on ETF trading behavior, which found that investors inclined to trade gravitated to ETFs. 16 Trading flexibility considerations do not always favor the choice of ETFs, however. For example, one trading feature that may influence investors to choose the traditional mutual fund share class is the ability to engage in regular, automatic investing a feature typically available with mutual funds but not offered by ETFs. In our sample of brokerage 15 For our trading behavior analysis, we restricted the data set to purchases made over only four years, through 211, because we required at least one full year of trading activity to categorize each investor into a behavioral group. 16 For additional information on our previous research, see Ameriks et al. (212). 9

Figure 8. Equity investors are significantly more likely to choose the ETF share class Figure 9. ETF assets are concentrated in equity investments ($ billions) 9% Percentage of investors choosing ETF share class 8 7 6 5 4 3 2 1 1% 41% 7% 3% 4% 78% Asset class Equities $1,46 Fixed income $259 Commodities $17 Alternative $39 Balanced $3 Overall Unfamiliar (has not purchased ETFs before) Familiar (has purchased ETFs before) $ 2 4 6 8 1, Assets in ETFs (in billions) 1,2 Fixed income Equity Note: Data cover January 1, 28, to December 31, 212, and include only those investors with a Vanguard brokerage account at the time of purchase. Source: Vanguard. Notes: As of March 31, 213. Data include exchange-traded notes and other legal structures. Sources: Vanguard calculations, based on data from Morningstar, Inc. investors purchasing before 212, 2% subsequently engaged in a pattern of regular investing, and among that group, 91% chose the traditional mutual fund share class. 17 Stocks A final consideration for investors deciding between the two vehicles is asset class. We found that investors contemplating an equity investment were much more likely to purchase an ETF than those considering a fixed income investment. However, this outcome may be skewed by the familiarity effect we discussed previously. To account for this familiarity effect, Figure 8 separates brokerage investors who have never purchased ETFs before from those who have. We found a large relative disparity between the two asset classes among the group of brokerage investors who were unfamiliar with ETFs. Among this group, only 7% of fixed income investors chose the ETF, but 3% of equity investors chose it. However, even among brokerage investors who were familiar with ETFs, only 4% of fixed income investors chose the ETF, whereas 78% of equity investors did so. Thus, although accounting for the familiarity effect narrowed the relative disparity between equity and fixed income investors, a large difference remained. This difference may reflect that investors who are familiar with ETFs may be more familiar with them as equity investments than as fixed income investments. After all, ETFs were available to investors only in equity form for the first nine years of their existence; fixed income ETFs weren t offered until 22. As shown in Figure 9, assets in equity ETFs dominate those of other investment categories, including fixed income. Time will tell whether this disparity will last, or whether increased familiarity with bond ETFs will bring their popularity closer to that of equity ETFs. If this equity gap begins to narrow, this could signal even faster growth for ETFs going forward. 17 We defined a pattern of systematic purchases/withdrawals as a rate of ten or more purchases per year without more than one sale, or ten or more sales without more than one purchase. 1

Conclusion ETFs are increasingly popular among investors, and many in the investment community have discussed reasons for their rapid growth. Our analysis of a comprehensive data set of investor purchases at Vanguard identifies five key factors that play an important role in the ETF purchase decision. We dubbed them the FACTS: familiarity, access, costs, trading flexibility, and stocks. This study examined investors choice between ETF and mutual fund share classes of the same underlying index portfolio. Outside Vanguard, however, investors (and advisors) may not have ready access to index mutual funds, and ETFs many of which are index-based may be more accessible within their investment platforms. Consequently, the decision to purchase an ETF may incorporate a motivation to choose indexing over active management. Nonetheless, several of the elements of our FACTS analysis costs, familiarity, and access would most likely apply in a similar way as they would to the decision by a Vanguard index investor to purchase an ETF. Although ETFs are owned by only about 3% of U.S. households and constitute only about 13% of combined mutual fund and ETF assets, investors who have used ETFs are much more likely to purchase an ETF for a future investment decision. This familiarity effect is likely to keep ETF growth rates high as additional investors cross the ETF Rubicon. Moreover, a further increase in commission-free ETF trading combined with continuing reductions in ETF expense ratios may keep making it more attractive for investors to start investing in ETFs. References Ameriks, John, Joel M. Dickson, Stephen Weber, and David T. Kwon, 212. ETFs: For the Better or Bettor? Valley Forge, Pa.: The Vanguard Group. Barber, Brad M., Terrance Odean, and Lu Zheng, 25. Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows. Journal of Business 78(6): 295 2119. Bennyhoff, Donald G., 28. The Choice Between ETFs and Conventional Index Fund Shares. Valley Forge, Pa.: The Vanguard Group. Britton, Diana, 213. WealthManagement.com Survey: Advisors Still Uneasy About ETFs. February 28; available at wealthmanagement.com/etfs/ wealthmanagementcom-survey-advisors-still-uneasyabout-etfs. Charles Schwab Corporation, 212. ETF Investor Study; available at aboutschwab.com/press/research/ etf_investor_study/. Greenwich Associates, 213. Institutional Investors Relationship With ETFs Deepens. May 6; available at www.greenwich.com/media-center/pressreleases/213/may-cus-blkrk-etf-213-pr. Investment Company Institute, 213. 213 Investment Company Fact Book, 53rd ed. Washington, D.C.: Investment Company Institute, 56 and 9; available at www.icifactbook.org. Lan, Shan, Christos Costandinides, Sebastian Mercado, and Bo Huang, 212. US ETF Holder Demographics: Understanding ETF Usage. New York: Deutsche Bank. Kinniry, Francis M. Jr., Donald G. Bennyhoff, and Yan Zilbering, 213. Costs Matter: Are Fund Investors Voting With Their Feet? Valley Forge, Pa.: The Vanguard Group. 11

Appendix: Details of the data set a. Summary of observed characteristics among investors who chose each share class all investors This table shows the characteristics of all 554,76 self-directed Vanguard retail investors in our data set, plus the breakdown of these characteristics by the investment product selected. For example, among the 55,16 mutual fund investors in our data set, 2% had made a prior ETF purchase and 98% had not. Among the 49,69 ETF investors, 42% had made a prior ETF purchase and 58% had not. Overall, 6% of our investors had made a prior ETF purchase and 94% had not. Mutual fund investors ETF investors Overall Has the investor purchased ETFs before? Yes 2% 42% 6% No 98% 58% 94% Would an ETF purchase be subject to a commission? Yes 48% 24% 46% No 52% 76% 54% Would a mutual fund purchase be subject to a fee? Yes 13% 22% 14% No 87% 78% 86% Did the investment exhibit a pattern of regular investing? 18 Yes 4% 1% 4% No 96% 99% 96% ETF expense ratio advantage 19 No advantage 18% 16% 17% 1 9 basis points (bps) 16% 9% 15% 1 17 bps 66% 75% 68% Average value 9.2 bps 1.1 bps 9.3 bps Account type Taxable 25% 35% 26% Roth IRA 27% 21% 27% Traditional IRA 48% 44% 47% Age at time of purchase 3 or under 11% 11% 11% 31 4 15% 14% 15% 41 5 18% 16% 18% 51 6 25% 24% 25% 61 7 21% 24% 21% Over 7 1% 11% 1% Average 52 52 52 Trading behavior 2 Buy-and-hold 79% 67% 78% Short-term 15% 24% 16% Hands-on 6% 9% 6% Gender Woman 4% 31% 39% Man 6% 69% 61% Overall breakdown 91% 9% 1% 18 Excludes 74,56 investments made in 212, because we required at least one full year of trading activity to categorize each investor into a behavioral group. We defined a pattern of systematic purchases/withdrawals as a rate of ten or more purchases per year without more than one sale, or ten or more sales without more than one purchase. 19 The expense ratio difference was calculated using the expense ratio for Vanguard Admiral Shares if the purchase amount was above the minimum required for them at the time of purchase. 2 Excludes 74,56 investments made in 212, because we required at least one full year of trading activity to categorize each investor into a behavioral group. 12

b. Summary of observed characteristics among investors who chose each share class brokerage account owners only This table shows the characteristics of 154,39 selfdirected Vanguard retail investors with a brokerage account at the time of purchase, plus the breakdown of these characteristics by the investment product selected. For example, among the 14,349 mutual fund investors in our data set with a brokerage account, 8% had made a prior ETF purchase and 92% had not. Among the 49,69 ETF investors, 42% had made a prior ETF purchase and 58% had not. Overall, 19% of our brokerage investors had made a prior ETF purchase and 81% had not. Mutual fund investors ETF investors Overall Has the investor purchased ETFs before? Yes 8% 42% 19% No 92% 58% 81% Would an ETF purchase be subject to a commission? Yes 39% 24% 34% No 61% 76% 66% Would a mutual fund purchase be subject to a fee? Yes 12% 22% 15% No 88% 78% 85% Did the investment exhibit a pattern of regular investing? 21 Yes 3% 1% 2% No 97% 99% 98% ETF expense ratio advantage 22 No advantage 24% 16% 21% 1 9 basis points (bps) 15% 9% 13% 1 17 bps 61% 75% 66% Average value 8.4 bps 1.1 bps 9. bps Account type Taxable 25% 35% 28% Roth IRA 18% 21% 19% Traditional IRA 57% 44% 53% Age at time of purchase 3 or under 6% 11% 8% 31 4 11% 14% 12% 41 5 16% 16% 16% 51 6 26% 24% 25% 61 7 28% 24% 26% Over 7 13% 11% 13% Average 56 52 55 Trading behavior 23 Buy-and-hold 75% 67% 72% Short-term 19% 24% 21% Hands-on 6% 9% 7% Gender Woman 34% 31% 33% Man 66% 69% 67% Overall breakdown 68% 32% 1% 21 Excludes 24,389 investments made in 212, because we required at least one full year of trading activity to categorize each investor into a behavioral group. We defined a pattern of systematic purchases/withdrawals as a rate of ten or more purchases per year without more than one sale, or ten or more sales without more than one purchase. 22 The expense ratio difference was calculated using the expense ratio for Vanguard Admiral Shares if the purchase amount was above the minimum required for them at the time of purchase. 23 Excludes 24,389 investments made in 212, because we required at least one full year of trading activity to categorize each investor into a behavioral group. 13

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