Nithin Kamath, Founder and CEO of Zerodha, recently shed light on why exchange-traded funds (ETFs) are preferred over mutual funds (MFs) in the US, citing tax efficiency as a major factor.
In a post on X (formerly Twitter), Kamath wrote: “Something I learned recently on why ETFs in the US are preferred over MFs. 😬 US mutual funds are pass-through vehicles — if they generate capital gains, these must be distributed to unit holders who pay the taxes on the gains, which makes MFs less tax-efficient. ETFs avoid this through ‘in-kind’ creation/redemption that washes away gains. This tax advantage is significant. This is one underrated reason for the popularity of index funds, especially ETFs in the US.”
He added that in India, both MFs and ETFs do not pass taxes to unit holders, unlike Portfolio Management Services (PMS) and Category 3 Alternative Investment Funds (AIFs).
The data Kamath shared highlights a significant shift in investor preferences. Domestic equity mutual funds — both actively managed and index-based — are seeing outflows, while ETFs, especially index ETFs, are attracting inflows. Among mutual funds, actively managed strategies are losing the most investors.
The trend suggests investors are favoring ETFs due to their lower costs, tax efficiency, and growing familiarity. Over time, this shift has led to large cumulative outflows from mutual funds and substantial inflows into ETFs.
By 2024, passive funds have extended their lead, with around 53% of long-term open-end and ETF assets now in indexed strategies. After decades of active management dominance, passive investing has taken the lead, driven by cost efficiency, transparency, and the performance struggles of many active managers.
As index funds and ETFs continue gaining traction, their simplicity, lower expense ratios, and clear tracking of market indices make them an increasingly attractive choice for investors. This trend is expected to accelerate, further solidifying passive strategies as the preferred approach for long-term investing.