Why ETFs in 401k plans make sense

Lower costs and better choices are some of the advantages.

By InvestorPlace Oct 20, 2010 4:14PM

By ETFGuide.com


Exchange-traded funds have seen impressive growth over the past several years.


Despite the growth, hardly any of it has come from retirement plans like 401(k)s.


Critics claim that ETFs have no business inside 401(k) plans, but are they right? Will ETFs shakeup the slow-moving 401(k) market?


Let’s analyze why ETF(k) retirement plans make sense. 

Today’s 401(k) Market
Defined contribution (DC) plans like 401(k) plans, 403(b) plans and profit-sharing plans are today dominated by mutual funds or company stock. At the end of 2009, employer-sponsored DC plans held $4.1 trillion in assets, with the largest share in 401(k) plans ($2.75 trillion in assets), according to the Investment Company Institute.


Related Article: 5 Mutual Funds to Play the Small Cap Surge


Last year investors poured $118 billion into ETFs, according to Strategic Insight, and total assets in both ETFs and ETNs in the U.S. are projected to reach $1 trillion by 2012. Just how much ETF(k) plans will contribute to that asset growth in the future is up for debate, but defined contribution plans are a huge opportunity.


Despite the proliferation of exchange traded funds, most 401(k) plans have not yet adopted them. Why? It’s because today’s 401(k) market is mostly built on outdated legacy retirement platforms that only accommodate mutual funds. For that reason, the Ford Edsel is a good analogy to today’s 401(k) marketplace. It’s an expensive, burdensome and inefficient jalopy. And just like the Edsel, will oblivion be written on the tombstone of 401(k) service providers that don’t change?


Lower investment costs

There are many components to a 401(k) plan that result in many fees. But the single largest cost within most 401(k)’s is investment-related charges.


The annual investment fees for ETFs are often 75% to 90% lower compared to actively managed mutual funds. But in the context of large corporate 401(k) plans with price negotiating power, those fees may narrow, especially if the plan is using index mutual funds. However, ETFs unlike mutual funds do not have hidden pay schemes like 12b-1 fees attached to them. This results in lower costs for 401(k) participants.


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ETFs inside 401(k) plans are also reducing expenses in another surprising area: Trading costs. In this regard, exchange traded funds and commingled trusts can save people a bundle.


“By holding a selection of suitable ETFs, trusts can mimic closely the returns for any large mutual fund’s investment objective without having to trade as aggressively as actively-managed mutual funds,” said the Center for Retirement Research at Boston College in a report titled Reducing Costs of 401(k) Plans with ETFs and Commingled Trusts.

“Consequently, compared with the median trading cost of 0.66% of assets in our sample of equity mutual funds, ETFs can cut investors’ annual expenses by as much as 0.5% of assets.


For ETF(k) plans using a brokerage window, ETF trading costs are further diminished because major brokerage platforms like Charles Schwab, Fidelity, Vanguard and TD Ameritrade now offer commission-free ETF trading.


Broader investment choices

Have you ever come across someone who loathes their 401(k) plan’s investment menu? Maybe it’s you! There are an untold number of people in this predicament. Many individuals complain they’re being boxed in by their employer and 401(k) plan administrator with mutual fund choices that only offer stocks or bonds.


Related Article: Invesco PowerShares to Close 10 ETFs


A major advantage of exchange traded funds over traditional mutual funds is broader asset coverage which in turn can help 401(k) participants to build more efficient and diversified portfolios. In fact, ETFs cover important investment categories that mutual funds consistently miss.


Examples include key areas like commodities, gold, international small cap value, international TIPS, international real estate and U.S. REITs.


Thankfully, more 401(k) plan sponsors are becoming educated and aware of the need to have broader investment choices for their employees. “I think access to less-traditional asset classes and strategies is going to slowly become more important in DC plans, but we’re not there yet,” says Loren Fox, Senior Research Analyst at Strategic Insight.


Conclusion

While exchange traded funds inside 401(k) plans makes definite sense, adding them to a 401(k) requires altering the plan’s record-keeping system. Unfortunately, most 401(k) legacy record-keeping systems are designed to trade mutual funds and not ETFs.


Regardless of these obstacles, ETFs have already been a disruptive force inside the mutual fund industry and are just starting to shake up the stodgy 401(k) market.


ETF(k) plans have become a serious competitive threat to traditional mutual fund-only 401(k) plans by lowering plan fees and offering more diversified investment choices. In the long run, this potent combination should increase the bottom-line performance for 401(k) investors.


While it’s still too early to say which ETF(k) platforms will achieve FaceBook like domination, the clear losers will be the companies and financial advisors that resist progress. Check back for more etf research and etf information.


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1Comment
Oct 27, 2010 10:24AM
avatar
I believe that ETF were created as another tool to rip off the small investor. As they are traded like stock, they can be bought an sold all day long. The hedge funds, plus others, have the high speed computers that can track when the ETF is out of sync with the stock, or commodities, that it is made up of. With this information they can buy, or short, the ETF and most of the time skim some money off the top, before the price of the ETF and the underlying base come back into sync. ETF's would be OK, for the most part, if they were traded like mutual funds that are priced once per day. This would reduce the ability of hedge funds and others to skim some of the cream off the top at the expense of the small investor. 
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