ETFs In 401(k)s: 3 Reasons for a Solid Look

[From the October 2015 issue of 401(k) Specialist magazine.]

WHILE EXCHANGE TRADED FUNDS themselves aren’t new, they are relatively new to 401(k) and other defined contribution retirement plans. They’ve been slow to catch on, but are gaining some momentum.

One key impediment has been that unlike mutual funds, you can’t buy fractional shares of ETFs. This makes it operationally difficult to buy and sell ETFs intraday in 401(k) plans, which have historically operated in a daily valuation environment. Commissions, the bid/ask spread, and the cost of pooling are other hurdles that must be overcome to make ETFs 401(k)-ready (and more attractive than their mutual fund counterparts).

But there are at least three characteristics where ETFs may have an advantage.

No.1 Lower cost. We’ve reached a point where it’s possible to buy ETFs that track the same indexes as comparable mutual funds, but at a lower cost. There has been a price war in the ETF space among providers such as Blackrock, Schwab, and Vanguard that has reduced the cost of owning ETFs. Particularly for small DC plans that might not have the scale to demand the best pricing from traditional passive mutual fund and CIT options, passive ETFs have the potential to lower a plan’s overall investment management expense. The potential benefits of ETFs are even greater when compared to actively managed investments, but so are index mutual funds, so this is a bit like comparing apples to oranges.

No.2 More choice. While there are plenty of mutual funds that cover the common style-exposures (especially U.S. equity), if a 401(k) plan sponsor wants to track a more niche index (e.g., the Morningstar or S&P Pure indexes) or include additional passive diversifiers (e.g., in the alternative space) there is likely to be more options in the ETF space. This isn’t to suggest plan sponsors should put leveraged gold ETFs in the core menu (or even if they did that participants should use them), but this greater choice generally doesn’t come with higher expense. A good example are the many “smart beta” ETFs in the marketplace, that may track a broad basket of large stocks passively, but in a less traditional way than the S&P 500 or Russell 1000 Indexes.

No. 3 Better engagement. Investors are interested in ETFs, and anything that gets them excited about investing is a good thing. An often-cited concern is that ETFs encourage 401(k) participants to day-trade their 401(k) accounts, but in practice, few do.

One potential concern around ETFs is historical performance, since the ETF creator can tout the hypothetical, back-tested performance of the strategy even if the index is brand new. Consultants and investment professionals will have to become more knowledgeable about the inner workings of ETF operations and design before wide-scale adoption of ETFs in 401(k) plans occurs.

ETFs offer a number of advantages, but they’re not always the best investment option. Regardless of platform or invest­ment type it’s important to be aware of the total costs associated with the investments that are available and to make sure they’re suitable for participants’ risk capacity and risk preference. ETFs can offer potential cost savings, especially when compared to actively managed funds and potentially even when compared to index mutual funds. Better choice and engagement are other potential benefits. Whether ETFs continue to gain traction in the 401(k) space is unknown, but they may be worth another look.

David M. Blanchett, CFA, CFP, is the head of retirement research for the Morningstar Investment Management group in Chicago, IL. Nathan Voris is the director of sponsor and workplace investment solutions for Morningstar, Inc. in Chicago, IL.

1 Comment on "ETFs In 401(k)s: 3 Reasons for a Solid Look"

  1. David,

    ETFs are not new to 401(k) plans Invest n Retire has been record-keeping all ETF 401(k) plans since October 2003. However you are correct that ETF 401(k) plans are slow to catch on. The reason for this is twofold one is Invest n Retire has the only patented technology (pat. US 8,060,428 and pat. US 8,639,604) for record keeping and trading (ETFs) through-out the trading day for 401(k) plans. With INR’s system employees do own whole and fractional shares of ETFs in their retirement accounts. The major reason that ETFs are slow to catch on is that the large record-keepers are mutual fund companies that do not want ETFs in their customers plans.

    My question is which ETF provider(s) will take advantage of this $4.5 trillion opportunity to replace mutual funds with ETFs and lead the industry? Vanguard recognized the potential for mutual funds in 401(k) plans in 1982. Vanguard approached Dyatron Corp (record keeper later acquired by SunGard EBS) to program for mutual funds as investment options. Dyatron believed there was no demand for mutual funds in 401(k) plans and initially declined the request. Vanguard worked with Dyatron to add mutual funds and as they say the rest is history as of 2014 mutual funds represented 80% of 401(k) plan assets.

    My question is why are ETFs any different for 401(k) participants than they are for their taxable accounts? As Matt Hougan stated in Death of Mutual Funds Accelerates August 2015 on ETF.com, “The mutual fund is dead and the ETF is ascendant. Charles Schwab earned $839 million last year from its lucrative Mutual Fund OneSource program. And yet, ETFs outpolled mutual funds for net inflows 130-to-1 last year among its customers. Over the past six years, ETFs have pulled in more than $1 trillion in net inflows while mutual funds haven’t managed to attract $200 million.”

    Which ETF provider(s) is going to take the lead and replace mutual funds in 401(k) Plans?

    Darwin

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