Exchange-traded funds (ETFs) continue to grow in popularity. According to the Investment Company Institute, at year-end 2006, ETF assets totaled $422.6 billion compared to $65.6 billion in 2000. There were also 359 funds available to investors compared with just 80 at year-end 2000. However, these versatile funds have not made it into many retirement accounts.
Traditionally there have been two things keeping ETFs out of 401(k) accounts:
- The unavailability of cost-effective trading software that allows participants to perform the necessary tracking.
- An inability to own whole and fractional shares of ETFs in their accounts (outside of self-directed brokerage accounts).
This meant that many people missed out on the opportunity to hold these low-cost funds in their retirement plan accounts. Read on as we examine the benefits of and problems with adding ETFs to a client's 401(k) plan. We'll then examine one possible solution to help advisors in clearing ETF transactions in retirement accounts at affordable costs.
The growing popularity of ETFs among consumers is not in question. Financial advisors want to provide their clients with the most suitable products and services, but the question for them is, "Why provide ETFs?" One key reason is that advisors want to look out for the best interest of the client. The other is self-preservation through protection against lawsuits from dissatisfied participants and public interest groups.
Benefits for Clients
While both mutual funds and ETFs are composed of securities in their underlying indexes, there are marked differences that make ETFs more consumer-attractive. These include trading features and pricing.
Over time, high fees can significantly reduce the balance in a participant's retirement account. A large percentage of these fees are trade-related and annual fees that often amount to an average of 1% of a participant's 401(k) balance. ETFs provide a solution to these high costs, primarily because they do not have the redemption and management fees often associated with mutual funds.
Benefit for Financial Advisors
For financial advisors, one key attraction of an ETF is the higher level of protection it provides for plan fiduciaries. With all the litigation and fee disclosure requirements, ETFs are said to be the cleanest investment vehicle to use for investment and fiduciary purposes. They cost less than mutual funds and index funds and have no short-term redemption fees. In short, they come without the "fee baggage" that goes along with other kinds of funds. Therefore, they are a fiduciary's dream investment vehicle.
Mutual funds held in 401(k) plans usually have higher fees than those held outside of 401(k) plans, because those held in the plans are usually special class funds, such as R-Shares. (For more information on this mutual fund class, check out the Forbes article by William Barrett, titled "R-Shares, Competitive - But For Whom?".)
As such, advisors can often build better asset allocation models with ETFs than with mutual funds, hence the popularity with advisors who work with wealthy clients.
Commissions and Tracking Requirements Keep ETFs from 401(k) Plans
While ETFs are becoming increasingly popular in 401(k) plans, the progress is slow because of the commission that is usually applied to each trade. This cost is a deterrent for participants who trade frequently by investing periodic salary-deferral contributions made to their 401(k) accounts through payroll deduction. For most participants, the frequency can be as often as weekly, monthly and semi-monthly. Also, because the contributions are often systematically invested upon being credited to their 401(k) accounts, there is usually no opportunity to accumulate contributions and make "bulk" trades, instead of multiple trades.
Additionally, third-party administrators are faced with the challenge of finding software that is properly designed to allow ETFs to trade in 401(k) plans outside of a brokerage account environment, while tracking the performance of participants' portfolios and tracking transaction fees.
In order for financial advisors to overcome these challenges, they need to be able to collaborate with a firm that can provide solutions to these issues. These solutions are currently being developed, including proprietary software to build asset allocation models with ETFs and change asset allocation between ETFs without incurring any redemption fees.
The Bottom Line
The opportunity to provide an asset allocation model, with costs lower than those associated with traditional investments, such as mutual funds, is a key asset-gathering and asset-retention tool. In addition, it helps to provide peace of mind for fiduciaries in what has become an area of concern - fees reducing participants' return on investments in their 401(k) accounts. ETFs, offered through a platform that allows the institutional trading of participants' shares, helps to provide solutions to these issues.