Exchange traded-funds (ETFs) have become a major part of the investing landscape and their popularity continues to grow. The ability to buy and sell ETFs throughout the trading day, the low cost of many index ETFs, and their transparency have made them the investing product of choice for many individual investors and financial advisors.
ETFs as 401(k) Picks
ETFs offer many advantages for investors. However, some of these advantages are irrelevant in a 401(k) setting. The ability to trade ETFs during the day is unlikely to appeal to employers who don’t want employees sitting at their computers watching or trading their holdings during work hours. Depending on the platform, the option to trade real-time may or may not be available to plan participants, as many 401(k) providers will aggregate trades at the end of the business day. In any case, retirement plans are not really designed for intraday trading. They are supposed to be long-term investments.
Many ETFs offer tax-efficiency due to their structure. This is not a relevant feature in a tax-deferred retirement plan such as a 401(k). ETFs are similar to mutual funds. If your 401(k) options include an ETF (or any mutual fund) you think is a great pick, there's no reason not to choose it.
All ETF 401(k) Products
To date, ETFs have not made major inroads into the 401(k) market. Robo-advisor Betterment launched a 401(k) product. It will be using all the ETF portfolios offered in its core service as managed accounts for 401(k) participants. The company promises a top all-in cost of 60 basis points for administration and 10 basis points for ETF expenses. This fee will decline to 10 basis points for plans with $1 billion or more in assets.
While this approach may gain some traction in the marketplace, by and large, the hype surrounding ETFs in 401(k) plans has been just that, hype. Charles Schwab launched an all ETF 401(k) product and the results to date have been decidedly mixed.
Index Mutual Funds
Generally, plain vanilla index mutual funds offer the low costs and style purity of index ETF products. For example, the Vanguard Total Stock Market Index ETF (VTI) has an ultra-low expense ratio of 0.05%. The mutual fund version Vanguard Total Stock Market Index also has an expense ratio of 0.05%.
In the case of Vanguard, ETFs are simply an additional share class of their mutual funds. While it is true that there is an ETF price war among some providers, this only matters if the ETFs on sale are ones your company offers plan participants.
Complexity and Cost Disclosure
The use of ETFs makes the issue of cost disclosure that much tougher for plan sponsors due to the structure of many ETFs.
One issue is the bid-ask spreads that can vary during the trading day. While not part of the ETF’s expense structure, this does represent a cost to the participants.
The issue of intra-day trading could also be problematic. This could result in different end-of-day values for the same holding among participants.
The reality is that participants do talk to each other and any situation like this is bound to surface. This is just a headache that plan sponsors don’t need.
ETFs trade as whole shares on the various exchanges. Small investments are the norm in a 401(k) plan and would certainly result in fractional ETF shares. While record-keeping technology has or will evolve to handle this at some point, there is likely an extra cost here somewhere. Fractional shares are the norm with mutual funds.
ETFs vs. Actively Managed Funds
Among the arguments that I’ve read in favor of all-ETF plans is that index ETFs are less expensive than actively-managed mutual funds.
This may be true but not really relevant to retirement accounts. Many excellent low-cost 401(k) plans offer a mix of index funds and actively-managed funds.
ETF Managed Accounts
The place where ETFs might work the best in a 401(k) plan is in the area of managed accounts. These might be offered instead of the target date funds that are currently the staple managed account offering today.
However, it would still be up to the plan sponsor to vet these accounts and ensure they are appropriate for their participants. They would also want to ensure that they can be used as qualified default investment alternatives.