investment-oriented | PLANADVISER November/December 2016

ETFs Find DC Entry via TDFs

17 TDF providers leverage exchange-traded funds as underlying investments

By Rebecca Moore | November/December 2016
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Art by Kevin Hong

Despite being known as a low-cost investment—offering access to many different investment classes and styles—exchange-traded funds (ETFs) have struggled for years to enter defined contribution (DC) retirement plan lineups.

According to 2015 data from Cerulli, mutual funds continue to be the most common investment vehicle in 401(k) plans, with collective trusts a distant second. ETFs make up just a fraction of a percent (0.02%) of the investment vehicles used in 401(k)s.

One reason ETFs have failed to catch on in the DC market is their intraday trading is incompatible with most defined contribution plan recordkeeping systems, which were built to accommodate mutual funds, or similar investment vehicles. Mutual funds trade once per day and are pooled along with other investors’ trades. ETFs can be traded intraday, have fractional shares and, therefore, are more liquid.

“In order for folks to adapt to ETFs now, they have to trade after market or with some kind of roll-up activity, which drives up costs and takes away the benefit of ETFs,” says Bob Ward, chief revenue officer for Vertical Management Systems, in Pasadena, California.

However, ETFs may have finally found their point of entry into the DC market, says Matt Cirillo, senior analyst, retirement, at Strategic Insight in Boston. ETFs are slowly gaining traction as underlying investments within other vehicles, such as target-date mutual funds (TDFs). Cirillo says the trend has been building for the last six to eight years. Some analysts credit the cost advantages.

According to Strategic Insight data, among the top five TDF providers, only one uses ETFs as underlying investments, but, among all 39 TDF providers analyzed, 17 now do so. Still, Cirillo notes, ETFs account for only approximately 2% of the $861 billion TDF market.

Cirillo says newer entrants and smaller managers are significantly more likely to include ETFs in their TDF funds, in trying to combat the scale of larger managers. Using ETFs in this way has not caught on with established retirement plan investment providers, however, as they have the capacity to create their own indexed funds and utilize them for core asset classes.