Sean Kelly

PA: What are the benefits of exchange-traded funds [ETFs] and what do they offer as part of a fund lineup?

Kelly: An ETF has distinct benefits that are a tremendous help to plan participants. The ETF structure can help to drive down costs and make a plan more cost-effective for, ultimately, a plan participant. There are other various passive investments that generally have a lower cost structure, too.

Recently, the American Airlines 401(k) plan banned some of its participants from trading in their portfolios. That wouldn’t happen with an ETF. There are no trading restrictions, no minimums and no revenue sharing. You don’t have to hold it for 60 days or pay a 1% penalty for any reason. If you subscribe to a trading service, like some participants in the American Airlines plan did, that’s all right.

ETFs can provide precise exposure to asset classes. So, generally, there’s no style drift in an ETF, except in some of the newer, active ones coming out. An ETF, registered under the ’40 Act also provides full transparency, disclosing its holdings every day. So, there are no surprises—you know what you’ll get. And they’re widely available. Those are all pretty big benefits for plan participants.

Traditionally, it’s a lower cost structure. If you look at WisdomTree, iShares, Vanguard or a Schwab ETF product, you’re still getting high quality; you know you’re getting lower-cost product. So, for a participant to access that, at that lower cost point, it’s pretty strong.

PA: Are there any other hurdles?

Kelly: We’re getting mixed messages throughout the industry. Right now, ETFs are slowly—but surely—gaining traction in the retirement space. The industry is taking baby steps toward getting comfortable with using ETFs. For example, earlier in the year, one major custodian said it wasn’t going to enter that market, but yet it has. It has two separate platforms—one institutional and one adviser-driven, and the latter allows for ETFs. 

PA: How do ETFs compare to low-cost institutional index funds, which have about the same price as an ETF and overcome all the administrative obstacles?

Kelly: With an ETF, each participant owns the ETF with zero cash in it, so it’s more precise from an asset-allocation standpoint. You still have to overcome the ’40 Act requirements for a mutual fund to have a cash position. Mutual funds require it to hold cash for redemptions.

If you’re looking at an index mutual fund and trying to construct a portfolio, you’ll still typically have more cash than you may want in your portfolio. With the ETF, if you buy the S&P [Standard & Poor’s] 500, you’re buying the 500 stocks for the S&P 500 without a cash position.

So, in an upmarket, you don’t benefit by holding the index fund. In a down market, you do. As you can see, the market environment can have an effect—it depends on what you’re looking at.

PA: Have you seen people who are using ETFs—especially in their risk-based models or custom targeted funds—turn them into collective funds?

Kelly: Yes, we’re seeing a number of model managers that create ETF portfolios going the route of collective trusts. One of the hurdles to accessing ETFs is that only five custodians are ETF-enabled. So if you have a plan sponsor that wants a particular ETF portfolio and that sponsor is at Fidelity or Schwab or Great-West—name your provider—you can’t access ETFs unless they’re in a collective trust.

There are some model managers developing collective trusts that will disclose all the fees—the cost of creating the collective trusts, as well as the expense ratios of the underlying investments inside the collective trust. Then I see the other side, where certain providers just show the cost of building the collective trust as the cost for the plan participant.

Defined contribution (DC) plan participants are not saving enough, so there is a need to maximize their returns, something that can be helped by controlling fees, said those taking part in “The Low-Cost 401(k)” panel.

According to Sean Kelly, director of retirement services at WisdomTree Asset Management Inc., passive investing drives down costs. The benefits of exchange-traded funds (ETFs) include no trading restrictions, no redemption fees, no minimums, precise exposure to asset classes (no style drift) and full transparency. “If the ETF is based on a benchmark, that’s what you’re going to get,” he said, adding that there is no revenue sharing with ETFs.

Advisers should do all they can to lower fees and increase returns for participants, and that can include helping plans incorporate low-cost ETFs in plans, Kelly said.