Exchange Rates
When the 401(k) market was in its infancy some three decades ago, most plan assets were invested in stable value and insurance contracts. Two decades later, the bulk of plan participants’ retirement dollars is lodged in mutual funds. Today, when some industry analysts look into the crystal ball of the future, they see the possibility of a third investment class consuming many defined contribution assets: exchange-traded funds (ETFs). Of course, they have been predicting that shift for more than a decade now.
These investment vehicles, which are traded daily on a stock exchange and generally are indexed rather than actively managed, gradually are capturing the attention of plan advisers and sponsors because of their relatively low cost, their diversification features, and their transparency.
“We’re not even a blip on the radar right now,” says Darwin Abrahamson, CEO of Invest n Retire, a major provider of ETFs in retirement plans, “but the use of ETFs in 401(k) plans is going to explode over the next few years.”
Industry Uptake versus DC Plans
The popularity of ETFs in the general investing community can be seen in these figures from 2008: While $230 billion moved out of all equities last year, according to Abrahamson, ETFs gained $134 billion. Unfortunately for ETF providers, however, that popularity has not translated to the defined contribution world. Today, surveys show that no more than 4% of 401(k) assets are invested in ETFs.
Part of that can be linked to the fact that most mainstream 401(k) platforms are designed to accommodate mutual fund trading features, including end-of-day trading and net asset value pricing, making them seemingly incompatible with ETFs’ intraday trading and lack of partial share pricing, leaving some cash float at the end of the day. However, as interest has grown in trying to accommodate ETFs in retirement plans, providers have developed collective trust funds and managed account programs that contain ETFs as the underlying investments, rendering them compatible with practically any 401(k) platform.
Choosing a Plan Model
Vendors promoting ETFs emphasize that plan advisers who investigate the market quickly will discover two big advantages over mutual funds. ETFs are generally less costly, and they provide consistent long-term returns. Vendors say that, because ETFs are generally index funds, they will have less volatility than actively managed mutual funds and, because of their often lower costs compared with mutual funds, they will net more overall to the investor.
That is particularly true when ETFs are part of another investment structure, the collective trust, according to Stan Milovancev, President of ValMark Advisers. Mutual funds, he points out, charge the same fee to plans regardless of how large they grow, whereas, generally speaking, the more money that flows into a collective trust, the less expensive it becomes (see “Collective Wisdom“). “[When you couple this collective trust structure with the low-cost ETFs,] all the benefits of scale go right back to the participants who are building the scale,” he explains.
However, not everyone sees collective trusts as the best choice for an ETF as a 401(k) plan investment. Recordkeeper Invest n Retire offers software to advisers so they can do comparative shopping on fees and then design their own ETF models. These investment vehicles provide more transparency than collective trusts, says Abrahamson.
So, one of the first decisions an adviser should make when trying to incorporate ETFs into retirement plans is whether to go the collective trust route or design a plan lineup of individual ETFs. Formerly, plans with assets of less than $5 million were not eligible to buy Invest n Retire’s ETFs but, recently, the company designed a multiplan program that enables advisers serving plans with $1 million or more in assets to group plans together and purchase the funds.
ETFs offer advisers and their plans an opportunity to buy a highly diversified fund at the price of a single stock, says Richard Michaud of Boston-based institutional research and investment advisory firm New Frontier Advisers. At the same time, he points out, the transparency of ETFs should be attractive to advisers because an investor can go to any ETF and find out the underlying investments and follow the returns on a stock exchange, like many mutual funds.
ETF Differences
While passive management currently is the favored style, some vendors are beginning to market actively managed ETFs. As a result, like mutual funds, management style may be one issue to be explored. Depending on a plan’s recordkeeper, advisers might find they have to go with a provider’s proprietary ETFs but, with other providers, they might have access to open architecture and be able to shop for funds on the open market.
Like putting together any fund menu, in constructing an ETF lineup, advisers also should strive for diversification so that the funds offer a range of asset classes. Michaud recommends that advisers attempt to use ETFs that span alternative investments including, perhaps, international and domestic equities, fixed-income vehicles, and even options such as REITs. Others suggest that an adviser add an assortment of ETFs that can appeal to participants with differing risk tolerances.
Advisers interviewed say it is important to be sure the underlying investments in an ETF program are sound and meet the requirements of the plan sponsor. Advisers have the fiduciary responsibility to ascertain that ETFs that are chosen have established benchmarks. That might be particularly important as ETFs gain in popularity and new ETFs hit the market, warns Abrahamson.
“We’re seeing more and more active funds and funds created on off-the-wall indexes or commodities,” he says. “It’s getting more like the mutual fund industry. Just because it’s an ETF doesn’t mean it’s a good investment. You have to pop open the hood and look at what’s there. You’re going to see a lot more ETFs that are not good ETFs.”
Illustration by Edel Rodriguez