Wrapping Them Up
The use of exchange-traded funds (ETFs) in 401(k) plans has been debated since their creation, and there is disagreement in the industry over how well they work but, for small and mid-size plans, ETF-based options can replace or complement existing investment lineups at significant cost savings. Further, though much of the discussion about 401(k) investments today is toward the use of target-date funds as qualified default investment alternatives (QDIAs), advisers also can enlist specialist ETF managers to guide participants’ portfolios, or use ETFs as underlying funds in managed account products.
In the 1990s, “choice” was the buzzword surrounding 401(k)s, and investment options were given over to elaborate menus of actively managed mutual funds carrying management fees of 100 basis points and up, with additional fees tacked on by recordkeepers, administrators, advisers, and anyone else in the process.
Plan participants, especially those at larger employers, have gotten some cost relief from the introduction of institutionally priced mutual funds, as well as cheaper index funds. However, nagging high costs of retirement plans led Congress and the Department of Labor to require extensive disclosure of asset management fees, plus the many other servicing fees and revenue-sharing rebates to plans and sponsors in the Pension Protection Act. “In plans with assets between $1 million and $25 million, plan sponsors and participants still are being taken advantage of,” says Alvin Rapp, Founder of RPG Consultants, New York, and a 25-year veteran in retirement plan administration.
RPG Consultants and a handful of other consultants, asset managers, and advisers are working hard to spread the gospel of low-cost, transparent 401(k) plans that replace traditional mutual funds with exchange-traded funds as their investment vehicles.
“As 401(k) plans with daily valuations came to the market in the 1990s…we didn’t add anything besides another layer of cost,” says Rapp, “but, with ETFs, we saw something different. We’re not saying that mutual funds should not be part of a plan, but we do think that ETFs are a low-cost product that should be available to sponsors.” RPG started developing an ETF-based structure in 2002.
The cost savings can be substantial for mid-size plans. “Assume a plan with assets of $5 million, where the financial adviser charges 25 basis points, and our firm is charging 50 basis points for recordkeeping and administration,” Rapp explains. “The management fees on the ETFs are just 25 basis points, even at the high end, so you can bring in a $5 million plan at less than what most mutual funds charge just for asset management.”
“We can show them a saving in the neighborhood of 1% per year, which, over time, can really add up,” Rapp says. (The Investment Company Institute reports that the total expense ratios of retail mutual funds—which often appear in the investment menus of small plans—have averaged about 150 basis points and 110 basis points for stock and bond funds, respectively.)
Working Them In
Traditional 401(k) platforms were designed to suit the peculiarities of the mutual fund world, such as end-of-day trading and pricing at net asset value. Thus, when ETFs arrived on the market in the 1990s, they were deemed incompatible with the retirement account infrastructure because they trade like conventional stocks, not only during the trading day, but so that each participant would incur a commission on each trade every payday. Moreover, ETFs do not trade in partial shares as mutual funds do, and the likely mismatch between the fund price and a participant’s contribution would leave some residual cash. (See “The Battle Rages.”)
These technical discrepancies have largely been resolved, although generally at new recordkeepers created specifically for this marketplace. The first ETF-based 401(k) plans got around the trading issues by purchasing shares for an entire plan at once, or at a platform level, thus reducing per-participant commissions. For its part, RPG Consulting added the innovation of a system that invests the small balances of cash left over from trading. More recently, providers have devised collective trust funds and managed account programs that invest in ETFs, putting them on an equal trading footing with mutual funds for practically any 401(k) platform.
Moreover, advisers can readily build target-date and target-risk funds from ETFs at very low cost, or they can rely on independent managers enlisted by recordkeepers. “We have hired Avatar Associates [New York] for our lifecycle portfolios,’ reports James Crocicchia, Managing Partner of Charter Oak Pension Group, Litchfield, Connecticut. “They deliver lifecycle strategies in a collective trust format at a total cost of 35 basis points, and even the lower-fee mutual fund companies charge two to three times as much. Avatar shows up as a top performer in all categories.”
Recordkeeping Options
Perhaps the most ardent proponent of ETF-based 401(k)s is Darwin Abrahamson, who developed the first such programs in 2000 through his company Invest n Retire. “We now are working with about a dozen adviser firms, including Wachovia Securities and Investment Advisers International [a division of insurance company Aegon],” he reports.
Invest n Retire has introduced a nonqualified deferred compensation product lately, and Abrahamson is particularly proud of winning a multiple employer trust account covering 8,500 physicians and their employees. “Sponsors are becoming more and more aware of these plans. By the first of the year, we should have about $500 million in our accounts,” he reports.
He also claims to offer the only managed account structure in which participants can receive individualized portfolio planning and performance reporting. Clients can choose asset allocation from a number of managers including Flexible Plan Investments (based in Bloomfield, Michigan), Main Management (San Francisco), and McLean Asset Management (McLean, Virginia).
WisdomTree Investments, an ETF sponsor based in New York, offers advisers access to a recordkeeping platform that accommodates a plan’s existing mutual funds as well as ETFs. The platform currently is being used by a few dozen plans and has $25 million in assets. “[To add ETFs to a plan,] sponsors don’t have to change their adviser, or their third-party administrator, or their mutual funds,” says Al Shemtob, Director of Retirement Services with WisdomTree. “Yes, they do have to change their recordkeeping platform, but ours is Web-based and looks and works the same as everyone else’s,” he adds. “We’ve tried to make it as easy as possible for the sponsor to make the switch.”
The Wisdom Tree platform offers a degree of customization as well. Included in the firm’s basic offering is asset allocation guidance from CLS Investments, based in Omaha, but advisers can hire their own choice of firms to allocate among Wisdom Tree’s target-date and risk ETF products and any additional funds in individual plans’ lineups.
Outside the Circle
Conspicuously absent from this growing market are the large mutual fund companies—including Vanguard, which champions low-cost investing and even sponsors a large segment of the ETF market. In Vanguard plans, participants can buy ETFs through a self-directed brokerage window, but they are not integrated with mutual fund offerings. Further, ETF-based 401(k) plans are not on the radar screens of leading managed-account providers such as Ibbotson Associates, Financial Engines, or Guided Choice.
ETF-based 401(k)s are only starting to chip away at the enormous market share of mutual funds (see “Watch Out Mutual Funds!”). They won’t appeal to every sponsor, especially those who believe in active management, or draw comfort from having a well-known mutual fund complex associated with their plans. However, with the greater disclosures coming about revenue-sharing among investments, over time, the potential savings from ETF-based plans may become more and more apparent to sponsors, as well as to advisers wishing to win new accounts, and re-energize old relationships.
“I am thrilled at the reception and comprehension that advisers have given our program,” says Al Shemtob of WisdomTree Investments. “We’re looking for advisers who may have sold turnkey insurance company packages a number of years ago, and realize that, with the new disclosure requirements, those old plans costing 250 basis points a year need to be revisited and cleaned up.”
The Battle Rages
A theological battle on the merits of ETFs for 401(k) plans has been raging in the pages of the Journal of Indexes (available at www.indexuniverse.com). The journal’s July/August 2008 issue carried “Why ETFs and 401(k)s Will Never Match,” by David Blanchett and Gregory Kasten, respectively a student in University of Chicago’s MBA program, formerly a financial consultant at Unified Trust, and Chief Executive of Unified Trust Company in Lexington, Kentucky.
Armed with a sheaf of studies, the two authors review in great detail the costs of buying and selling ETFs and pooling them in collective trusts, compare the investment merits of ETFs and mutual funds, and defend the practice of revenue-sharing. Their conclusion begins: “Given current technology, the cost savings from ETFs in 401(k) plans are minimal.”
ETF pioneer Darwin Abrahamson responded in kind in the September/October issue: “Debunking the Myth that ETFs Have No Place in 401(k)s.” No clear conclusions are reached—the advantages probably depend on plan size, the effort required to switch a plan from one setting to the other, and whether participants will show interest in the change. However, for retirement plan sponsors and those who sell 401(k) plans for a living, the argument is a worthwhile read.
Watch Out Mutual Funds!
They have been slow to catch on in 401(k) plans, but a new report says that exchange-traded funds, or ETFs, are a potential threat to mutual funds in investor portfolios.
Distributors and platforms play an important role in vehicle usage, according to a Cerulli Report: “Product Development in an Evolving Portfolio Construction Environment.” Their ability—and willingness—to support different product vehicles and structures directly affects asset managers’ ability to raise assets in the retail third-party distribution channel. Technology hurdles often are to blame when certain vehicles are not adopted. “For example, ETFs have not yet made a meaningful mark in the DC marketplace because of technology constraints and other issues but this is changing,” says Cindy Zarker, Director and lead author of the report.
While ETF usage in portfolio construction is “dwarfed’ when compared to mutual funds, the report notes that, in the competition for assets in the various components of investors’ portfolios, ETFs are a potential threat to those mutual funds. It notes that advisers are using ETFs in multiple ways in both the core and satellite allocations, as well as in the active and passive slices of investors’ portfolios.
The report notes as an example that some advisers are tapping diversified U.S. equity ETFs, such as the S&P 500 SPDR, as “cheap beta.” However, asset allocation also plays a role in the usage of ETFs in portfolio construction—both from the perspective of asset managers’ competency as asset allocation specialists and financial advisers’ approach to asset allocation, according to Cerulli. Advisers who are strategic asset allocators are likely more interested in ETFs for their lower fees and long-term investment themes, whereas advisers who employ a tactical asset allocation approach in their clients’ portfolios may use ETFs because they offer continuous liquidity and access to commodities and other markets where they want to make a concentrated bet.
However, one issue confronting ETFs, according to the report, lies in the area of product development. “Unlike mutual funds, where the product development has not only facilitated innovation but also spawned many “me too” products (the report notes that there are now almost 700 large-cap blend portfolios), it is less viable for firms to replicate index-tracking vehicles.” As a result, the report claims that, after exhausting the pool of mainstream indexes, and then the supply of more discrete benchmarks, “ETF architects are slicing and dicing the universe of investable securities, as well as commodities, into new indexes from which to construct ETFs.”
Mutual fund assemblers have jumped on the ETF product development bandwagon, launching mutual funds that invest in ETFs. The report notes that one of the challenges to ETF “wannabe” has been to identify unique indexes. “Unlike mutual funds, the ability to develop copycat products has been constrained by the need to obtain rights on an index or to create a new index.” Additionally, the report notes that ETFs based on traditional broad-based indexes justify very low fees that require the ETF to garner substantial assets in order to be profitable.
According to the study’s authors, many asset managers that have not yet entered the ETF marketplace are concerned about the competitive threat of actively managed ETFs, and some asset management executives see that the need for transparency places trading limitations on active ETFs. The report notes that “many insist that the higher fees associated with active ETFs, particularly equity ETFs, will negate one of the biggest advantages—low fees.” However, ETF manufacturers counter that the benefit is not related to cost as much as tax efficiency and transparency.
“Some asset managers that were once steadfast in their belief that ETFs did not pose a threat to mutual funds are reconsidering this position now. At this juncture, with the future of active ETFs just now beginning to be written, asset managers must determine their position via a well-defined product strategy. It is too soon to tell how investors, and their advisers, as well as platforms, will weigh the trading, tax efficiency, and other advantages of ETFs relative to the strengths of mutual funds,” says Zarker. —Nevin E. Adams
Illustration by Morgan Blair