Are ETFs Ready for 401k “Primetime?”

November 16th, 2010
by Jonathan Leidy

In his Nov 1st Fiduciary News article, Chris Carosa relays insights garnered from a group of industry experts at the recent Art of Indexing Summit in New York. Specifically, he details the top 10 reasons why plan sponsors feel Exchange Traded Funds (ETFs) are not yet appropriate for 401k plans. Although I agree with the conclusion, only one of the ten seems particularly valid in the context of retirement plans.

According to the experts, the top 10 reasons for excluding ETFs from 401k plans are as follow (I’m paraphrasing):

  1. 401k plan investors are “performance chasers” and will use ETFs to do so, as compared to building balanced allocations.
  2. ETF proliferation is based on the popularity of various market segments, which likely does not coincide well with the long-term interests of retirement plan participants.
  3. ETFs are a trading vehicle, suggesting that plan participants may be more prone to experience, and participate in, market bubbles.
  4. The spreads on certain ETFs can be fairly wide, subjecting plan participants to trading inefficiencies.
  5. ETF trading encompasses many “dangers and counter trades” which could be to the detriment of 401k participants.
  6. Due to the fact that ETFs trade and settle like stocks, including them in 401ks suggests that plan fiduciaries may feel pressured to include individual stocks in their plans going forward.
  7. ETFs are not as easy to evaluate as mutual funds.
  8. ETFs are best traded using conditional orders, e.g. stops, limits, etc., which are not currently available in retirement plans.
  9. Retirement plan participants already have access to indexes through the mutual fund marketplace.
  10. Plan participants are not properly educated on how to trade ETFs.

After reading this list, my first instinct was to go back and check the corporate affiliation of each contributor; I was expecting a cadre of talking heads from mutual fund companies. However, most of the individuals cited are either ETF-industry experts or Registered Investment Advisors.

Regardless of their background, these individuals do not appear to be retirement plan experts. The majority of their objections (no.s 1-5, 8, & 10), although generally accurate about ETFs, are not relevant in the context of a retirement plan with proper fiduciary oversight. I emphasize this last point, because any plan built with unsuitable investments, whether using mutual funds or ETFs, is going to run afoul of fiduciary guidelines. Settlement issues, large spreads, rampant trading, and performance chasing are all going to be the result of poor fund selection, monitoring, and/or participant education on the part of the plan fiduciary. Points 6 and 7 are frivolous, but Point 9, although seemingly obvious, is the most relevant.

Before we consider the reasons that ETFs are “not ready for primetime,” we must consider why we would want to include them in retirement plans in the first place. Since retirement plan participants already have access to mutual funds, switching to ETFs should engender some distinct benefits.  Of the various differences between the two investment structures, by far the most compelling rationale for switching would be to capture the inherent cost savings of ETFs. As an example, the Schwab S&P 500 Mutual Fund (SWPPX) charges .13%, whereas the Schwab ETF (SCHX) tracking the same index charges .08%. Although there is a .05% benefit to making the switch, only a year ago that difference was much larger, as the Schwab S&P 500 mutual fund was charging .35%. Ironically, it is the widespread success of ETFs that has led to this type of fee compression among mutual funds, which in turn, has made swapping ETFs into retirement plans less and less meaningful over time.

Couple mutual fund fee compression with the idea that ETFs are much more complicated to keep track of, and making the switch becomes even less attractive. In particular, most recordkeeping systems are built for mutual funds, which are vehicles that trade at one, end-of-the-day, market-clearing price. Conversely, ETFs trade intraday, meaning that switching would belie the current efficiencies inherent in batch-processed trades. In addition, ETFs have different settlement schedules than mutual funds, creating more recordkeeping challenges. A preliminary estimate of the increased cost resulting from the additional recordkeeping associated with the use of ETFs in 401k plans is .15%, a figure that more than outweighs any cost savings engendered in the switch.

In my book, plan participants need two things in order to succeed, solid fiduciary oversight/education and high quality, low cost investments. With the former in place, plan participants will not fall victim to the majority of the potential pitfalls outlined in the “Top 10” list, irrespective of the structure of the underlying investment vehicles. Additionally, having solid fiduciary practices will ensure that fund menus are largely comprised of highly efficient, low cost index investments.

The infrastructure and delivery mechanisms are already in place to provide participants with sound investment options. Adding ETFs to the mix simply muddies the waters, and may actually increase the cost to participants in the process.