Are ETFs a Good Fit for 401(k) Plans?

Exchange traded-funds (ETFs) have become a major part of the investing landscape and their popularity continues to grow. The ability to buy and sell ETFs throughout the trading day, the low cost of many index ETFs and their transparency have made them the investing product of choice for many individual investors and financial advisors.

To date, ETFs have not made major inroads into the 401(k) market. Robo-advisor Betterment announced it will be launching a 401(k) product. It will be using all ETF portfolios offered in their core service as managed accounts for 401(k) participants. They promise a top all-in cost of 60 basis points for administration and 10 basis points for ETF expenses. This fee will decline to 10 basis points for plans with $1 billion or more in assets. While this approach may gain some traction in the marketplace, by and large the hype surrounding ETFs in 401(k) plans has been that, hype. Charles Schwab Corp. (SCHW) launched an all ETF 401(k) product and the results to date have been decidedly mixed. (For more, see: Betterment's all-ETF Online 401(k) Plan.)

ETFs offer many advantages for investors. However, many of these advantages seem irrelevant in a 401(k) setting. The ability to trade them during the trading day likely wouldn’t appeal to a lot of plan sponsors who don’t want their employees sitting on their computer watching their holdings and trading them while they should be working. Depending upon the platform, the option to trade real time may or may not be available to plan participants as many 401(k) providers will aggregate trades at the end of the business day.

Many ETFs offer tax-efficiency due to their structure. This is not a relevant feature in a tax-deferred retirement plan like a 401(k). Every time I read a piece advocating ETF-based 401(k) plans, I have to wonder if this isn’t a push for wider distribution of these products by ETF providers versus a “better mousetrap” for 401(k) sponsors. (For more, see: ETFs for Your 401(k)?)

Generally plain vanilla index mutual funds offer the low costs and style purity of index ETF products. For example, the Vanguard Total Stock Market Index ETF (VTI) has an ultra-low expense ratio of 0.05%. The mutual fund version Vanguard Total Stock Market Index (VTSAX) also has an expense ratio of 0.05%. In the case of Vanguard, ETFs are simply an additional share class of their mutual funds. While it is true that there is an ETF price war among some providers, this only matters if the ETFs that are “on sale” are the ones that you want to offer your participants.

The use of ETFs makes the issue of cost disclosure that much tougher for plan sponsors due to the structure of many ETFs. One issue is the bid-ask spreads that can vary during the trading day. While not part of the ETF’s expense structure, this does represent a cost to the participants. The issue of intra-day trading could also be problematic. This could result in different end of the day values for the same holding among participants. The reality is that participants do talk to each other and any situation like this is bound to surface. This is just a headache that plan sponsors don’t need. (For more, see: The Basics of the Bid-Ask Spread.)

ETFs trade as whole shares on the various exchanges. Small investments are the norm in a 401(k) plan and would certainly result in fractional ETF shares. While record keeping technology has or will evolve to be able to handle this at some point there is likely an extra cost here somewhere. Fractional shares are the norm with mutual funds.

Among the arguments that I’ve read in favor of all-ETF plans is that index ETFs are less expensive than actively-managed mutual funds. While I totally concur, this is like comparing apples and oranges. Many excellent low-cost 401(k) plans offer a mix of index funds and actively-managed funds. Some advocates might argue that smart-beta ETFs are an alternative to actively-managed funds but explaining smart beta to plan participants could be a challenge. Further many of these strategies are untested in real market conditions. (For more, see: Smart Beta Funds vs. Index Funds.)

David Blanchett, head of retirement research at Morningstar Investment Management, suggested in an article for CNBC that offering a menu of ETFs and the ability to trade them during the day might be a motivation for some participants to become more engaged in their retirement savings efforts. He may well be right, but I think this is a bad idea for plan sponsors for a couple of reasons. First, many participants have enough trouble understanding the mutual funds offered in their accounts already. Adding the ability to trade ETFs in the plan all day does nothing for these participants and may lead to actions that are not in their best interests.

Retirement savers are told that retirement is a long-term proposition. How does the ability to day-trade their accounts reinforce this? If allowing access to ETFs is desired, why not offer a brokerage window in the plan? I’ve seen this done in plans and frankly it is a great vehicle for participants who work with a financial advisor as it allows more flexibility in integrating the client’s other investments and their investments within the plan. (For more, see: 6 Problems with 401(k) Plans.)

The place where ETFs might work the best in a 401(k) plan is in the area of managed accounts. These might be offered instead of the target date funds that are currently the staple managed account offering today. However, it would still be up to the plan sponsor to vet these accounts and ensure that they are appropriate for their participants. They would also want to ensure that they can be used as qualified default investment alternatives and qualify for the safe harbor.

While I am a huge fan of ETFs and have been for a long time, I have not read or seen anything that presents a compelling case for them in a 401(k) plan. At some point this likely will change, but at this point I have to wonder if this isn’t just a lot of hype on the part of ETF providers seeking greater distribution of their products. (For more, see: The Best ETFs for Your 401(k).)