From the March 2010 issue of Investment Advisor • Subscribe!

The Battle for 401(k) Accounts

ETFs have only established a small beachhead so far in the 401(k) arena. That may not change any time soon

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Judging by the numbers, there has been no decrease in the investing public's appetite for exchange traded funds: ETF assets surged by almost $40 billion in December, according to Investment Company Institute data, to close out 2009 at $777 billion, a vigorous 45% annual gain.

While the ETF industry's long-term growth has been impressive--assets have increased by about $100 billion every year since 2002--almost all of those assets are held in taxable accounts, and with ETF sponsors always hungry for more, they have been increasingly targeting the more than $3.6 trillion held in 401(k) retirement accounts as their next territory to conquer.

So far, they haven't had much luck. The Wall Street Journal reported in January that BlackRock's iShares, the largest ETF sponsor with almost half of the market, has just $2 billion of its $372 billion in assets held in 401(k) accounts, indicative of about $4 billion of ETF assets in 401(k) accounts industrywide, the paper said. Only a small number of 401(k) plan providers even offer ETFs as an investment choice, and most of them target small to medium-sized businesses.

With a view to tapping the market for retirement assets, about a dozen target-date ETFs--funds that anticipate contributions will stop and withdrawals will begin at a certain date--are now trading. New York-based Xshares Advisors was the first to market with target-date ETFs, and now has five funds with dates stretching to 2040, while iShares has about eight such funds. These funds have gathered about $180 million in assets, according to ETF Database, and are often composed of other ETFs to conform to a proprietary asset allocation model. Target date mutual funds are a popular component of many 401(k) plans, though they have recently come under scrutiny by the Securities and Exchange Commission after posting steep declines in late 2008. (A number of academic studies have also questioned the validity of target date funds; see InvestmentAdvisor.com for links to some of those studies.)

Only a Beachhead

That ETF providers have not managed to dig their paws very far into the 401(k) honey pot is hardly surprising, since the primary advantages that make ETFs attractive to investors in taxable accounts, tax efficiency and intraday pricing, vanish in a retirement account. The fact that ETFs are able to avoid the capital gains liabilities that mutual funds incur by dumping low cost-basis shares to fund redemptions is meaningless in a 401(k) account, which isn't subject to capital gains tax. Also, most 401(k) plans do not allow participants to make intraday trades, negating the advantage of intraday exchange trading.

Furthermore, many investors value ETFs for the ability to trade from either the long or the short side and the easy access they provide to more exotic investment strategies, including futures, options, and leverage. While there is no specific rule that prohibits any of these assets from being held in a 401(k) account, the Internal Revenue Service does not allow 401(k) assets to be used as collateral for loans, thereby prohibiting margin accounts, a must for short sellers and margin buyers. Also, since a 2008 Supreme Court ruling explicitly stated that employers are responsible for losses in 401(k) accounts caused by mismanagement, it would be unlikely that employers would allow those ETFs in their 401(k) plans.

The Cost Issue

Even the issue of cost, where ETFs generally have their strongest appeal, becomes muddled in a retirement account setting. ETFs in general have lower annual expense ratios than identical mutual funds, a powerful advantage when they are held for the long term as retirement assets usually are, but investors still must pay a brokerage commission to buy ETF shares, which could become a significant cost if the purchase involves frequent purchases of a relatively small number of shares, as 401(k) accounts usually do. (It should be noted that some major brokerage platforms, notably Schwab and Fidelity, now offer a variety of commission-free trading on certain ETF). S&P Equity Research uses an ETF's and a mutual fund's expense ratio in generating a ranking for the investment, favoring those that are below average.

Lastly, all 401(k) accounts--whether or not they include ETFs--incur administrative costs for services such as record keeping, accounting, legal, and trustee services. In some plans, these fees are subsidized by the management fees or 12(b)-1 "marketing" fees and investment management fees that fund providers already charge. The ultra-low annual expense of owning an ETF, in some cases less than 0.1%, would have to rise to pay for administrative expenses, eroding much of their cost advantage.

Whether ETF sponsors can eventually crack the 401(k) market will depend on their abilit y to undercut mutual funds on cost while still offering an attractive variety of investment choices in retirement plans, as they do for taxable accounts. Until that happens, the effort to gain access to the 401(k) market is really a solution in search of a problem.


S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_Scully@standardandpoors.com. Send him your ideas for ETF story topics.
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