From the November 2010 issue of Investment Advisor • Subscribe!

November 1, 2010

The Trouble with Target-Date ETFs

As ETFs gain market share, they struggle to find a place in retirement plans

One by one, the rollout of new exchange-traded funds has begun to challenge mutual fund providers for investor asset share. U.S.-listed ETF assets topped $900 billion for the first time in September 2010.

When it comes to the world of retirement investing, however, ETFs have yet to find their footing. BlackRock’s iShares unit, which dominates the ETF industry with a 47.5% share of the market, has made a push into the 401(k) world, gathering about $2 billion in assets according to a January 2010 Wall Street Journal report. Other firms are still mostly standing outside the castle walls looking in.

One idea ETF sponsors have had to gather more retirement assets was to launch their own set of target-date ETFs. Target-date mutual fund assets have soared since they were approved by the Department of Labor as a Qualified Default Investment Alternative (QDIA) for 401(k) investors in 2007. Two ETF sponsors, iShares and TD Ameritrade/XShares, now offer target-date ETFs, but acceptance by investors has been tepid.

The Issues of Target-Date ETFs
ETFs from these sponsors have a number of similarities and differences worth noting. The TD Ameritrade funds own assets directly and have a higher expense ratio, while the iShares ETFs are funds of funds. Both currently start at 2010 and stop at 2040, and have ETFs for current retirees. iShares offers ETFs at five-year intervals while TD’s ETFs are spaced at 10-year intervals.

Unfortunately, both fund sponsors force investors to read the prospectus in order to find out how their funds’ assets are allocated. TD provides a generic graph showing the allocations from 33 years prior to target date to 20 years after, while iShares does not.

Asset allocations for both ETF groups are similar for the 2040 ETFs. TD has 96% of ETF assets invested in equities, which includes an international equity allocation of about 22%, and the remaining 4% in fixed income. The allocations gradually shift to 10% equity/90% fixed income at the target date. After the target date, the equity allocations rise again so that five years later, the ETFs have a 32% equity allocation, which stays constant for the next 15 years.
The iShares 2040 ETF has about 86.5% in equity, which includes 23.5% international equity, and 11.2% in fixed income. The ETF for investors in retirement holds about 31% in equity and 67.5% in fixed income, with the remainder in real estate and cash.

For investors firmly sold on the ETF format, these funds seem adequate, and they certainly charge lower annual fees than some target-date mutual funds. Still, it’s difficult to see why they are superior unless intraday trading is an absolute must. Those who don’t have self-directed retirement plans can’t hold them in a tax-exempt account, something even the tax efficiency of ETFs can’t overcome. In short, while target-date ETFs may appeal to a small group of investors, they don’t appear ready to achieve the success that other ETFs, or target-date mutual funds, already have.    

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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