From the July 2012 issue of Investment Advisor • Subscribe!

June 26, 2012

Square Peg in a Round Hole?

After a decade of tremendous growth among both retail and institutional investors, in which assets under management eclipsed the $1 trillion mark, exchange-traded funds have yet to gain a meaningful foothold in 401(k) plans, which are still dominated by traditional mutual funds. However, as an increasing number of 401(k) recordkeepers introduce platforms that offer the option to include ETFs, and as the newer generation of ETFs develops a more seasoned track record, the momentum may soon shift in their favor.

Historically, one of the key arguments against incorporating ETFs into 401(k) plans has been the fact that ETFs generally lose certain competitive advantages over traditional mutual funds in this framework. For example, while many investors associate equity ETFs with better tax efficiency than mutual funds, this is irrelevant in a tax-deferred 401(k) plan. And while many investors are drawn to ETFs for their intraday tradability, most 401(k) plans that offer ETFs consolidate ETF trades, which are priced once a day. Even the cost advantages often touted by ETFs are much narrower when compared to institutional share classes offered by some of the largest traditional index mutual funds that are available in larger 401(k) plans. As a result, even as the demand for ETFs in 401(k) plans grows and recordkeepers make adjustments to platforms to allow for their inclusion, many plan advisors have been hesitant to include them.

In light of these obstacles, future opportunities for ETFs to make headway with 401(k) plans may ultimately have less to do with structural “ETF-specific” advantages over traditional mutual funds and more to do with the underlying exposure provided by specific ETFs. After all, while there is plenty of overlap between the investment strategies employed by traditional mutual funds and those followed by exchange-traded funds, there are also numerous strategies and asset classes followed by ETFs that are not presently available via traditional mutual funds.

For example, over the past five or six years, ETF sponsors have been busy introducing equity ETFs that follow proprietary enhanced-index strategies, many of which are unavailable via traditional mutual funds. These strategies provide exposure to a number of single- and multi-factor models, resulting in risk/return profiles more akin to active management than passive indexing, and quite often at a significantly lower cost than active management offered via traditional mutual funds. As these ETFs develop longer-term track records, I believe the best among them will inevitably filter through the screens of 401(k) plan advisors, ultimately resulting in increased adoption in 401(k) plans. Since many of these ETFs were launched between 2007 and 2008, they are only now beginning to achieve the minimum five-year track record by which many 401(k) plan advisors screen mutual funds.

Another area of opportunity in which ETFs may see increased usage in 401(k) plans comes from their ability to provide cheap, transparent access to certain “alternative” asset classes. Over the past decade, many ETFs in this category have become mainstream, effectively democratizing exposure to certain asset classes that were previously unavailable to smaller investors. While ERISA requirements related to suitability will certainly prevent many ETFs in this category from finding their way into 401(k) plans, exposure via ETFs to gold or to a broad basket of commodities, for example, would provide investors with new tools to further diversify their 401(k) portfolios. Many of these options are not presently available via traditional mutual funds.

Exchange-traded funds’ slow rate of acceptance into 401(k) platforms has led many to doubt their long-term viability in this market. In some respects, ETFs are the proverbial square peg in a round hole, especially when competing with traditional mutual funds, in which most 401(k) plans were specifically designed to invest. However, even in the absence of certain competitive advantages enjoyed by ETFs outside of 401(k) plans, there remains great opportunity on the horizon for specific ETFs to gain market share within 401(k) plans. While the first generation of ETFs, which tracked traditional indexes, proved to be too similar to existing index mutual funds to carve out a place in most 401(k) plans, the underlying strategies and asset classes offered by the newer generation of ETFs may soon warrant their inclusion.

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