May 13, 2005 — It’s no secret that exchange-traded funds (ETFs) have caught the fancy of investors. ETF assets have soared to about $229 billion at the end of March 2005, from just $464 million in 1993. In calendar 2004 alone, ETF assets grew by 50%, and could reach the $1 trillion mark by the end of the decade.
Despite an exhilarating acceleration in asset growth, the ETF market still remains dwarfed by the mutual fund industry, an $8 trillion behemoth. One crucial area where ETFs may seek to close that gap is in the nation’s retirement plan business, particularly 401(k) plans, which are currently dominated by traditional mutual funds.
While recent data is not available, the Investment Company Institute estimates that at year-end 2003, 401(k) plans totaled $1.9 trillion in assets, representing about 16% of the total U.S. retirement market. Nearly half of those 401(k) assets were held in mutual funds, with the remaining business occupied by institutions like banks and insurance companies.
Clearly, ETFs face an enormous challenge in putting a dent in the 401(k) arena. Moreover, experts are divided over the viability and appeal of ETFs as a constituent in 401(k) plans.
“There is very little intrinsic value added by having ETFs in a retirement plan,” said Louis Harvey, president of Dalbar Inc., a Boston-based mutual fund consultant. “With respect to costs, fees, and investment returns, there really isn’t a significant differentiation between ETFs and conventional mutual funds in 401(k)s. In addition, plan sponsors face unknown fiduciary risk by replacing the well-established mutual fund with the ETF, which has not been tested in 401(k) plans.”
Mike Hatlee, head of the retirement services group at Chemung Canal Trust Co., which manages $1.3 billion in assets, catering primarily to small- and medium-sized plans, said, “I haven’t had any requests from plan sponsors about adding ETFs as investment options to their retirement plans.”
Whatever perceived advantages ETFs enjoy over mutual funds in regular investments — low expenses, low turnover, short-selling, trading options, buying on margin, tax-efficiency, transparency, and intra-day trading, among others — either disappear or become irrelevant under the bubble of a 401(k) or any qualified retirement plan, Hatlee noted. For example, while ETFs can be bought or sold throughout the trading day to take advantage of equity price movements, “this is certainly not something that a long-term investor in a retirement plan should be doing anyway,” he added.
As for ETFs’ low-tax characteristics, Hatlee asks “who cares about taxes and capital gains distributions in a retirement plan? It all gets taxed as ordinary income when it comes out anyway.”
In addition, Hatlee noted that the low expenses offered by ETFs get cancelled out by their associated trading costs and brokerage commissions. “Many vendors, including ourselves, are very careful to include funds with below average expense ratios, no 12(b)1 fee allocations, and no sales loads of any kind,” he said. “Our fees are fully disclosed and not hidden in the mutual fund structure. I think more vendors should follow this ‘up-front; approach to pricing rather than rush to jump on the ETF bandwagon.”
Another hurdle facing ETF entry into the retirement markets is that most plan sponsors don’t have record-keeping platforms in place to handle ETFs in their 401(k) products.
“The plan sponsors themselves don’t benefit much by having ETFs in these products,” Harvey said. “In fact, ETFs would make it more difficult for the plan sponsors because the platforms for 401(k)s are currently built only for mutual funds, and the way funds are priced daily. For the plan sponsor, it’s more expensive to trade ETFs since they have to create a whole new mechanism for them since they trade intra-day, like stocks.”
The slight cost savings that ETFs provide, Hatlee adds, “is not great enough incentive for most plan sponsors to totally revamp their 401(k) platforms and accommodate ETFs.” Moreover, mutual funds and ETFs have different settlement cycles, further complicating the picture.
He proposed that, assuming a 401(k) platform for ETFs can be easily developed, such a product would likely have to feature high trading volume, substantial assets and a large base of participants, “so you can spread out the trading costs.”
Harvey noted that while participants can access ETF’s today through brokerage windows, they are not part of the core investment options in 401(k) plans.
“I think ETFs are great investment products, but not in a qualified retirement plan,” Hatlee concludes.
However, with mutual fund fees running higher than those of ETFs, and equity markets flattening, others believe ETFs are a viable, less-expensive 401(k) investment alternative, at least for smaller retirement plans.