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.

“There is more interest being shown in ETFs for retirement plans, but it’s still relatively small,” said Rick Meigs, founder and president of 401khelpcenter.com, an Oregon-based provider of 401(k) information. “The reason behind the interest seems to be a direct result of the mutual fund scandals — market-timing issues, trading irregularities, expensive fees, etc. Plan sponsors have been looking at alternative investments.”

“ETF assets in 401(k) plans are so far rather modest, but we have noticed that there is an increasing amount of interest in iShares in retirement plans,” said Gerry Rocchi, director of Americas iShares Ventures at Barclay Global Investors. “A number of 401(k) providers are seriously researching the introduction of 401(k) platforms with ETFs. They call us and go over technical details, seek our advice on how to structure their plans. We’ve had discussions with over ten plan sponsors to facilitate the usage of ETFs in 401(k) platforms. We [Barclays] see the 401(k) business as largely an untapped area that should have some interesting growth opportunities for Barclays in the years to come.”

While Rocchi concedes that service providers have to retool their 401(k) platforms to accommodate ETFs, “this is not an “insurmountable problem, although it needs a solution.”

On the difficulty of establishing an efficient platform for ETFs in retirement products, Meigs said “platforms for 401(k) plans can accommodate ETFs when they treat them like individual stocks, but the problem is the expense involved. However, we are now seeing some platform-providers creating modified record-keeping mechanisms to use ETFs quite economically, which reduces the cost dramatically to the plan.”

One such company doing exactly that is Invest-n-Retire, a record-keeping firm based in Portland, Ore. “We are definitely seeing more interest in having ETFs in retirement plans,” said Darwin Abrahamson, founder and chief executive officer of Invest-n-Retire. “Executives of plan sponsor companies/trustees currently have ETFs in their personal portfolios, and they are asking about including them in 401(k) plans. Financial institutions that are offering ETFs are looking to add ETFs in their retirement plans.”

Abrahamson’s company offers 30 Barclay Global Investors iShares ETFs, 4 NASDAQ ETFs, 13 Vanguard VIPERs, and 18 Dimensional Fund Advisors funds in about 25 retirement plans, with assets ranging from $1 million to $10 million.

Abrahamson cites low cost as the biggest attraction of having ETFs in retirement plans. “Participants are currently paying exorbitant fees for their 401(k) plans, he said. “We estimate that between 70%-90% of the cost of any 401(k) plan is tied to the associated mutual fund fees. For the fiduciaries, the number one advantage with having ETFs in a 401(k) plan is the transparency of fees; that is, they won’t have the problem of all the hidden fees, like 12b-1 fees, wrap fees, sub-TA fees, etc. With ETFs, fees are 100% transparent.”

From the participant’s point-of-view, Abrahamson indicates, it’s all about cost. “The more you can reduce the costs inside an investment option, the higher the returns for participants,” he noted. “By using ETFs, we can cut down investment costs — which always comes out of the participants’ accounts — in a retirement plan. Also, with ETFs, our advisors/consultants can design more efficient asset-allocation models within a retirement plan.”

Abrahamson also noted that another motivation for keeping ETFs in 401(k) plans lies with the Department of Labor, which, in its capacity as a retirement plan regulator, is pushing for reduced fees in light of the mutual fund industry’s trading scandals. Abrahamson said that by using ETFs, his firm can significantly reduce the costs associated with managing 401(k) plans, resulting in expenses that are 30% to 60% below plans associated with conventional 401(k) service providers.

Banneker Capital Management Corp., an investment advisory firm based in Owings Mills, Md., recently introduced a bundled, all-ETF 401(k) plan with BenefitStreet, a third-party provider.

Srikant Dash, global equity index strategist at Standard & Poor’s, said one big advantage with ETFs is the asset-allocation models they provide. He expects to see more ETF assets in 401(k) retirement plans “because of lower cost, convenience and the availability of a wide variety of investment options and growing awareness of this asset class.”

Abrahamson is highly optimistic about the future growth of ETFs in retirement vehicles. “Over the next two to three years, we will see huge inflows of ETF assets into 401(k) plans,” he declared.

Meigs strikes a more cautionary stance. “I think ETFs in 401(k) plans will be, at best, a niche product. I don’t think the plan sponsor industry will aggressively pursue ETFs in place of mutual funds,” he said. “However, perhaps if we witness another major scandal or blow-up in the mutual fund industry, that may increase the attraction of ETFs. At the moment, most plan sponsors are not that interested. ETFs don’t pose much of a threat.”

In the end, most agree that for ETFs to make any headway into the 401(k) market, transaction/brokerage costs have to decline, investors need to become more familiar with ETFs, and the ETF industry has to market itself more aggressively as an attractive retirement asset instrument.

Contact Bob Keane with questions or comments at: .