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The ETF Solution

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With most workers responsible for their own retirement planning these days, the pressure on corporate America has never been greater to offer effective investment choices within 401(k) plans. The goal is simple: Employees want and desperately need a good investment selection that maximizes returns while minimizing risk and fees.

We all know what the combination of negative returns, severe volatility, and high fees will do to an employee’s retirement nest-egg over the years. For example, a Department of Labor study on the effect of 401(k) fees found that a difference of 100 basis points in expenses can gobble up 23% of a portfolio’s worth over 35 years. No one wants, or can afford, to leave one-quarter of their retirement savings on the table because they paid too much for ineffective mutual funds whose risk-adjusted performance does not justify their own respective fees.

One solution that is becoming increasingly clear to forward-thinking companies and their advisors is allowing plan participants to leverage the benefits of ETFs, which provide a transparent, low-cost way to maintain a potentially wide range of index exposures.

Because ETFs are not allowed in the defined contribution marketplace, traditional 401(k) plans cannot take advantage of these offerings. However, there is a product available now that helps to solve this growing investor need: funds of ETFs.

Since the ETFs available today track to a wide variety of indexes ranging from traditional asset classes to currencies and commodities, ETFs make it possible to provide more effective diversification than most traditional mutual funds, if used correctly. However, being used correctly is the key point of distinction here. If the plan participants do not understand the individual ETFs, or their differences, investors could find themselves lost in their complexity–paralyzed from ever making any changes to their investment selections, just as they do today with the mutual funds in their 401(k) plans.

Despite the advantages that ETFs offer, you might wonder why the vast majority of companies out there don’t offer funds of ETFs in their 401(k) plans.

Perhaps the complaint we in the investment field most often hear is that companies and 401(k) plan administrators simply don’t know how to incorporate individual ETFs into their plans. The challenge that many administrators have been unwilling to face is how to reduce the ETF brokerage costs and trading commissions related to their purchase and sale without violating any ERISA or IRC provisions. With the advent of mutual funds comprising ETFs, this immediate concern should be alleviated.

Down the road, the future for ETFs is extremely bright. In 2007 alone, ETF assets grew by approximately 40% and there are now over 600 ETFs in the marketplace, with hundreds more in the pipeline, and assets closing in on $600 billion. It is likely that the ETF’s place in comprehensive benefits packages will also grow.

We expect that the proliferation of new ETFs in the marketplace will make it difficult for participants to make individual ETF selections within their own plans if they are ever ultimately allowed on a standalone basis. Once again, funds of ETFs can help solve this difficulty. Just as target maturity asset allocation funds have sprung onto 401(k) platforms, mutual funds using ETFs should not be far behind them.

Unless employers begin to tackle some of the misconceptions surrounding ETFs, investors might miss out on this increasingly important low cost and efficient investment vehicle.

Kevin D. Mahn

Managing Director, Hennion & Walsh

Parsippany, New Jersey


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