Rates of growth in exchange-traded funds, or ETFs, have trounced the growth of mutual fund assets over the last decade. Except for retirement. Mutual funds remain the dominant investment within defined contribution savings plans.
Yet 2015 marked the first year in which retirees began pulling more money out of 401(k)s than they invested. This great American pullout isn’t going away as the boomer wave drives rollovers into IRAs and ultimately withdraws required minimum distributions (RMDs).
Is this the moment where retirement ETFs can start making a comeback? The short answer is that ETFs provide modest advantages over mutual funds in IRAs, but they could provide significant advantages in taxable accounts once the government starts forcing boomers to start taking RMD checks. ETFs might also benefit from the continuing movement toward automated, passive investments by American workers.
Let’s review what ETFs are. In order to create an ETF, an investment company buys assets like stocks, bonds, real estate or commodities, and issues shares of the fund to investors. An investor owns a theoretical slice of the aggregate portfolio of assets. Shares of ETFs trade on an exchange just like stocks, and any income or capital gains earned by the ETF are passed to investors and taxed just like direct investments in that asset. Generally ETFs are considered more tax efficient than mutual funds because mutual funds incur more frequent short-term capital gains when fund managers sell assets to meet redemptions.
So why have ETFs lost the defined contribution battle? According to Hollie Fagan, head of BlackRock’s dedicated Registered Investment Advisor Consultant Team, “the mechanics of a 401(k) make it more difficult to allow ETFs into a plan as an investment option versus a mutual fund. There are a lot of issues structurally that have made it difficult for plan sponsors to add ETFs as an investment choice.”
Defined contribution plans continue to support a mutual fund industry that has consistently lost ground to ETFs outside of employer-sponsored plans. Since 2000, the rate of growth in ETF assets has consistently outpaced mutual funds. Assets poured into ETFs during the 2000s and inflows continue to favor ETFs over traditional mutual funds. Despite a higher rate of growth, however, investments in ETFs were still only 12% of mutual fund assets in 2014.
The trillions of dollars in employer plans won’t stay there forever. Each year, hundreds of billions will make their way into investment accounts in which ETF strategies are becoming mainstream.
Despite marginal advantages over the best passive index mutual funds, ETFs are a generally more efficient fund structure that allows investors to trade during the day and avoid some of the expense drag. In addition, ETFs are the preferred investment of advisors using contemporary wealth management tactics that focus on creating a core of passively managed assets and an overlay of alpha-seeking strategies.
Fagan sees an emerging trend among investment advisors who rely heavily on ETFs when building client portfolios. “If you look at the industry flows in the past three or five years, you see the increasing use of a barbell type of approach in which investors and financial advisors are no longer willing to pay high fees for beta returns.”
Instead, advisors view market returns as a commodity, and ETFs are the most efficient way to gain access to broad financial indexes. “People have a risk budget, and they have a fee budget,” notes Fagan. “When they’re constructing a portfolio, they’re no longer willing to use the fee budget and the risk budget on closet indexers.”
While ETFs dominate on one end of the barbell, at the other end are investments held specifically to improve the risk/return characteristics of the portfolio. These may include more active strategies by managers who are less constrained by traditional style boxes in order to provide an edge over passive market strategies. A barbell provides the highest risk-adjusted return from both active and passive strategies, and the passive money is held in ETFs.
In addition to asset allocation strategies, ETFs can be useful in locating investments within taxable and tax-sheltered accounts. In general, higher-yield corporate bond ETFs are tax disadvantaged and well suited to IRA accounts. In taxable investments, ETFs are less likely to incur short-term capital gains taxes of up to 43.4% than mutual funds — particularly mutual funds that have higher turnover.
“In a taxable account, the advantage of an ETF would be its low cost,” Fagan points out. “If you look at the S&P 500, the iShares S&P is 1/6th the cost of the average style box mutual fund. If you look at that same fund, it has outperformed 87% of actively managed mutual funds over the past 10 years.”
The benefit of ETFs over mutual funds in taxable accounts may be somewhat overstated, mainly because passive index mutual funds have low turnover and create few short-term capital gains. According the David Blanchett, head of retirement research at Morningstar, “ETFs obviously cost less than all mutual funds (viewed collectively), but that’s more of a comparison of active/passive than passive/passive. When doing the passive/passive comparison (index mutual funds versus ETFs), there really isn’t much difference.”
On the aggregate, however, ETFs provide a tax efficient diversified portfolio in taxable accounts that can serve as the core risky investment allocation within a retiree’s portfolio. If you want to maintain a 50/50 portfolio, invest in equity ETFs within taxable accounts and bond funds and alpha-seeking, higher turnover investments in tax-sheltered accounts.