Consensus can’t be reached on ETFs’ role in 401(k)s

Retirement plan advisers, analysts and executives can’t seem to reach consensus on the place of exchange-traded funds in 401(k)s. Proponents point mainly to the cost benefits of using ETFs as core investments on a 401(k) menu, especially for smaller plans, which typically aren’t able to negotiate investment management fees as low as their large-market counterparts.

Naysayers, however, say index mutual funds and collective investment trust funds have comparable fees, and that the structural advantages ETF investors enjoy in the retail market are lost in a 401(k) setting. They also question intraday trading in a long-term retirement vehicle meant for buy-and-hold investors.

The common ground for the two factions, though, is the expectation that ETF penetration would be a very long-term, perhaps multidecade, proposition.

At this point, ETF use can only go up. ETFs make up less than half a percent of the investment vehicles used in 401(k) plans, according to Cerulli Associates. The exposure that does exist isn’t in the major 401(k) asset classes, but instead negligible amounts in sector funds, emerging markets and company stock, for example, according to the Plan Sponsor Council of America.

Most participants can get ETF exposure through a retail brokerage window, or indirectly through underlying fund holdings, advisers say. In those contexts, many agree ETFs make sense. But as stand-alone funds, opinions vary widely.

BOOM TIME FOR ETFS

“It’s going to be a long time, if ever, before ETFs get a lot of traction in 401(k)s,” said Jon Chambers, managing director at registered investment adviser SageView Advisory Group.

Outside 401(k) plans, ETFs have swelled in popularity. Net issuance of 1940 Act ETF shares ballooned 175% from 2009 to 2014, catapulting to $242 billion last year, according to the Investment Company Institute. Assets in “40 Act ETFs stood at $1.9 trillion at the end of 2014, up from $703 billion five years earlier.

The likes of Betterment and Charles Schwab Corp. have staked positions in the 401(k) market to attempt to capitalize on the boom.

Betterment, a robo-adviser, recently announced its intent to launch an all-ETF record-keeping platform, called Betterment for Business, to be rolled out in the first quarter of 2016. Schwab Retirement Plan Services Inc. launched its Schwab Index Advantage 401(k) ETF platform in February 2014, following a few years of anticipation.

The technology represents a vast departure from the platforms developed by some of the most prominent record keepers, such as Fidelity Investments, TIAA-CREF and The Vanguard Group Inc., which are tailored to the daily pricing of mutual funds rather than intraday pricing of ETFs.

Further, the ETF-based technology accounts for the fact that ETFs trade in whole shares; mutual funds, on the other hand, can be purchased in fractional shares, which fits well with the way participants contribute to a retirement plan.

“The robo-adviser industry is helping a lot of this, because a lot of the robo technology is overwhelmingly ETF-based,” said Chris Karam, chief investment officer at Sheridan Road Financial.

Although the 401(k) market tends to be slow to adopt new features, Steve Anderson, president of Schwab Retirement Plan Services, thinks the ETF concept will catch on.

The present-day market sentiment is similar to that in the late 1980s and early 1990s, when most plans were serviced by banks offering investment options with quarterly valuation and little transparency, Mr. Anderson said. Providers transitioned to daily valuation around that time, and mutual funds, which represented only 8% of 401(k) assets in 1989, grew to take a 45% share in a little over a decade.

Mutual funds made up $2.9 trillion, or 63%, of the total $4.6 trillion in 401(k) plans in 2014.

“When that happened there was a lot of noise from plan sponsors and consultants saying, “Why do we need to create access on a daily basis to 401(k) plans?’ There was a lot of push-back,” Mr. Anderson said. “We see moving to ETFs as maybe the next step.”

Some advisers also expect them to catch on.

“I think it will gain in popularity,” Mr. Karam said. “I think you’ll have advisers build their business models around something like this.”

“It will take those advisers who are already committed to an all-ETF solution in their portfolio management philosophy and [would] apply that to a 401(k) plan sponsor,” he said.

MAIN SELLING POINT

Supporters tout low cost as a main selling point. ETF economics are more compelling when looking at plans down-market, according to Nathan Voris, director of sponsor and workplace investment solutions at Morningstar Investment Management.

The gap in fund expenses between large and small plans is wide. For example, in 2012, domestic equity mutual funds cost an average 95 basis points, on an asset-weighted basis, in 401(k) plans with less than $1 million. That dipped to 48 bps for plans with at least $1 billion, according to a joint ICI-BrightScope study published last year.

Schwab, which does record keeping for plans with more than $20 million, says its fund cost could be 10 bps or less. The firm offers approximately 80 index ETFs, both proprietary and non-proprietary, covering 26 asset categories.

Apparently, some big plans see the appeal, too. The largest 401(k) sponsor using Schwab’s all-ETF product has $700 million in assets, and there are some others with more than $100 million, Mr. Anderson said.

He declined to say how many have signed on in total. Cerulli Associates data peg it at more than 120 plans.

Based on cost, advisers potentially can differentiate themselves from a fee perspective by using ETFs, Mr. Karam said.

However, detractors say some index mutual funds and collective funds are equally competitive price-wise, or perhaps even less expensive.

“The cost savings argument for ETFs is currently debatable,” said Bridget Bearden, director of retirement research at Strategic Insight.

According to Morningstar data, passively managed open-end mutual funds have an average asset-weighted expense ratio of 8 bps for institutional shares, compared to 27 bps for a passive ETF. ETF expenses do beat passive A-share mutual funds, which average 68 bps.

The average index mutual fund across all 401(k) plan sizes costs 13 bps on an asset-weighted basis, according to the ICI-BrightScope study. Costs range from 11 bps for plans with more than $500 million to 33 bps for plans with less than $1 million.

“If you want to offer cheap, passive investing in DC plans, there’s access to do that,” said Sam Campbell, director of research at Fuse Research Network. “So I think the ETF is much more of a marketing appeal, potentially, than bringing real benefits to the space.”

Dan Egan, Betterment’s director of behavioral finance and investments, thinks ETFs’ fee transparency is the most compelling reason to use them in 401(k)s.

Whereas mutual funds can charge 12b-1 fees and pay revenue sharing to providers as a way to compensate them for plan expenses, ETFs can’t do that from a structural standpoint, he said. These kinds of fees may be “hidden” from participants, Mr. Egan added.

BROADER EXPOSURE

While there’s been a move toward more fee transparency in 401(k) plans, R-share mutual funds accomplish the same thing as ETFs in that regard, said Michelle Rappa, head of defined contribution investment only marketing at Neuberger Berman.

ETFs are often popular among retail investors as a way to get exposure to unique markets. That doesn’t translate well to DC plans, which largely seek out broad exposure to traditional markets, Mr. Campbell said.

The 401(k) vehicle also negates many of the benefits ETFs provide in other settings, critics say.

For example, the tax-efficient nature of ETFs isn’t an added value in 401(k)s, which are already tax-advantaged, according to Ms. Rappa. And the ability to trade in real time is contrary to the long-term nature of 401(k) accounts, others say.

“In a 401(k), are people really trying to nail the intraday price?” asked Joe Ready, director of Wells Fargo Institutional Retirement and Trust.

Mr. Voris disagrees. Access to data such as intraday pricing is one of the allures of ETFs for participants, he said.

“We live in an age of information. If we can have intraday pricing in a DC plan, I don’t think that’s a bad thing,” he said. “If there’s a participant that wants that information, it’s available to them.”

Schwab said 85% of participants in the ETF product are enrolled in a managed-account service offered through the platform, and those who participate that way can’t do intraday trading.

Among the remaining participants, trading activity was slightly lower with ETFs than that seen with mutual funds across Schwab’s other record-keeping platforms in 3Q — 14% vs. 16%, respectively, in terms of the number of participants executing a transaction.

PLATFORMS NOT READY

Betterment’s platform requires that participants stay in a managed account, so they wouldn’t be able to try timing the market, Mr. Egan said.

The majority of big record-keeping platforms are not structured for ETFs, and until that changes, ETFs probably won’t gain much traction in the retirement space, Ms. Rappa said.

Nor do most record-keeping firms have much desire to invest in such a capability, which potentially could cannibalize their proprietary mutual fund business, some argue.

There are only a handful of other parties that have the ability to support ETFs in 401(k)s, namely a few clearing platforms such as SunGard and Matrix, Mr. Campbell said. Those firms don’t have a bundled record-keeping platform like Schwab, for example, but RIAs and third-party administrators theoretically can build an ETF platform for plans that way, he added.

Ultimately, the use of an ETF platform comes down to a plan sponsor’s philosophy and goals. The vehicle is much less important than the overall plan strategy, Mr. Voris said.

For example, ETFs might work well for a plan sponsor looking for broad market exposure across broad asset classes, Mr. Karam said.

However, Mr. Chambers said he advocates for a mix of active and passive management in 401(k) plans, which doesn’t gel with all-passive ETF lineups. “I almost always recommend that they blend them together,” he said.

Mr. Karam echoed that sentiment, saying that for those sponsors looking for the flexibility to use active and index funds, it would be difficult to mix and match on an all-ETF platform.