Neither offering is new to the marketplace. Exchange-traded funds, or ETFs, as they are called, have been available since the early 1990s (see About ETFs). Yet, in recent weeks, a plethora of new offerings have either come to market, or come to light: State Street (an exchange-traded fund family that tracks developed and emerging-market stocks outside the U.S.), Vanguard (four bond ETFs), XTF (two offerings—one a sector rotation, the other a country rotation portfolio), Deutsche Bank and PowerShares Capital Management LLC (seven commodity-sector ETFs), and First Trust Advisors (an ETF that tracks the NASDAQ Clean Edge U.S. Liquid Series Index)—and that’s just a partial list of January’s introductions. Meanwhile, SSgA has rebranded its ETFs, ending the streetTRACKS label and consolidating under the SPDR brand.
At the same time, lifecycle funds—those target-date-based asset allocation offerings—are clearly the hottest investment ticket in the market, and that was before the Department of Labor affixed its sanction of the date-based design as an effective default investment alternative (see “Instruction Manual,” PLANSPONSOR, November 2006).
Still, if target-date funds have found a warm reception in the 401(k) market—in short order leaving their older lifestyle fund cousins, offerings based on an assessment of individual risk tolerance—ETFs have proven to be a slower sell, until now.
Slow To Start
Early on, ETFs appeared to offer greater trading flexibility than most mutual funds (they trade during the day, not just at the market close), were cheaper (an advantage that admittedly could be offset by higher transactional trading costs), and they were not tainted by the scandals that plagued the mutual fund industry. Moreover, they offered some innovative investment packaging—the ability to invest in a NASDAQ index, for example, or even gold. However, none of that seemed to make much impression on plan sponsors or retirement plan participants accustomed to the trading patterns and characteristics of mutual funds, despite the pioneering work of a handful of firms in the space.
Stephan Roche, Vice President and General Manager, Small Business Group, at ShareBuilder, which offers an ETF-option 401(k) program, recalls a conversation with a potential client in the state of Washington that sums up the challenge. The plan sponsor said it would be sticking with a more traditional path in its 401(k) since participants had indicated that they wanted access to traditional mutual funds. “It’s going to be very difficult for the industry to adopt ETF-based plans,” Roche says.
However, a shift could be under way already, says Michael Woods, Chief Executive Officer, XTF, which already has about $25 million in the Target Date ETF family the firm launched in October. “I think it’s right on the cusp. I think it’s a paradigm shift. [By the end of 2007,] I’d be surprised if we don’t have 30% to 50% of 401(k) plans with ETF fund options.” XTF’s October launch mirrored a series of recent ETF launch initiatives at Seligman, Two Rivers Capital Management, ShareBuilder, and 401kDesign.
“Early adopter” plan sponsors are just now beginning to appreciate the value of having ETF offerings in their 401(k) programs—particularly when those ETFs are built on a lifecycle/risk-based orientation, concedes ShareBuilder’s Roche.
The Push from PPA
Also fueling the enthusiasm, according to some, is the Pension Protection Act (PPA). Charles Kadlec, a Managing Director of J. & W. Seligman & Co. and President of Seligman Advisors, believes that, without the PPA, it would have taken five years to have any significant ETF take-up. However, with that in place—more specifically, the target-date orientation of the Department of Labor’s current default investment alternative proposal—Kadlec predicts a 12- to 24-month timeline.
Since the PPA’s passage last summer, Kadlec said his company has had 70 plans choose an ETF as a default choice. Last October, Seligman added two lifecycle ETFs to the three it kicked off a year earlier. Kadlec said the target-date ETFs now have about $115 million in assets—about 40% of which is from retirement plans (the rest from IRAs).
Roche says that the notion that ETFs give you a certain amount of ready-made asset allocation is part of an overall strategic shift in retirement plan focus. “What we want to do,” Roche says, “is take the participant out of the decisionmaking process.” The growth of lifecycle funds and managed accounts is part of this trend. Taken together, Roche labels this the “golden era of 401(k) plans.’
Kadlec sees the impact of the PPA on ETF 401(k) plans as one of officially endorsing the notion that retirement savers have more to be concerned about than just market risk; they also have to make sure they have enough on which they can live in retirement. Says Kadlec: “That is a dramatic and extraordinary shift in the way people think about managing risk in 401(k)s. It’s got people asking “Well, how do you do that?’—and that has people focusing on lifecycle funds.’
“Currently, vendors are using actively managed mutual funds, which can carry expense ratios near 100 bps, to create an acceptable asset allocation depending on retirement date. Using ETFs to create that same allocation can provide a much more cost-efficient lifecycle fund,’ notes Patrick J. Morrell, Lead Investment Analyst at Capistrano Beach, California-based National Retirement Partners. Acknowledging the potential cost savings of the structure, Troy Hammond, President of AmeriFlex Financial Services, cautions, “The proof will be in the pudding. After these portfolios have a significant track record, we can analyze them as we would any other type of investment—on a true cost/benefit basis.’
Ironically, in view of the dollars involved, ETF-based 401(k) programs have taken root first among smaller employers. Consider that ShareBuilder’s focus is the micro market, plans with fewer than 50 employees—not for want of trying to extend the appeal up market. Darwin Abrahamson‚ Founder and CEO of Portland, Oregon-based Invest n Retire, claims that a growing concern about revenue-sharing lawsuits (see “Share Alike,’ PLANSPONSOR, January 2007) and a looming expansion of fee disclosures to regulators are prodding a new level of interest in the ETF model. However, Abrahamson, whose firm now offers access to a half-dozen ETF family offerings, eschews the lifecycle fund packaging in favor of a more individually customized approach.
It is not clear that plan sponsors will abandon their mutual fund menus soon, but it seems likely that, simply by creating an alternative, ETFs have the potential to alter the debate, if not the dynamics. Roche contends that the macro-level legacy of ETF 401(k) plans may not be an industrywide acceptance of the approach, so much as how their existence and viability may pressure mutual fund companies on fees.
In fact, concerns linger about the relative performance of index-centric ETFs compared with more active approaches. Moreover, Henry Schwarzberg, Chief Investment Officer, InterServ LLC, cautions that some fund companies have created lifestyle/lifecycle funds with ETFs with expense ratios that “range from more than 2.5% to as much as 3.8%.
“That’s worse than an overpriced index fund,’ he cautions. “It might even be deemed by some as unconscionable.