ETFs More Cost Effective Than Index Mutual Funds

Invest n Retire, LLC has been a big proponent of using exchange-traded funds (ETFs) in defined contribution (DC) plans, and now it has data to support its stance.

Neil Plein, vice president of Invest n Retire, LLC, told PLANADVISER there is a lot of pushback for using ETFs in DC plans. Plein says some people think there is no need to use ETFs instead of index mutual funds because costs are the same.  

Invest n Retire told plan fiduciaries that index funds do not compete with ETFs, but there was no real study to compare the costs.

Invest n Retire therefore conducted a study and found—for the majority of plans—they would be better off using ETFs than index mutual funds because ETFs offer substantially lower costs. Plein says this is an important finding with fee disclosure requirements coming into effect and the requirement that plan sponsors use investment options that have reasonable fees. The findings offer incentive for sponsors to look into using ETFs as an option.

Invest n Retire has approximately 25 investment managers across the U.S. that have analyzed retirement plans to prepare proposals, so there are thousands of these plan analyses in its system. Ninety-two plans from across the country were chosen at random, and with their permission, Invest n Retire analyzed the cost of their investments using data from Form 5500s and plan audit reports.  

According to a report Plein wrote about the study, the expected decrease in pricing was observed as a function of plan size. For the micro plan market (less than $5 million in assets, the largest pool of plans studied), the average cost of an index mutual fund was 52 basis points (0.52%). For the small plan market ($5 million to $50 million), the average cost was 36 basis points, for the mid-size plan market ($50 million to $200 million), the average cost was 24 basis points, and for the large market (more than $200 million), the cost was 12 basis points.  

By taking the five major indexed asset classes from the study and the respective ETFs for each class from the three major service providers, an average cost of 18 basis points (0.18%) can be established. Given that ETFs do not have multiple share classes or minimum asset levels for investment, the expense ratio of ETFs for retirement plans would be the same regardless of plan size. At this rate, index mutual funds only become truly competitive in the large plan market ($200+ million in assets).  

Invest n Retire used the same asset level breakpoints used by PLANSPONSOR Magazine in its 2011 DC Plan Survey. The PLANSPONSOR data shows that the overwhelming number of plans (88%) in the U.S. has less than $200 million in assets.

So why are ETFs more cost effective? Plein says the main reasons are: 1) ETFs are traded in the open market throughout the day like a stock, whereas a mutual fund must be traded through an investment company; there are higher costs associated with exchanging a fund via a company compared to exchanging a fund through an exchange; and 2) ETFs have a lower turnover ratio than mutual funds; the way ETFs are constructed, participants are only paying the cost of the day, whereas mutual fund investors have to pay trading costs with each turnover of fund.  

“ETFs are really maximizing the cost effectiveness in every aspect of their design,” Plein adds.  

He concludes that while plan sponsors are in the position of closely looking at expenses and making sure investment costs are reasonable, they should take a serious look at using ETFs.  

“We are really big proponents of helping the average participant, and ETFs are a good way to do that,” Plein says. “They [ETFs] are waiting for their breakout in retirement plans, and we’re hoping with fee disclosure, now will be the time sponsors will look at ETFs as a way to lower costs and increase outcomes for participants.”  

The full report is here.