Inside: Exchange Traded Funds

Exchange-traded funds, or ETFs, appear to be enjoying a resurgence in popularity among 401(k) providers.

Exchange-traded funds, or ETFs, appear to be enjoying a resurgence in popularity among 401(k) providers.

ETFs have long appeared to have a bright future among retirement plans. In fact, considering their relatively low expense ratios, their index composition, and a growing concern with mutual fund investments (revenue sharing concerns, the mutual fund trading scandal, and an overall concern with fees), many are surprised that it has taken so long for the offerings to gain traction in the retirement plan space.

Not that there haven’t been legitimate concerns with ETFs on a retirement plan menu. Their valuation and liquidity cycles are different than mutual funds, and while they have lower expense ratios, they have trading costs which, depending on the size of the trade, can greatly diminish, if not obviate totally, that advantage. ETF proponents have focused on, and in many cases, remedied, these potential shortcomings – and enhanced participant communications materials, largely to no significant avail in terms of market impact.

Why then the sudden renewed interest? Quite simply, the growing popularity of lifecycle funds, which can offers a participant-friendly packaging of the offering, appears to be positioning ETFs in a new light.

What ARE ETFs?

An exchange-traded fund looks like a mutual fund, but trades like a single stock. Like a mutual fund, an ETF is a basket of stocks, most typically reflecting a particular index (like the S&P 500 or Dow Jones Industrial), or-more recently-specific market or geographic sectors.

First, let’s establish what ETFs, are not: They are not mutual funds, though they are registered funds with the Securities and Exchange Commission under the 1940 Investment Company Act. Secondly, they are not exactly new, having been with us in some form or other for more than a decade now.

Trading ETFs

While most mutual funds trading occurs at the fund’s NAV (net asset value) at 4:00 p.m. daily, an ETF–like a stock-is priced in real time throughout the trading day.

Like stocks, ETFs also can be bought on margin, and sold short. ETFs also typically have expense ratios that are a fraction of the expenses associated even with index mutual funds.

However, this brings with it some disadvantages as well. Every ETF trade-including reinvestments-triggers a brokerage commission, varying by size and amount, depending on the selected broker – just like a stock.

Additionally, there may be differences in the price at which you initiate a trade request, and the actual execution price. An increasingly common practice among 401(k) platforms using ETFs is to maintain an omnibus holding, and to use that account to net buys/sells of individual plans. This structure minimizes the need to maintain a large liquidity buffer, and also allows the placing of a single trade for the platform, greatly reducing transaction costs. This can also facilitate a trading cycle comparable to mutual funds, which generally settle in one day versus three days that ETF investors must typically wait to get the proceeds of selling the investment (again, just like stocks).