A Closer Look at ETF Fees

Marty Schmidt works with plan sponsors submitting requests for proposals (RFPs) to find new recordkeepers, so he gets a clear, inside view of what products and services most interest sponsors. For now, the principal at Chicago-based consultant HS2 ­Solutions Inc. says his sponsor clients are curious about exchange-traded funds (ETFs)—but not enough to offer them as an investment. In fact, across all plan sizes, only 1% of all defined contribution (DC) plans have put the funds on their plan investment lineup, according to the 2011 ­PLANSPONSOR DC Survey.

Still, with so much industry focus on 401(k) fees, Schmidt sees the potential for ETFs. “The main reason that a plan sponsor would add [them] is, No. 1, probably the low cost,” Schmidt says. “Then there are the expanded asset classes.” He expects the funds initially to come into play in self-directed brokerage windows.

Some providers already see a market for exchange-traded funds in 401(k) plans. ShareBuilder 401k offers an all-ETF 401(k), and TD Ameritrade Trust Co. has added them as a 401(k) option. About 8% of TD Ameritrade Trust’s plan clients currently employ them, usually along with mutual funds, President Skip Schweiss says.

Charles Schwab Corp. looks to late 2013 to launch its all-ETF 401(k) option, says Dave Gray, vice president of client experience. Schwab is talking to clients about it, he says, but is waiting until the offering has launched to sign on a plan.

“ETFs have the potential to shake up the 401(k) space,” says Brooks Herman, head of research at BrightScope Inc., a San Diego-based financial information company. “The question is whether the adoption is going to be that quick.” ETFs have yet to make much progress in the 401(k) market, he says, attributing that to factors including plans’ relatively slow adoption of new features, as well as the sense that key ETF advantages in the retail market—namely, allowing intraday trading and providing more tax efficiencies—translate poorly in the 401(k) world.

Still, the issue of fees merits giving the funds a look. The two biggest factors guiding a 401(k) investor’s success are his answers to the questions: “How much money am I putting aside?” and “Am I controlling expenses?,” Schweiss says. The desire to address the second point has motivated some sponsors to add ETFs, he says.

“When you look at long-term performance, typically the low-expense funds beat the high-expense funds,” says Stuart Robertson, president of ShareBuilder 401k. “In general, costs are the driver of performance.”

Schwab’s Gray is asked about the potential expense-ratio savings for 401(k) participants. “When we look at mutual fund lineups versus an all-ETF lineup, we think the weighted average [for ETFs] can be five basis points lower, down to about 15 basis points on average,” he says. “In our all-index mutual fund lineups, the average is closer to 20 basis points.” The weighted-average figure looks at all asset classes traditionally used in a 401(k) plan, he says.

ShareBuilder 401k’s paper “Exchange-Traded Funds: A Great Fit for 401(k) Plans” provides some data about investment fees. Among large-cap equity, for example, expense ratios run 1.14% for average active mutual funds, 48 basis points for average index mutual funds and 10 basis points for the ShareBuilder ETF, ShareBuilder says.

However, for large plans, the potential to substantially lower expense ratios may not exist. “There has been a move within investment lineups from active to passive strategies, and to index funds,” Schmidt says. “And there has been a move from mutual funds to collective trusts and separate accounts, especially in large plans. That combination has started to have some downward pressure on fees.”

Exchange-traded funds will not always be the cheapest investments, particularly for large plans, Herman says. “But if we look at small plans, with $10 million and less in assets, their 401(k) plans might be dominated by an insurance product, and those expenses can be quite high,” he says. “For small plans, using ETFs can have a substantial savings.”

Spreads and Transaction Costs 

Exchange-traded fund costs differ from mutual funds in some ways, such as the possibility of bid/ask spreads.

“One of the things that would make ETFs move forward in 401(k) plans is that, with index funds, you have a limited universe,” Schmidt says. “What ETFs bring to the table is more specialized investment offerings.” But when an exchange-traded fund trades intraday, it can have a bid/ask spread, particularly on more thinly traded funds. So a participant putting in a trade order during the day might end up with a different price from what he thought.

“There are issues of execution,” agrees Greg Carpenter, chairman and CEO of Mobile, Alabama-based Employee Fiduciary Corp. “Are you getting the exact price you thought, or are you getting some market spread?”

Schwab will allow for intraday participant ETF trading—“unlike some other folks who have introduced [a 401(k) ETF] offering in the market,” Gray says. He acknowledges the potential for a bid/ask spread and says that Schwab intends to make only highly liquid exchange-traded funds available for 401(k) plans. “That is exactly the reason why we are not looking to have any niche ETFs—the spread can be wide,” he says.

Schwab plans to have 19 investment options in the exchange-traded fund version of Schwab Index Advantage. These include intermediate government bonds, corporate bonds and inflation-protected bonds; value, blend and growth options each for domestic large-cap, mid-cap and small-cap equity, as well as foreign large-cap equity; foreign small-cap/mid-cap growth equity; emerging market equity; and real estate. In addition, Schwab Bank Savings, an FDIC-insured deposit feature, will serve as the capital preservation option.

Robertson says ShareBuilder 401k works to minimize the spread for participants by offering ETFs that have a large trading volume and market capitalization, along with typical bid/ask spreads of no more than one to two cents per share. “If that is a concern, the adviser should be talking to the plan sponsor about picking ETFs with significant trading volume,” Schweiss says. “I do not know that someone needs an exotic, thinly traded ETF on their core menu.”

Advisers also should know whether an ETF carries a transaction cost. The investment expense ratios compare very favorably with mutual funds, Carpenter says, but, as with stocks, buying or selling exchange-traded funds normally incurs a transaction cost. “All mutual funds traded in 401(k)s are fee-waived, and participants do not have load fees, so moving in and out of them is really easy,” Carpenter says. “An ETF has to trade on an exchange, and the brokers trading it take a fee. That commission puts it at a disadvantage to a mutual fund.”

But the newer wave of ETF 401(k) offerings may come without transaction fees. ShareBuilder does not charge for them, Robertson says, since it does the trades in-house rather than through an external broker. “We only allow folks to move in and out of ETFs and do our trades once a day, similar to a mutual fund,” he says. “We aggregate all the participant trades per ETF as one order, so it is not the same cost [as] if all the trades were being filled throughout the day.”

Likewise, TD Ameritrade processes ETF trades for 401(k) clients without a transaction fee, Schweiss says, since the firm can execute the trades internally. It rolls trades up to the end of the day, he says, which allows for better execution and can save money.

Schwab, when it launches its all-ETF offering, “will do it in a no-commission approach,” Gray says, and will execute the trades internally. Many ETFs it plans to use do not have commissions, he says, and Schwab will waive any for funds that normally have one.

Handling Administrative Expenses  

Also, keep in mind that exchange-traded funds include no revenue sharing. “You have to charge separately for your administrative and recordkeeping services,” Carpenter says. “There is not going to be any subsidy from the investment.”

That can pose an obvious challenge for sponsors. But ultimately, Herman believes, it will help in that “it is going to be more transparent and less obtuse for participants.” Carpenter likes the fact that an exchange-traded fund levels the playing field in full fee disclosure.

“It is much more of a pure fee-for-service approach,” says Gray.

As Schwab readies its all-ETF offering, he says, “It is our goal to be in the market with as little administrative expense as possible—and, in many cases, [with] no administrative expense.”

Without revenue sharing, sponsors can pay the administrative fee out of plan assets or pass it along to participants. Employee Fiduciary works with numerous startup plans as well as micro-market plans that typically have 20 to 25 employees and $500,000 to $1 million in assets—the type of plans that may see the biggest investment-fee savings from adding exchange-traded funds. “With 90% to 95% of our plans, the plan sponsor pays our fees,” he says, explaining that a company’s owner/operator often takes on the plan sponsor role. “The trustee of the plan has a significant stake in the 401(k). And any fees they pay are tax-deductible for the company, if they pay them out of their own treasury.”