ETFs Find DC Entry via TDFs

Art by Kevin Hong

Despite being known as a low-cost investment—offering access to many different investment classes and styles—exchange-traded funds (ETFs) have struggled for years to enter defined contribution (DC) retirement plan lineups.

According to 2015 data from Cerulli, mutual funds continue to be the most common investment vehicle in 401(k) plans, with collective trusts a distant second. ETFs make up just a fraction of a percent (0.02%) of the investment vehicles used in 401(k)s.

One reason ETFs have failed to catch on in the DC market is their intraday trading is incompatible with most defined contribution plan recordkeeping systems, which were built to accommodate mutual funds, or similar investment vehicles. Mutual funds trade once per day and are pooled along with other investors’ trades. ETFs can be traded intraday, have fractional shares and, therefore, are more liquid.

“In order for folks to adapt to ETFs now, they have to trade after market or with some kind of roll-up activity, which drives up costs and takes away the benefit of ETFs,” says Bob Ward, chief revenue officer for Vertical Management Systems, in Pasadena, California.

However, ETFs may have finally found their point of entry into the DC market, says Matt Cirillo, senior analyst, retirement, at Strategic Insight in Boston. ETFs are slowly gaining traction as underlying investments within other vehicles, such as target-date mutual funds (TDFs). Cirillo says the trend has been building for the last six to eight years. Some analysts credit the cost advantages.

According to Strategic Insight data, among the top five TDF providers, only one uses ETFs as underlying investments, but, among all 39 TDF providers analyzed, 17 now do so. Still, Cirillo notes, ETFs account for only approximately 2% of the $861 billion TDF market.

Cirillo says newer entrants and smaller managers are significantly more likely to include ETFs in their TDF funds, in trying to combat the scale of larger managers. Using ETFs in this way has not caught on with established retirement plan investment providers, however, as they have the capacity to create their own indexed funds and utilize them for core asset classes.

Rather, the use of ETFs is a play by providers, in a down market, to get into the space and capitalize on efficiencies in larger asset classes that have less appeal to active managers, Cirillo says. Consequently, the funds are being used in building core portfolios, with 63% of ETF assets in TDFs distributed across three broad categories: intermediate-term bond, large blend and foreign large blend.

“To a large extent, the focus on these three categories is that, even when using indexed funds, TDFs use these three categories as foundations, or building blocks,” Cirillo says. “Those categories provide fewer advantages with active management than some of the more ancillary categories where there may be fewer efficiencies in the market and a great opportunity to take advantage of active management.”

Why Use ETFs?
Stadion Money Management Senior Vice President and National Sales Manager Tim McCabe, based in Abbotts, Georgia, explains that ETF trading is wrapped inside the target-date fund. At the end of the day, the trustee inputs the trades as a group. “With a standalone ETF, it can’t do that without a wrapper such as a TDF, collective investment trust [CIT] or managed account,” he says. Stadion Money Management uses all exchange-traded funds within a CIT structure for its target-date funds, to keep costs low.

Jake Gilliam, senior multi-asset-class portfolio strategist for Charles Schwab Investment Management in Richfield, Ohio, says its TDF product that employs ETFs is in a mutual fund structure—something defined contribution plan advisers and plan sponsors will recognize well. “Using ETFs within the TDF, we can trade ETFs in a function similar to mutual funds; the way our funds trade and will be priced is the same as [with] mutual funds, priced at the end of the day,” he says. “The portfolio manager’s trading process will follow what [that manager does] on other products. To the participants, it will look and feel like another TDF but with lower costs.”

Gilliam says Schwab’s use of ETFs allows it to provide defined contribution retirement plans with a fully diversified investment solution as well as lower costs. Its recently launched TDFs offer 8 basis points (bps) with no minimum investment.

“In the long run, [using the funds] helps managers keep costs and expenses down,” Cirillo says. “It benefits long-term returns for participants. Using lower-cost funds for larger asset classes in portfolios drives costs down.”

Gillam points out that Schwab’s ETF asset class exposure is more specific than broader categories—for example, it offers particular asset classes within U.S. equities such as large cap, small cap and real estate. Internationally, the funds offer emerging market, as well as broad, international countries.

Schwab’s glide path is also something the investment company believes adds value. “We don’t just move to a stock-to-bond mix over time, but, within each asset class, we move to lower-risk investments,” Gilliam says. “We are able to do so at a low cost.” He adds that providing ETFs in TDFs is a way to employ the power of the value of ETFs in a format familiar to defined contribution plan advisers and sponsors.

However, McCabe says, whether using exchange-traded funds in TDFs benefits shareholders depends on the TDF provider. “Our institutional, zero-revenue-share TDFs come in at 29 bps—which includes the cost of underlying ETFs and CITs—but different share classes have different costs, so ETFs don’t necessarily reduce costs,” he notes.

Still, McCabe says, advisers should consider TDFs with underlying ETF investments because they are able to access different areas of the market very inexpensively and they have no individual security risk—like investing, for example, in Coca-Cola. “I think we will see more and more managers using ETFs in TDFs because of the cost advantages,” he concludes.

Gilliam says an adviser’s first conversation with a DC plan sponsor client about using TDFs with underlying ETF investments should discuss active vs. passive management. “Industrywide, plan sponsors want costs down,” he says. “Going to a passive solution using ETFs allows efficient exposure to broad asset classes and lower costs.”

The desire to reduce investment costs has been driven by the increase in defined contribution plan excessive fee suits over the past decade or so. The lawsuits have been increasing since the Department of Labor (DOL) issued fee disclosure regulations in 2012.

But, Cirillo says, “keep in mind, ETFs are still a very small percentage of TDF assets overall. Unless some of the larger players decide to utilize ETFs in some of their series, it’s going to be a long road ahead for ETFs in this market.”

KEY TAKEAWAYS:

• ETFs have not gained traction in defined contribution plans because their intraday trading is incompatible with most recordkeeping systems.
• However, a handful of TDFs, mostly new entrants and smaller managers, are investing in ETFs to lower costs.
• TDFs using ETFs are also looking for specific asset classes within categories.