Exchange-Traded Funds - Future Funds?

Although continuing to garner billions of dollars in assets from individual investors, exchange-traded funds (ETFs) are the new kid on the block of 401(k) investment options. Touted as a lower-cost way to provide passive, indexed investment options to participants, ETFs have garnered a lot of interest in recent years, while still failing to really take off. Part of the reason, say experts, is unfamiliarity with ETFs by advisers, including the following misunderstandings:

Every 401(k) provider can offer exchange-traded funds as an option.

Many recordkeepers claim they can provide ETFs as a 401(k) investment option, but the reality is that ETFs are really not on every recordkeeper’s platform. Many providers claim they can offer ETFs, but what they really do is only provide them to participants through a self-directed brokerage window, says Darwin Abrahamson, the Chief Executive Officer of Invest n Retire LLC in Portland, Oregon, a recordkeeper of 401(k)s using ETFs. So, although technically ETFs are available in many plans, he says, using the brokerage window is an expensive option and not really available to everyone. The provider can provide ETFs, but it is very expensive to do so, and the participant would need a self-directed brokerage account, he says.

Therefore, asking a provider if ETFs are available is not enough, says Abrahamson. If a plan is interested in providing ETFs to its participants as part of the plan lineup, advisers should be asking if ETFs are available without participants having to have a self-directed brokerage window, he suggests. A few recordkeepers are able to process ETFs directly, says Abrahamson, while other recordkeepers depend on their custodian to offer ETFs.

On the opposite end of the spectrum, many advisers still are not aware that ETFs are available for retirement plans, says Jason Katz, the Managing Director with UBS Private Wealth Management in New York. For example, advisers who are not 401(k) specialists, he says, are usually unaware that ETFs are even at their disposal and think that mutual funds are the only available investment option for 401(k) plans.

ETFs are always the lowest-cost solution.

“Just because it’s an ETF does not mean that it’s cheaper especially when it comes to qualified plans,” says Steven Kaye, the President of American Economic Planning Group in Warren, New Jersey. Some ETF providers charge more for third-party administrator/wrap fees than can be obtained from third-party administrators with index funds, says Kaye.

Many recordkeepers add costs that can defeat the low cost of the ETF, agrees Abrahamson. For example, he says, one ETF fund group has an agreement with a provider to make its fund family available to 401(k) plan participants, but the provider adds a custodial fee for having the ETFs on its platform. By the time that cost is added on, he says, the ETFs are more expensive than many of the mutual funds offered on the platform. Another way the costs can add up is by putting wrappers around ETF products, such as using them inside a mutual fund or collective trust.

Therefore, if a platform does make ETFs available to participants, says Abrahamson, advisers should check out the total fees on the ETF package. Often, he says, the added fees defeat the ETFs’ low costs and makes them just as expensive, if not more expensive, than the mutual fund index funds.

Additionally, while typically ETFs have lower expense ratios to index mutual funds, that is not always true, says Aldo Vultaggio, an Assistant Portfolio Manager with American Economic Planning Group, Inc., in Warren, New Jersey. Some index mutual fund families offer institutional share classes at lower expense ratios than ETFs. “People automatically think that ETFs are cheaper than mutual funds in all cases,” says Kaye, “but that is not necessarily true in defined contribution plans where you can pool funds to access institutional share classes.”

For example, says Vultaggio, Vanguards’ S&P ETF is available for 7 basis points, but the institutional share class for its similar mutual fund index fund is available for 4.5 basis points for a minimum of $100 million and 6 basis points for a minimum of $5 million. That same index fund is available for 2.5 basis points for a $200 million minimum. Sponsors may need to keep a minimum in the fund to access those institutional share classes, but it is usually not difficult for 401(k) plans with more than $30 million in plan assets to get institutional share-class pricing for a U.S. large-cap stock fund, an international large-cap stock fund, or a Total Bond Market fund (i.e., funds where you typically see 15%+ of a plan’s assets invested), he says. Advisers, says Kaye, should always check to see whether mutual fund institutional share classes are available, and whether they are cheaper than ETFs.

ETFs provide participants with the ability to trade their funds throughout the day, versus only once a day with mutual funds.

Many advisers have the misconception that, if ETFs are in the plan, participants can trade them throughout the day. Most third-party administrator/recordkeeping platforms that support ETFs, however, typically only support trading once a day, similar to mutual funds, says Kaye. Typically, they use block trades at the end of the day, says Vultaggio, so, effectively, participants can only get into and out of an ETF once a day. The only exception is if the plan allows for self-directed brokerage accounts for participants.

All ETFs are created equal.

MMany advisers throw all ETFs into the same category and think they are pretty much generic, says Abrahamson. The truth is that, like mutual funds, there are good, bad, and mediocre ETFs, he says. With the explosion in growth in ETFs in the last few years, he says, there are more mediocre and bad ETFs.

Some fund providers have many years of indexing experience and currently have substantial assets under management in all their ETF fund products, says Kaye. Other ETF providers have only been in the business a few years, do not have a long track record of indexing experience, and do not offer funds with more than $100 million, he says. ETF fund products with less than $100 million typically end up closing in a few years, he adds.

Additionally, many advisers feel that all ETFs are equal because of trading costs to the participant, says Abrahamson. However, he says, advisers should be looking at how each provider trades and what costs they are charging to trade. “Advisers also often have the perception that trading costs are treated like a commission device, but that depends on the platform. In our case, it is strictly a fee-based solution,” says Katz.

Another myth held by advisers is that ETFs that track the same index are exactly the same (other than their expense ratios). “Advisers think that an index fund is an index fund is an index fund,” says Kaye. This is not true, he says, as some ETFs employ “representative sampling,” which replicates the index with a large sample of the index’s holdings, versus “full replication” ETFs that replicate the index by having every single holding in the index. This could affect performance. Representative samples are good, says Vultaggio, but do not have every single stock in the index, and this can lead to trading errors.

There is also a misperception that all ETFs are managed passively. This also is not always true. Some ETFs are managed actively, and others employ enhanced index strategies, says Kaye; some use derivatives and some even employ leverage to achieve a particular return objective.

ETF share prices always trade at the net asset value of the underlying holdings of the fund.

ETF share prices will trend toward net asset value (NAV), but this is not always true, says Kaye. In reality, share prices of an ETF can trade slightly above (premium) or below (discount) their NAV. This is particularly true if the ETF’s underlying holdings are not very liquid, says Kaye, and/or if the shares of the actual ETF trade at a relatively low volume throughout the day. Discounts are not too much of an issue with standard ETFs, such as on a large-cap fund where there is strong demand, he says, but can be problematic in some of the more exotic ETF offerings.

—Elayne Robertson Demby