Hard to Fit
Despite interest by clients, ETFs are not a slam dunk in retirement plans
Reported by Louis Berney
Fiduciary issues argue in favor of alternative investment vehicles, including exchange-traded funds (ETFs). “The biggest way to get around hidden costs,” asserts Abrahamson, “is to go for options that don’t include them”—such as ETFs. However, as many advisers know, it’s not necessarily that simple.
ETFs, securities structured like an index fund, but that trade during the day and through brokers like stocks, are increasingly attractive investment options for defined contribution plans because they generally carry lower expense ratios—sometimes significantly lower—than mutual funds. They are an accumulation of stocks that mirror an index fund and, therefore, are passively managed.
As awareness of these investment options goes, the question facing advisers is, do ETFs make sense for their retirement plan clients? If so, what issues must be confronted when trying to introduce them on a traditional recordkeeping platform designed for mutual funds?
Some investment houses and consultants have been leery of ETFs for the simple reason that they are new in the retirement plan market place. “We ran into a lot of resistance from [defined contribution plan] clients,” says David Twibell, President of Wealth Management at Colorado Capital Bank and a self-proclaimed “big fan of exchange-traded funds.” He thought it would make sense to offer ETFs in the 401(k) market but, he says, research showed that a lot of the advantages of ETF investments in a retail context—including low cost, tax benefits, and transparency—“didn’t translate to the 401(k) side.” Moreover, he adds, too many sponsors wanted to wait and see how ETFs worked in other plans before adopting them. Since looking into the idea of designing ETFs for defined contribution plans over the past two years, Colorado Capital also had trouble finding suitable platforms or TPAs that offered the funds.
Others believe ETFs are perfectly suited for defined contribution plans today. “We believe they’re good for every long-term investor,” says Katinka Domotorffy, Managing Director for Goldman Sachs Asset Management and Portfolio Manager for GSAM’s quantitative strategies group. “We think these are an excellent option for a 401(k) plan,” she says, saying the best access is to allow participants to be able to select ETFs just as they would any other investment option offered by their sponsors. GSAM currently offers four diversified ETF portfolios. As ETFs become a more visible investment vehicle, and garner much more interest in the mainstream media as well, increasing numbers of people are hearing about them and expressing interest in them, according to David Wray, President of the Profit Sharing/401(k) Council of America (PSCA), and others in the industry. Jill Iacono, Vice President and Director Of National Accounts at State Street, says there are three ways 401(k) participants can invest in ETFs: through self-directed brokerage accounts, via unitization, and by wrapping them in collective investment trusts or mutual funds.
Fund Wrapping
One firm that allows access to ETFs in a way that fits with Iacono’s third category is Seligman Advisors, Inc., which has a series of five mutual funds that all invest exclusively in ETFs. Four of them are target-date funds. Even though the funds were launched in 2005, Seligman is promoting them as default vehicles that satisfy the safe harbor requirements of the Pension Protection Act of 2006.
Gary Terpening, Senior Vice President of Seligman Advisors and the Product Manager of Seligman Target Horizon Portfolios, says ETFs offer advisers “a very reliable way to provide return.’ He adds that ETFs provide diversification though their mix of index funds. More than 200 retirement plans already have adopted the Seligman Horizon ETF portfolios, which invest in ETFs by Barclays and State Street Global Advisors, as their default option, according to Paula Smith, Seligman’s Director of Retirement Plans. “The investment rationale is that, not only are we providing a well diversified portfolio,’ says Smith, “but also, by investing in an ETF, we’re eliminating the active manager risk.’
That is another selling point frequently offered by ETF advocates: Because the ETFs function like index funds, they remove some of the risk factor of active management. Iacono says ETFs are excellent investment options for defined contribution plans. “They’re low cost, they’re efficient, and they’re pure,’ she explains, “and they give participants access to a new investment pool.’
Cost Issues
The Seligman funds, according to Terpening, range in cost from 122 to 127 basis points, which includes all the normal operating expenses associated with mutual funds. He describes the cost as “reasonable’ and one that falls right in the middle of the various types of target-date funds that are being offered on the market. Yet, the Seligman funds, which actually are mutual funds investing in ETFs, are far more costly than other ETFs on the market.
For less expensive ETFs, advisers might explore the offerings of Invest n Retire, which recordkeeps individual ETFs offered through Vanguard, Barclays, or State Street. Invest n Retire is offering ETFs that range in cost from about 35 to 145 basis points, according to Abrahamson. The company has been offering ETFs since October of 2004.
“We’re finding the hot-button issue for plan sponsors is that they’re concerned about fees and revenue sharing,’ says Abrahamson. Advisers, he goes on, can help their plan sponsors alleviate those concerns through ETFs, which “are always the lowest cost of any of their investment options.’ Moreover,, Invest n Retire is working on its ETF offerings with Vanguard, which already has the reputation of being a low-cost provider of investment funds. “With ETFs,’ says Abrahamson, “there’s absolutely no revenue sharing, no hidden costs, and no short-term redemption fees.’ Advisers are paid on a fee system, based on amount of assets.
To attract advisers and brokers to its ETF products, Invest n Retire offers an adviser portal, TandemModels. The company invites advisers to build their own asset allocation models. They do not need to pay to use Tandem Models. “The advisers are designing the models with ETFs,’ says Abrahamson. “We provide, and they come in with our software and name the models and pick the ETFs. This is their expertise.’ The models constructed by the advisers, he adds, are less expensive than either managed accounts or investment trusts. The firm’s ETFs cost from 15 to 25 basis points. Typical ETFs cost about 25 basis points. Invest n Retire can offer a cheaper product because they are built through TandemModels and do not use collective trusts or managed accounts, which can add another layer of expenses. After the advisers use the Invest n Retire software, they are able to show clients the total slate of costs they currently are paying for their various investment options, including any revenue sharing and short-term redemption fees. Invest n Retire then will analyze those costs and compare them to those of ETFs.
He recommends that advisers “shop around’ to find the best deals for their clients. With so many firms now beginning to offer products that include ETFs, Abrahamson suggests, “You’ve really got to look what’s going on out there, because anything that’s excessively priced is really going to get hammered [by less expensive products]. Costs are critical.’
Twibell also believes that, if advisers and providers “figure out a way to bundle the transaction costs, that takes a huge obstacle out of the way.’ He anticipates that ETFs eventually will catch on in the retirement field. “ETFs possess characteristics that make them particularly suited for investors who want a low-cost way to get broad exposure to different sectors of the financial markets,’ he says. Such exposure meshes with strategies that most advisers espouse in their meetings with plan sponsors.SIDEBAR: Things to consider when evaluating ETFs in 401(k)s
1. Compare expense ratios. While most ETFs are less costly than mutual funds, the costs can vary widely. If you are considering more expensive ETF products, find out why the price is as high as it is.
2. Check with other advisers or sponsors who have experience with ETFs. Because these funds are relatively new to the 401(k) market, it might help to learn how participants are taking to them and whether plan sponsors feel they are delivering the advantages that have been promised.
3. Ask providers if they offer an education program for ETFs. Most participants, and even sponsors, know little if anything about exchange-traded funds. Simply offering them to a plan without any type of education program almost guarantees they will generate little interest among plan investors.
4. Discuss with plan sponsors the idea of using a series of ETFs as lifestyle or asset-allocation funds. As index-look-alikes, they can run from conservative to aggressive and, because they offer a mix of funds and can be greatly diversified, they may serve plans as attractive lifestyle vehicles. Of course, their cost can add to their lure.
5. ETFs are managed professionally, like index funds. This might fit in well with a plan’s investment policy goals. Then again, it might not. So, it is important to be sure that ETFs are well-suited for any plan you attempt to interest in them.
6. Be sure you have an efficient platform for introducing ETFs to a plan. Some advisers believe it is difficult to find a proper platform. Generally, commingled funds or investment trusts must be used. It is up to the adviser to help a plan interested in ETFs find the best means of delivering the funds to the plan’s investment lineup.
7. Watch out for plan providers that talk down ETFs. These providers, which might be mutual fund companies, often do not see any gain for themselves in adding ETFs to a plan. So, their natural inclination is to be negative. Be sure a provider is not promoting its own self-interest above a plan and its participants if it is critical of exchange-traded funds.