Odd Investment Out?

Exchange-traded funds (ETFs) remain scarce in the core lineups of 401(k) plans, but their low costs are piquing advisers’  interest.

Adviser Thomas Clark currently does not handle any 401(k) plans using exchange-traded funds as core investments. “From time to time, clients have brought [them] up,” says Clark, president of Kansas City, Missouri-based Lockton Investment Advisors. But several things keep the firm from pursuing them, he says, adding that “there has never been any real push.”

Only 1% of 401(k) assets are in exchange-traded funds, according to the PLANSPONSOR 2011 DC Survey. Sponsor interest “is starting to bubble up more, but [ETFs are] still a small fraction of plan assets,” says Daniel Farkas, an investment consultant at Morningstar Investment Management.

The use of the funds “is not taking off [in 401(k) plans], and I do not think it is going to for some time,” says Benjamin Taylor, a vice president and consultant at Callan Associates Inc., San Francisco.

Still, in an era of heightened fee sensitivity, advisers can help sponsors evaluate the pros and cons of ETFs in defined contribution (DC) plans. “Any investment could be the right solution for a particular group of participants,” says Mike DiCenso, president of Gallagher Fiduciary Advisors LLC. “But retail investing is where we have seen the popularity of ETFs really take off.”

Consider these five facts about exchange-traded funds:

1) Using them can mean lower investment fees. “The most obvious appeal [of] ETFs is lower expense ratios relative to comparable mutual funds,” says Farkas. “Their operating expenses are simply lower. Also, ETFs more frequently are passive, and there is a well-known cost advantage to passive management.”

That may not apply for larger plans, however. “While [ETFs] are cheaper than some mutual funds, for most [investment classes], mutual funds still will be cheaper if you have large asset pools,”  Taylor says. Once plans get into the several-hundred-million-dollar range, he says, more options are available.

Exchange-traded funds also typically have a brokerage or transaction commission, and factoring in those extra costs can make it more difficult for sponsors, from a 408(b)(2)- and a 404(a)(5)-reporting perspective, says Paul D’Auitolo, a Rochester, New York-based institutional consultant at UBS Financial Services. Although the investment fees themselves tend to be lower, he says, “capturing the all-in fees in a 401(k) context is harder.”

Advisers and sponsors also would need to determine how to handle a plan’s administrative expenses, especially those used to employ a revenue- sharing arrangement for investment fees, to cover recordkeeping expenses. “Some of the expenses still have to be paid, just separately,” Farkas says. “In an ETF, you don’t have the recordkeeping fees baked in like you do in retirement share classes of mutual funds, so you are going to have to pay for those recordkeeping services in another way.”

2) They have trading and recordkeeping issues. Although some platforms can handle exchange-traded funds, many 401(k) platforms cannot, sources say, because ETFs trade intraday, and the mutual funds that predominate in these plans trade at day’s end. “[Intraday trading is] not available on the recordkeeping platforms that [my clients] are on, and they don’t want to change recordkeepers to get a recordkeeper that supports it,” Clark says.

Adviser Jeb Graham has no clients with exchange-traded funds in their DC platform. Right now, primarily a few “boutique”  recordkeepers offer the funds for a 401(k), and switching to them could mean a plan has to give up other services, which the big recordkeepers provide, says Graham, a partner and retirement plan consultant at Tampa, Florida-based CapTrust Advisors LLC. “But if clients push hard enough on recordkeepers, then [the recordkeepers] will begin to invest more time and resources to getting [ETFs] up and running,” he says.

Even if a plan’s recordkeeper could facilitate intraday trading for participants, Taylor thinks most sponsors would rather withhold the option. “Generally speaking, the less often you trade, the better. In the retirement world, the general guidance is toward ‘buy and hold,’” he says.

Intraday trading does not mesh well with how sponsors want participants to make investment decisions, DiCenso agrees. “ETFs are a vehicle that can be traded hour by hour, minute by minute, if the recordkeeper can handle it,” he says. “Because a long-term investment strategy is used in retirement planning, market timing is not the philosophy behind successful retirement investing.”

3) They provide access to esoteric asset classes. Exchange-traded funds can appeal to people who want to invest in a particular sector fund or a less-known high-yield fund, for example, Taylor says. “ETFs have some more-esoteric asset exposures, and that is beneficial for some,” he says. “But typically, you do not want to offer investments like that as core options.” Providing those investments in the core lineup could lead unknowledgeable participants to buy them and pay extra with the brokerage commission. Says Taylor, “Clearly, a sponsor would have to justify offering a more-obscure beta opportunity in a plan menu.”

Offering direct access to highly specialized segments, such as emerging-market real estate, usually does not work for the core menu of a 401(k), Clark says, because sponsors have trouble communicating to participants how to use such a fund. A category like that would be missing from standard vendor instructions for how to allocate assets, he says, so having it available runs the risk of participants making decisions based on inadequate information.

4) They may best belong in a brokerage window. In the 401(k) world, Callan typically sees participant access to exchange-traded funds only through a self-directed brokerage window, Taylor says. Brokerage windows can be set up to permit intraday trading, he says. The fees charged for trading go specifically to the individuals involved, rather than grouped with a plan’s overall administrative expenses. When plans offer a brokerage window, typically 2% to 4% of participants utilize it, he says.

Clark also believes the funds work better in a brokerage window than as a core investment option. “There might be a small 401(k) plan that has participants who are all really sophisticated, but, in my mind, that would be the exception to the rule,” he says. “A self-directed brokerage window is a good place for sophisticated investors to find opportunities, and there is not the same obligation for the sponsor to provide information [about an investment].” With self-directed brokerage, he adds, most recordkeepers and sponsors have taken the position that the disclosure, when participants sign up for the account, stresses that they need to find the appropriate information themselves.

5) They can make sense inside ­professionally managed investments. D’Auitolo sees another potential use for ETFs in 401(k) plans (though participants would still be barred from directing assets into them): inside managed accounts aimed at those nearing retirement and worried about volatility. He envisions professionally managed, multi-asset-class portfolios focused on either absolute returns or an income stream. “I do not think you need collective trusts and ETFs to help people accumulate wealth,” he says. Good, low-cost index or institutionally priced mutual funds inside target-date funds are effective for dollar-cost-averaging into a portfolio over time, he thinks. But the upsides of ETFs—including the access to esoteric asset classes and ability to trade intraday—make sense for older participants or for those with larger balances in an account managed by a 3(38) fiduciary, he says.

“In a managed account, it’s a lot easier to determine the effectiveness of ETFs,” D’Auitolo says. “ETFs provide more access to specialized funds, have low costs and allow for intraday trading—all tools to help 3(38)s manage portfolios.”