Regulatory Environment May Accelerate DC ETF Use

Exchange-traded funds have struggled for years to enter the defined contribution market; they could see more success under a tighter fee and regulatory environment. 

The latest report from Cerulli Associates, “Cerulli Edge – U.S. Monthly Product Trends Edition” for January 2017, shows nearly half of advisers plan to increase exchange-traded fund (ETF) use in preparation for the emerging regulatory environment.

Despite being known as a low-cost investment approach offering access to many different investment classes and styles, ETFs comprise a tiny piece of the total investment made annually via defined contribution (DC) plans. According to 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 small 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 still incompatible with many 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.

Even facing this hurdle, with consumers every day becoming more fee conscious and mounting pressure from regulators and litigators, Cerulli finds that advisers “believe that lower-cost investment products translate to less business risk.”

“As a result, 45% of advisers plan to increase ETF use and 32% plan to increase allocations to passive investment products in preparation for a new regulatory environment,” Cerulli reports. “The shift to passive reached a new plateau during 2016, witnessing flows of more than $500 billion.”

NEXT: Asset flows for 2016 

Cerulli’s research suggests these inflows “come at the expense of massive outflows from active funds—totaling $310 billion.” Overall mutual fund assets experienced “modest growth” in 2016, increasing roughly 6.0% to $12.5 trillion.

“Annual flows were net negative, losing $90.8 billion,” Cerulli reports. “ETFs displayed another successful year in 2016, as assets jumped 3.4% in November and another 3.5% in December, contributing to a total growth rate of 20%. Flows were a major component, as the vehicle amassed $287.3 billion during 2016.”

Seeking guidance from advisers as they go, Cerulli finds some institutional investors are “beginning to question their portfolios' passive equity beta exposures after an extended period of upward momentum from larger stocks that drive the overall markets as well as relatively low equity market volatility.” This will be an important trend to follow in 2017 and beyond, Cerulli concludes.

More information on obtaining Cerulli Associates research is here