Will DC Plans Start Using ETFs?

Significant hurdles stand in the way of wider adoption of exchange-traded funds (ETFs) in 401(k) plans, according to research from Cerulli Associates.

As of 2012, total ETF assets stood at $1.3 trillion, growing 27.3% for the year and boasting an astounding 10-year compound annual growth rate (CAGR) of 29.3%. For comparison, open-end mutual fund assets grew 15.8% in 2012 with a 10-year CAGR of 9.6%. Even more promising was the record flows into ETFs in 2012 after three consecutive years of positive but flat inflows.

Investors poured $184.4 billion into the funds last year (though it should be noted that open-end mutual funds drew $238.7 billion in comparison). ETFs are a true success story and are poised to achieve even grander heights in the future.

It is premature to declare that ETFs are challenging the dominance of mutual funds, the report said. Open-end mutual fund assets stood at $9 trillion at year-end 2012. ETFs are competition for mutual funds and active managers, but there is still significant ground between these two products.

ETFs have yet to gain traction in some distribution channels, most notably defined contribution (DC) plans, which could eventually drive growth even further.

At year-end 2012, Cerulli estimated that 401(k) plans held $3.6 trillion in assets. Though ETFs continue to grow at astounding rates and penetrate the market, their failure to gain traction in 401(k) plans is the prime example of a future opportunity to accelerate growth even further. If ETFs are ever going to reach the asset levels of mutual funds, cracking this market will be essential. One roadblock is technological, the report said, though progress is being made.

Beyond the administrative hurdles, the advantages of offering ETFs in 401(k)s remain an unanswered question. Tax efficiency is an often-cited feature of ETFs. Within qualified retirement plans, tax efficiency is not a consideration. However, the ETF industry has matured through new products that provide exposure to indices using other weightings as well as exposure to sectors that are not available in mutual funds.

In the same way that pressure from plan sponsors for open architecture has expanded opportunities for non-recordkeeping managers, requests for access to these products will likely be the key for ETFs to proliferate in this space. As it stands, the picture for ETFs in 401(k)s can only improve. As of 2011, only $6 billion or 0.2% of 401(k) assets was in ETFs, compared with $1.6 trillion in mutual funds. ETFs ranked behind all other investment vehicles.

Other topics covered are active ETFs; product diversification; ETF strategists; and the challenges and risks of adviser and consumer adoption. 

“Exchange-Traded Fund Markets 2013”is an annual report on distribution and development trends in the ETF market, including active ETFs, institutional distribution, marketing and staffing, and the quickly growing ETF strategist space. 

The report is available for purchase on Cerulli’s website.