Journal of Financial Planning: September 2014
Rick Ferri is author of The ETF Book. He continually monitors and evaluates the latest trends related to index funds and ETFs. His research appears frequently in many major media outlets.
I’m not a fan of ETF-only 401(k) plans. Far fewer ETFs than mutual funds are available in the marketplace, and many of those are niche products that don’t belong in a 401(k). Plus, I do not think employers really want employees trading ETFs during working hours.
The ETF marketplace creates product for two reasons: when a product is needed by investors, and when a product is desired by the ETF industry. Good things come from ideas that fit investors’ needs. Products designed solely to benefit the ETF industry tend to fight for assets despite a lot of fanfare. Actively managed equity ETFs are one example, and I believe ETF-only 401(k) plans are next.
Charles Schwab recently joined a small number of 401(k) plan providers offering an ETF-only 401(k) platform. Dave Gray, Schwab’s vice president of client experience, went so far as to call their product a “third generation 401(k)” during a presentation at the ETF Managed Portfolio Summit in June. He described the first generation 401(k) as being dominated by high-cost insurance products; the second as being dominated by mutual funds; and a third generation 401(k) now being driven by the ETF market.
The advantages Gray presented for an ETF-only 401(k) are true, but not revolutionary. He said ETFs in general have lower average expense ratios than the average mutual fund in the 401(k) marketplace and that ETF holdings are transparent so plan participants can see what they hold day-to-day. He also mentioned the flexibility to trade ETF-only 401(k) accounts during the day, rather than waiting for end-of-day net asset value (NAV) pricing on a mutual fund.
These sound like valid reasons to consider an ETF-only 401(k) plan, but there’s always a flip side. Let’s compare the three points to a well-managed 401(k) plan that only holds mutual funds.
It’s true ETFs in general have lower expenses than mutual funds, but I don’t buy the argument that ETF-only plans would lower fund expenses if a plan already had low-cost funds in it. Index funds have been available across most stock and bond asset classes for many years, and astute plan sponsors have adopted these funds. There would be no fee advantage in an ETF-only 401(k) to participants in plans that already offer index funds.
The second point is transparency. What’s held in an index is what’s held in an index-tracking fund regardless of whether the basket is owned through an index mutual fund or ETF. Accordingly, there would be no transparency advantage in an ETF-only plan if the current plan already offered low-cost index funds in several asset classes.
This brings us to intraday trading. Is intraday trading an advantage to employers and employees? It depends on which side of the table you sit.
Proponents of ETFs in 401(k) plans also note the variety of alternative investments—ranging from gold to oil futures to foreign currencies—available in ETFs that may not be available as mutual funds. They argue that these exposures may help plan participants diversify their portfolios.
I’m not on board with adding alternative investments to a 401(k) plan. It’s not the place for them. I believe a prudent mix of low-cost stock and bond index funds and a stable fixed income fund are all the choices that 401(k) plan participants need to diversify, and these investments are abundant in the mutual fund marketplace. Let those who want to trade commodity ETFs and other alternatives do it on their own time and outside of an employer retirement plan.
That being said, I’d be open to a program that includes ETFs side-by-side with mutual funds in a 401(k), but that’s difficult to do because of different settlement dates and trading mechanics. Currently, dual availability is only available in plans that offer self-directed options, and those tend to be more expensive and often require a high minimum account size. So including ETFs along with mutual funds in a 401(k) is easier said than done.