Markets, Retirement, Small Business

Why ETFs Still Play A Small Role In The 401(k) Arena

8/29/17 8:00 AM

iStock-657277960.jpgAmericans have nearly $5 trillion invested in 401(k) plans, according to the latest data from the Investment Company Institute (ICI), and the bulk of these assets are allocated to equities using mutual funds. Exchange-traded funds (ETFs) provide another way for investors to obtain exposure to the stock market but this particular trading instrument only represents a fraction of total 401(k) assets. Why so? For starters, mutual funds have been around a lot longer than ETFs and are therefore much more deeply ingrained in the system.

This can be seen in the difference in daily pricing mechanics that exists between ETFs and mutual funds, which would require a significant change to many retirement plans’ legacy record-keeping systems should ETFs be incorporated. Changing a record-keeping system is of course not impossible but it can be a time-consuming process that costs money (raises fees). Further, the purchase of fractional shares has generally been a lot easier to accomplish with mutual funds than ETFs. This has made mutual funds ideal for handling the various-sized contributions commonly made to 401(k) plans, as well as the routine reinvestment of both dividends and capital gain distributions.

Similarly, Vanguard managing director Martha King in an interview with said that recurring purchases in the form of biweekly contributions and loan repayment purchases coming into a plan can “generate additional cost and additional risk in terms of the bid/ask spread on an ETF, and those are costs and risks you wouldn't incur in buying a traditional mutual fund.” Robert Massa, director of retirement at Ascende, added that “offering ETFs in 401(k) platforms ends up costing more than mutual funds because ETFs technically have to be converted into mutual funds under the hood, which creates an added cost.”

Another thing to consider is that most ETFs can be bought and sold at prevailing market prices at any time of the trading day, whereas mutual funds typically can only be traded at the end of the day. ETF shares can also be easily purchased on margin and sold short. All of this additional flexibility available with ETFs is great but many plan sponsors recognize that it can sometimes incline participants to be a lot more active in the management of their investments. Such behavior can be hazardous to one’s financial health, as evidenced by the countless academic studies that have demonstrated retail investors’ general inability to profitably time the market.

For example, Brad Barber and Terrance Odean looked at 66,465 U.S. households with accounts at a large discount broker and found that investors on average underperformed a risk-adjusted benchmark by as much as 3.7 percent annually even before the additional costs of federal and state taxes were accounted for. A part of the problem is that retail investors will often overestimate their skill or the value of their private information, and in turn trade too actively so that transaction costs (brokerage commissions) quickly erode not just profits but also any savings from avoiding management fees.



Sources: ICI, Reuters, Investopedia, Wikipedia, IFA, ETF, II, SSRN