Having gained widespread acceptance among investment advisers and investors, exchange traded fund providers are now turning their sights to the retirement plan market.

The $4,500bn (£2,270bn, €2,856bn) defined contribution business could represent the final frontier for ETFs, which have gone from relative obscurity some 10 years ago to a $700bn industry. Only a small fraction of that money is currently held in US 401(k) plans, but providers have high hopes.

They argue that it is just a matter of time before these investment vehicles become widely accessible to 401(k) plan participants.

One of the most compelling arguments for adding the products to a 401(k) platform is their low cost structure and fee transparency. That is relevant in light of the increased focus from the US Congress on fee disclosure of investment vehicles in 401(k) plans.

However, significant infrastructure and technological hurdles remain in the way of making ETFs fully viable in 401(k)s. For one, most defined contribution plans simply cannot handle a product that trades throughout the day.

“The major issue is that 401(k) platforms were not built to support seamless record-keeping of traded securities,” says Robert Nestor, head of Barclays Global Investors iShares product management.

“They really were built to support mutual funds, which obviously are not traded securities, as well as comingled trust and other pooled vehicles for investment. The issue is retrofitting the platforms in order to support traded securities.”

As administrators of the bulk of the defined contribution market, mutual funds “act as gatekeepers of sorts, thereby obstructing ETFs entry onto retirement platforms,” says Jeff Ptak, director of exchange traded security analysis at Morningstar.

Such challenges have not stopped the quest to crack the 401(k) business, however. Startup record-keeping firms and some ETF providers have funnelled resources to develop solutions.

In October, for example, WisdomTree, a New York-based provider of ETFs, developed its own 401(k) platform, consisting of WisdomTree’s ETFs as well as those offered by Vanguard and iShares. The platform also offers an open menu of mutual funds and can be used by plan sponsors, advisers, brokers and third party administrators.

“This structure will allow for the use of ETFs inside 401(k) offerings, side by side with mutual funds,” says Al Shemtob, director of retirement services for WisdomTree. “But like anything in life, it is an evolution, rather than an overnight kind of thing.”

To date, WisdomTree has not been able to add any plans to its new platform, but Mr Shemtob says the firm will make an announcement in the coming months.

Meanwhile, iShares has also been testing the waters in the 401(k) space. Eyeing the opportunity, the firm recognises the obstacles of establishing a foothold in the DC market, and there are many.

For one, the features that represent the very hallmarks of ETFs, namely their ability to trade intraday and their tax efficiency, are nullified in a defined contribution setting. Since the underlying investments of 401(k) plans are priced just once a day, “the fact that you can come in and out any time during the trading day won’t be a benefit for the 401(k) investor,” says Michael Sapir, chief executive of ProShares, a provider of leveraged and short ETFs.

“Some of the features and advantages of investing in ETFs become irrelevant to the 401(k) investor.” While Mr Sapir recognises that tapping into the 401(k) market is critical to the development of the ETF industry, bursting into DC plans is less of a priority for ProShares than for other providers.

Advocates for ETFs in the DC space argue that just because the products lose their tax and intraday trading advantages does not diminish their overall utility within a 401(k) platform.

Still, the challenge for ETFs is gaining access to large platforms, which have shut them out because the fee structure makes revenue sharing opportunities non-existent.

On the smaller end of the spectrum, some administrators, which cater to plans in the range of $1-$10m in assets, have launched their own ETF platforms.

That includes Invest N Retire, BenefitStreet, RPG Consultants and PAI. One of the issues tackled by the platforms is transaction costs, a significant concern for sponsors.

Theoretically, participants would rack-up transaction costs on a regular basis as they make contributions via payroll deduction or trade in and out of an ETF. The response to that is block-trading. At BenefitStreet, trading occurs three times a day.

“We pool the trades that we have across all platforms, which reduces the commission that participants pay,” says Ken Weida, co-founder and senior vice-president for BenefitStreet.

Making the leap from the small to mid- and large-plan markets will represent a bigger challenge for these and other players because the larger the plan the more complex it is to transition into a new 401(k) platform. Besides, despite all the arguments in favour of ETFs in 401(k) plans, for most plan sponsors, they are uncharted territory.

“One of the big challenges in 401(k) is that it is really a big deal to move a plan, to change providers,” Mr Nestor says. The amount of recordkeeping changes, co-ordination and communication with participants can be overwhelming. Still, providers and advisers are eager to get this functionality, he says. “The key to . . . widespread utilisation of ETFs in 401(k) is for some of the very biggest platforms to adopt it.”

In fact, providers are awakening to the opportunity of incorporating ETFs in DC plans. Indeed, 80 per cent of DC providers surveyed by Cerulli Associates in the fourth quarter of 2007 said they expected ETFs’ inclusion in 401(k) plans to rise.

“ETFs have some legs [in DC plans] because there is just a wide variety of markets being offered now, markets that many participants didn’t have access to invest in,” says D.J. Lucey, senior analyst for Cerulli Associates.

Despite the obstacles, industry players and experts say ETFs are viable in 401(k) plans and sooner or later will have a significant space in these plans.

Mariana Lemann is a reporter on Ignites, an FT publication