Exchange traded funds, baskets of securities that trade on an exchange like stocks, may soon be coming to a 401(k) plan near you.
Last month XTF, a New York-based asset manager specialising in tactical asset allocation portfolios composed of ETFs, introduced nine new low-cost, ETF-based mutual fund portfolios. Meanwhile, WisdomTree Investments, the Delaware-based ETF provider, recently opened a new business unit dedicated to bringing ETFs to defined-contribution programmes.
ETFs have been some of the hottest investment vehicles going in recent years. The sheer number of ETFs on the market has rocketed from 81 in 2001 to 432 today, according to the Investment Company Institute, the mutual fund industry body. Over that same period, assets within ETFs have increased 421 per cent to more than $433bn today.
Al Shemtob, the newly appointed director of retirement services for WisdomTree, describes ETFs as the “perfect building blocks for 401(k) plans”.
“When 401(k) plans first started out, they were the province of separately managed accounts, fixed income products and annuity product, then mutual funds came on the scene. We’re at the next plateau and I am hopeful that in 10 or 15 years, ETFs will have the lion’s share of the 401(k) market,” he says.
Michael Woods, chief executive officer of XTF, agrees. “The retirement market is something that can benefit greatly from the low fees, transparency and stability that ETFs offer, and providing our portfolios to plan managers is the next step in our evolution and that of the ETF industry,” he says.
While observers say adding ETFs to 401(k) programmes would undoubtedly transform the way Americans save for retirement, they warn that these companies face significant operational, structural and educational challenges.
Owen Concannon, a senior analyst at Financial Research Corporation, the Boston-based data company, says that because mutual funds are so entrenched in the $2,500bn 401(k) market, it will be hard to convince plan sponsors to seek out an alternative investment option. “Everyone understands mutual funds and all the technology is built around them. It’s certainly going to be an uphill battle for ETFs,” he says.
About 40 per cent of the $2,500bn in total 401(k) assets is invested in mutual funds, according to figures from the US Federal Reserve.
Mr Shemtob acknowledges that going up against the all-mighty mutual fund will be a challenge.
“One of our biggest hurdles is the fact that a lot of plan sponsors and participants don’t understand what ETFs are,” he says. “It’s an education process. We need to explain what they are, but I don’t expect [them] to be immediately received.”
A second potential difficulty in bringing ETFs to the defined contribution market is that many of their attributes are not as applicable to 401(k) plans. Take their capacity for intra-day trading, for instance.
ETFs are priced like stocks and traded throughout the day, enabling investors to dash in and out of the market while also using stop and limit orders. But this is not necessarily a benefit to investors in 401(k) plans.
In addition, because ETFs trade on a stock exchange, they also have tax advantages. The reasons have to do with the fact that, unlike mutual funds, ETFs do not need to sell their holdings to meet shareholder redemptions, helping to minimise capital gains distributions. But, again, this advantage is not particularly significant to tax-deferred 401(k) plans.
“ETFs are very flexible, but in 401(k) plans you don’t need that much flexibility because the money basically just sits there,” says David Wray, president of the Profit-Sharing/401(k) Council of America (PSCA), an association of companies that sponsor 401(k) plans.
“ETF providers are going to have to demonstrate that they provide superior outcomes over traditional index mutual funds. Companies make changes to their existing programmes with deliberation and any change is going to be slow.”
Costs are another stumbling block. Since ETFs are bought and sold like stocks, investors pay broker commissions for each trade. WisdomTree is working to resolve this issue by bundling transactions across plans and participants, so that trading expenses are spread.
“The goal is to make ETFs trade in a manner so that trading and broking costs are a non-issue,” says Bruce Lavine, chief operating officer at WisdomTree. “The cost of trading has already come down so dramatically in the past five years that it’s not a hurdle.”
John Cooper, director of business development at Aim, which distributes PowerShares, is also sanguine about ETFs’ prospects in the 401(k) market. He points out that while it might appear that competing with traditional mutual funds is insurmountable, there is no reason why investors should have to choose between them. “It’s not an either or proposition,” he says. “ETFs and mutual funds are a very good complement to each other.”