In case you hadn’t noticed, ETFs are here to stay.
U.S. and international equities saw November inflows of more than $14 billion. U.S.-listed ETFs could see total 2013 inflows of close to $200 billion. And now, U.S.-listed ETF assets total $1.7 trillion.
Clearly, investors are loving ETFs. But 401ks have been giving the asset class the cold shoulder for far too long.
It’s time for 401ks to finally buckle to ETFs. Here’s why:
Asset Allocation on the Cheap
As I discussed in my December 6 article about dividend ETFs, it’s very easy — and cheap — to put together a diversified portfolio of dividend stocks using just four ETFs. For just 37 cents annually per $100 invested (0.37%), you get an internationally diversified, truly all-cap dividend portfolio that has achieved a year-to-date return of 23.6% through December 10. Sure, that doesn’t match the S&P 500, but over the long haul it will serve you nicely with minimal work involved.
The argument against ETFs within 401k plans is three-fold. First there’s cost savings. Any advantage gained when compared to similar index mutual funds is lost when making monthly contributions, because the brokerage commission for each trade makes it prohibitively expensive.
Second, ETFs can’t be bought in fractional amounts. If you have $500 to invest in a mutual fund, the trade is executed at the end of the day based on the net asset value; you might end of with 22.35 units or some other odd amount which is perfectly fine. If you buy an ETF based on this scenario you’ll probably end up buying just 20 shares — defeating the purpose of a monthly contribution plan.
Lastly, some financial planners believe ETFs encourage frequent trading because they are bought and sold like stocks throughout the day. However, experts including Vanguard, have made it clear that this isn’t happening within 401k plans. John Ameriks, Vanguard’s head of active equity said this about ETFs in a 2012 interview: “We don’t see them trading more than they are trading with other vehicles. It just means they are bearing the freight of transactional activity and liquidity services they would get from a [mutual] fund.”
The simple truth is that ETFs haven’t been around as long as mutual funds. The new kid on the block always gets a razzing. Once 401k sponsors figure out that their employees are actively buying ETFs outside their retirement plans and wish for the same thing within them, they’ll push plan administrators to include them.
Solutions Already Exist
Although ETFs represent a very tiny portion of defined contribution plans — Callan Associates says just 2.3% of defined contribution plans with assets less than $200 million offered ETFs in 2012 — several firms already offer or will soon be offering 401k platforms that include ETFs.
Schwab plans to add ETFs to its IndexAdvantage 401k product in the near future.
In an early November Wall Street Journal interview with Steven Anderson, executive vice president of Schwab Retirement Plan Services, Anderson indicated that Schwab’s product would allow for fractional shares, the main reason why it has taken so long to bring to market.
That is a definite game-changer. And in addition, it plans to reduce the average plan’s operating expenses from 0.16% for index mutual funds to as low as 0.10% using ETFs. Anderson points out that more than 100 ETFs will be available, including ETFs from other providers.
ShareBuilder 401k offers ETFs within its 401k plans and has since 2006. Although you’re restricted to 21 specific funds from iShares, State Street, Vanguard and others, the offerings are pretty much everything a typical 401k plan would offer. The big knock against ETFs back when ShareBuilder was getting this operational was that record-keeping would be too expensive, forcing plan administrators to pass that cost onto the sponsors defeating the purpose. Today’s technology should eliminate this concern.
The major problem I’ve always had with mutual funds is transparency. If you bought an actively managed mutual fund like the Vanguard Windsor Fund Investor Shares (VWNDX) at the end of November, you had no way of knowing what the holdings were on the day you acquired your shares. The latest holdings report available was September 30, a full two months before you bought your shares. With end-of-year window dressing getting underway, you probably wouldn’t recognize some of the names in the year-end report for the fund.
With ETFs you get a real-time, daily view of your holdings, and you know how much volume is trading on your funds and the money flowing into them. These are three critically important pieces of information that mutual funds just aren’t able to provide in real time.
U.S.-listed ETFs totaled $1.1 trillion at the end of 2011. Two years later, they’re expected to hit $1.7 trillion. Some of that growth is due to two straight years of booming equity markets, but the underlying popularity for owning ETFs has kept the ball rolling nicely. Individual investors are always slow to catch on to trends; institutional investors have been using them for many years.
Once the average Joe with a 401k figures out that ETFs have a lot going for them compared to mutual funds, the rush of money will be significant.
Plan sponsors, listen up — it’s time for 401ks to finally buckle to ETFs. You have a moral, if not fiduciary duty, to do so.
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As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.