ETFs Eye Retirement Plans

| About: Aberdeen Emerging (ABE)

Countless statistics have been complied to illustrate what most in the financial services already know: the ETF industry is expanding with astonishing speed, eating into the market share of traditional portfolio powerhouses such as mutual funds.

Perhaps most indicative of this trend is the fact that in 2008, during the worst recession in a generation, investors poured $178 billion of new money into ETFs, while taking $320 million out of mutual funds.

But despite their tremendous popularity among investors and numerous relative advantages, ETFs have been unable to break the mutual fund stranglehold on retirement portfolios. At least until now.

Operational Issues

On paper, presence of ETFs in retirement portfolios appears to make a whole lot of sense. Think about it:

  • Retirement plans generally do not experience high turnover, instead following a "buy-and-hold" strategy over a long period of time. With expense ratios only a fraction of those charged by traditional mutual funds, ETFs can provide significantly higher "bottom-line" returns over long periods of time, making them the preferred choice for passive investing.
  • ETFs maintain numerous tax efficiencies compared to traditional mutual funds, providing investors more flexibility to delay capital gains taxes if desired. Such a scenario is particularly advantageous in a retirement portfolio. Since retirees often fall into a lower income tax bracket, delaying capital gains may be particularly valuable, and use of ETFs over mutual funds could result in material tax savings over the life of the investments.
  • With the ongoing development of the ETF industry, there are few corners of the investment universe that cannot be reached with an exchange traded fund. And most retirement portfolios can be constructed with only a handful of funds, bringing simplicity and transparency to investors' nest eggs.

So why aren't ETFs a major component of your retirement savings? Because mutual funds offer enhanced returns? Unlikely. More flexibility with mutual funds? Hardly. The real reason is primarily an operational one. Most 401(k) back offices simply aren't set up to handle ETFs, providing investors exclusively with mutual fund options when allocating their monthly contributions. Moreover, 401(k) plans shift the onus for asset allocation from employers to employees, many of whom may still be unaware of the benefits of ETFs and unwilling to put their funds into an "unknown" investment vehicle.

Change in the Air

To this point, the attempts to break the grasp of the mutual fund industry on retirement portfolios have been essentially grassroots campaigns, with several firms popping up offering ways to build a retirement fund using ETFs. While these firms experienced some success, the thought of toppling traditional mutual funds simply wasn't practical.

Until now. With BlackRock's (NYSE:BK) acquisition of Barclays' market-leading iShares fund family, change may be on its way.

Although Barclays unloaded iShares in an effort to bolster its capital position, bidding for the ETF sponsor was competitive, with numerous investment management firms and private equity buyers entering the fray. As a result, the $13.5 billion purchase price was hardly a bargain, implying a multiple of nearly 13 times EBITDA. So to make such an acquisition worthwhile, BlackRock will no doubt be looking to extend the reach of the popular line of ETFs.

While BlackRock will continue to launch new funds globally, CEO Laurence Fink indicated that his company also intends to grow iShares by pushing ETFs into retirement plans. "I think one of the real long-term trends is going to be lower-cost products," Fink said. "I think the expenses associated with many retirement products overwhelm some of the relative returns. Some passive strategies will have a larger component to the future of our retirement strategies."

Huge Potential

Fink is yet to elaborate on just how or when BlackRock will intensify its efforts to introduce ETF investing to retirement portfolios, and such a change surely won't be immediate or absolute. But it has always seemed like only a matter of time before ETFs creep into retirement funds. With BlackRock's weight and expertise now joining in the charge, that time may be sooner rather than later.

If Fink and BlackRock are successful, the prize for their efforts could be massive, as retirement portfolios hold trillions of investor dollars yet to be exposed to ETFs.

Disclosure: No positions.