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ETFs have become increasingly popular as part of taxable or self-directed IRA portfolios, and a flurry of new commission-free ETFs will only accelerate their adoption. There is another less visible but significant move to make ETFs a staple in traditional company sponsored retirement plans such as the 2.7 trillion 401(k) sector.

iShares (recently acquired by BlackRock) established iShares401k.com to promote ETFs within the 401(k) industry. Two vendors -- AdvisorETF401k and Ascensus -- have signed up to provide iShares ETFs for 401(k) plans.

It is interesting to note that Ascensus provides an aggregate ETF trading platform for participants. According to a document on the Ascensus web site: "All trades submitted for the day for each ETF on the Ascensus platform will receive the same average share price. The average share price is calculated based on the market price received for actual shares traded plus the fees noted below. This method allows for automation of trades, which minimizes trading costs, and enables participants to own whole and fractional shares of ETFs." That certainly makes ETF trading more like traditional mutual fund end of day settlements.

Sungard provides an ETF 401(k) platform that also allows late day processing for ETFs, i.e. ETF trades are treated as mutual funds and they are settled using market close prices at 4pm EST. This restriction/feature is arguable but certainly makes ETFs more like long-term portfolio building elements instead of intra-day trading vehicles. The other salient feature for Sungard's solution is that it allows participants to hold fractional ETF shares, much like mutual funds. This is very important for small accounts, which are typical in retirement 401(k) accounts.

Interested readers are referred to MyPlanIQ's iShares ETFs plan to see how these ETFs could be used in constructing a portfolio. There are a total of 187 iShares ETFs that cover major asset classes including US Equity (various Russell 1000, 2000, 3000 ETFs including IWF, IWB, IWD, IWZ, IWV, IWW, IWP, IWS, IWO, IWM, IWN, IWC, IWR and S&P large/mid and small cap ETFs), Foreign Equity (EFA, SCZ, ACWX), Emerging Market Equity (EEM), Real Estate (IYR and various foreign REITs such as IFGL) and US Fixed Income (AGG and many well known bond funds such as TLT, IEF, SHY, TIP, MBS, MUB, LQD, CFT, CSJ, HYG) and foreign bonds (EMB, IGOV). As in Vanguard's ETFs, the only major asset class missing is commodities. That, however, is a major asset class not covered by traditional mutual funds in most 401(k) plans anyway.

Another notable ETF 401(k) provider is ShareBuilder401K, whose goal is low cost. It is sponsored jointly by ING Direct and ShareBuilder, a discount brokerage. The ShareBuilder401K consists of 15 ETFs, though one noticeable major asset missing is Real Estate Investment Trusts (REITs). It would also be improved with more coverage on asset classes such as fixed income and foreign bonds. MyPlanIQ has constructed a plan to help participants in ShareBuilder401K in portfolio building. Both iShares ETFs plan and ShareBuilder 401K Plan have shown that it is possible to achieve very reasonable performance if proper portfolio strategies, such as the Strategic Asset Allocation and Tactical Asset Allocation strategies provided by MyPlanIQ, are used.

In an effective retirement plan that uses mutual funds or separately managed accounts, the key factors to select candidate funds in a plan are low cost, quality of funds and quality of diversification. With ETFs, low cost is a standout factor but it still varies from one ETF to another. The quality of funds include how close those ETFs track their intended benchmarks (so called tracking errors), liquidity and bid-ask spread (trading friction). The quality of diversification or coverage is about how many major and minor asset classes are covered by the candidate funds, as discussed above. A follow up article will give more detail on how to construct and rate a good ETF plan.

The following table compares ETF 401(k) platforms with traditional mutual fund 401(k) platforms.

ETF 401KsMutual Fund 401Ks
Diversificationcover most major assets other than commodities. But with more varieties of ETFs introduced, this could be a advantagecover most major assets other than commodities
Fund SelectionIndex fundsActive and Index Funds
CostExtremely low, <0.5%Vary, some of the, as high as 2%+
Trading SettlementEnd of Day available, Sharebuilder401Ks are intra-dayEnd of Day
Trading CostCommissions is the major obstacle. Also bid-ask and NAV/price spreadsNo
Fractional SharesYes for some.Yes

To summarize, ETFs are rapidly becoming a viable alternative in 401K investment. Plan participants, however, need to be aware of several drawbacks, especially in trading cost and tracking errors.

Tom Lydon has written several good articles on ETFs in 401(k) such as this and this.

Disclosure: Long IJK, EEM, LQD

Source: Building a 401(k) Portfolio With ETFs