A June survey conducted by State Street Global Advisors and Knowledge@Wharton determined that financial advisors think the biggest potential growth area for the exchange-traded fund industry is in 401(k) plans. Of the survey's 840 respondents, 43% said that 401(k)s would be the biggest area of growth for the ETF industry going forward, compared with 27% for actively managed ETFs and 20% for unified managed accounts.
Ironically, this perspective was soundly rebutted in a July 2008 article in Journal of Indexes. The article, "Why ETFs And 401(k)s Will Never Match" (by David Blanchett and Gregory Kasten), outlined a variety of reasons why ETFs may never gain a large foothold in the 401(k) industry. Among the reasons listed were transaction costs, including the bid/ask spread and the brokerage commission associated with every purchase and sale of ETF shares. Another disadvantage noted was the inability to buy fractional shares of ETFs. The fact that the tax advantage ETFs offer in taxable accounts disappears in a tax-deferred plan such as a 401(k) was another highlighted drawback.
It's been nearly two and a half years since I first reported that the industry is devoting resources to the idea of incorporating ETFs into the 401(k) platform. It seems like a perfect time to evaluate the current state of ETFs in defined contribution plans in general, and in 401(k)s specifically.
Early In The Game
The big conclusion? Let's just say the game is still in the early innings ... like the bottom of the first.
Last year, I reported that the total number of ETF assets in 401(k) plans was so small that the Investment Company Institute—the mutual fund industry trade group—didn't even keep records. That hasn't changed. However, whether the number is still so small is unknown because there is neither a requirement for plans to disclose what kind of products they use, nor how the plan assets are invested. And people who have those numbers aren't talking. It would be inappropriate to assume that a lack of reporting means there is nothing to report, but let's just say it's hard to have a fire without smoke.
Robert Nestor, head of product management for Barclays Global Investors' iShares, says BGI has anecdotal evidence detailing that more than $2 billion in 401(k) plans is in ETFs. That's miniscule compared with the $4.5 trillion held in employer-sponsored defined contribution plans at the end of 2007, and also represents a tiny fraction of the $600+ billion invested in ETFs overall.
Alvin Rapp, the founding partner of RPG Consultants—a record keeper and consultant for retirement benefits plans—says more than 100 of RPG's clients use ETFs in their 401(k) plans and hold assets in the range of $125 million to $150 million. Over the next 12 months, he expects that figure to double.
Company By Company
Vanguard and WisdomTree Investments (WSDT.PK) are the only two ETF providers selling 401(k) plans. Neither Vanguard, nor mutual fund giant Fidelity Investments-the nation's two largest providers of 401(k) plans-have expressed any interest in offering ETFs in the plans. Even though Vanguard sells ETFs, it doesn't believe ETFs are a good fit for 401(k)s, for reasons similar to those mentioned in Journal of Indexes:
- ETFs tend to appeal to investors who want intra-day trading, which is not important to most investors in 401(k) plans.
- The tax advantages of retirement plans make ETF's tax efficiency moot.
- Small contributions would be eaten up by brokerage commissions.
- Institutional share classes of pooled index funds are likely to be cheaper than most ETFs.
While this may be true, Jill Iacono, director of national accounts at SSgA, says demand for ETFs in 401(k)s is coming from financial advisors who understand that ETFs give access to markets around the world and to alternative assets that haven't been available before.
Currently, WisdomTree Investments is the only ETF provider that sells 401(k) plans with ETFs. WisdomTree began selling the plans in October and says it has solved the fractional share and commission problems, but it declined to elaborate on how. Focusing on small companies with small 401(k) plans, Al Shemtob, WisdomTree's director of retirement services, says the reception has been very positive, but he declined to say how many plans have been sold. He did not elaborate on number of assets currently invested in ETFs in the plans, either.
One big problem New York-based WisdomTree faces is that the company does not sell the plans directly. Most of these small plans are sold by financial advisors. So even if WisdomTree proves to financial advisors that these are great plans, the advisors need to convince the actual plan sponsors to buy them. Shemtob also says most 401(k) plans are bought in the third quarter, and WisdomTree didn't go live with its plan until the fourth quarter of 2007. In other words, the results could dramatically change by year end.
Among the other top ETF families, iShares and SSgA don't sell plans, but the few 401(k) plans offering ETFs often have funds from these two players. ProShares and Invesco PowerShares say currently no 401(k)s offer their funds.
One surprising fact is that for all the talk about putting ETFs into 401(k) plans, most ETF providers don't even offer ETFs in their own 401(k) plans. WisdomTree is the only firm offering its employees the ability to build a retirement portfolio out of ETFs. In January, BGI made two ETFs available to its employees for asset classes not previously offered. But in most cases, BGI offers institutional funds that are cheaper than ETFs. SSgA and ProShares don't offer any ETFs in their programs for employees.
The biggest provider of 401(k) plans with ETFs remains the creator of the concept, Invest n Retire. Darwin Abrahamson, the company's founder and chief executive, says the biggest change in his business has been moving away from small independent advisors who develop plans to work with independent fiduciaries who design their own ETF-only allocations.
Foxhall Capital Management, which has built allocation models for about $600 million on the taxable side, is now selling those same clients 401(k) plans worth up to $500 million with Invest n Retire's platform.
Abrahamson says he's also working on a $500 million plan that will be managed by Zacks IFE, and another for an association of eye, ear, nose and throat doctors that will be launched to the whole association at their convention later this year.
While the SSgA survey and WisdomTree's experience show financial advisors are ready to sell 401(k) plans with ETFs, in the end it comes down to convincing plan sponsors to buy them. Considering the increased fiduciary responsibilities imposed upon plan sponsors, it's unlikely that many will take the risk of offering ETFs in 401(k)s, when the ETF providers themselves won't offer the products in their own retirement plans. Until the major ETF providers step up to the plate, this could be a very slow game.