By Kevin S. Price
Between January 2002, and September 2007, assets invested in open-end mutual funds increased by roughly 71%. In the same period, exchange-traded fund [ETF] assets increased by roughly 564%. Notwithstanding those divergent growth rates, conventional mutual funds dwarf ETFs by a margin of more than 21-to-1 ($11.9 trillion in conventional funds, $551 billion in ETFs).
Given the immense importance of the 401(k) marketplace in the development of the mutual fund industry, one has to wonder: What role might ETFs play in defined-contribution plans? More to the point, what role should they play?
To arrive at sensible answers to those questions, we begin at the beginning, not with the interests of the financial services industry, but those of rank-and-file plan participants. At the core of the Employee Retirement Income Security Act (ERISA) is a very simple premise: Plan sponsors and service providers must act in the long-term interests of participants.
In turn, ERISA's fiduciary principles lead to an important corollary: Plan design and implementation should maximize the probability of participants' success by eliminating unnecessary expenses, minimizing the rest and delivering long-term returns as close to the efficient frontier as possible.
As plan sponsors and service providers in the legal, accounting and investment fields adapt to the new responsibilities and opportunities created by the Pension Protection Act [PPA] of 2006, index-based ETFs should gain ground in the 401(k) marketplace. Why? Because they serve the objectives mentioned in the preceding paragraph. They're inexpensive, they generate near-market returns by definition and they fit comfortably in the "managed portfolio" framework envisioned and encouraged by the PPA.
According to the Investment Company Institute, roughly 71% of 401(k) plan assets were invested in conventional (equity, hybrid and bond) mutual funds at year-end 2006. The vast majority of the remaining 29% was in guaranteed investment contracts, stable-value funds, company stock and money market funds. ETFs have made some headway in the 401(k) market, but they still represent a tiny fraction of total plan assets (generally estimated at less than 1%).
That should change in a big way, but not overnight. So what explains the slow adoption of ETF-based plans?
First, sponsor inertia is a major factor. Whatever benefits an improved plan might confer on an employer (reduced fiduciary liability, the attraction and retention of excellent employees, an improved plan for their own retirement savings) or plan participants (lower expenses, simpler decisions, better long-term outcomes), few of those benefits flow directly or immediately to a company's bottom line. Even an expensive, poorly designed retirement plan is unlikely to top a business owner's lengthy to-do list.
Second, those sponsors who are motivated to make positive changes to their plans are often uninformed about ETFs as investment vehicles in general, let alone their utility in defined-contribution plans.
Why might sponsors be uninformed about ETFs? That leads us to the third reason for the slow uptake of ETF-based plans: They don't (and won't) get sold by brokers who are motivated by commissions, sales loads, or 12b-1 fees. This problem extends beyond ETFs to index-based vehicles in general. According to University of Illinois finance professor Jeffrey Brown and his colleagues, only 11% of domestic equity funds added to 401(k) plans between 1998 and 2002 were index funds. Let's be blunt: Retirement plans aren't so much adopted as sold. And the 401(k) marketplace—to say nothing of the 403(b) marketplace, with its density of egregiously expensive variable annuity products—has been powerfully shaped by the financial services industry's nonfiduciary sales practices. I'll return to this theme below.
Fourth, sponsors and service providers have struggled to overcome the obvious drawback of ETFs relative to mutual funds: per-trade commissions that make dollar-cost averaging prohibitively expensive if each participant has to pay them individually. Fortunately, a small but growing number of recordkeepers and ETF providers have built omnibus platforms that reduce trading expenses to negligible levels by aggregating trades across plans and participants. With the trading-expense obstacle out of the way, ETF adoption should accelerate.
Before I dig any deeper into this story, let's remember one thing: There's a lot of money at stake here, so one should interpret all the big players' claims in that context. But an underlying profit motive doesn't make all competing claims equal. Some, you might say, are more equal than others.
It's no mystery why mutual fund providers fear competition from ETFs (and other alternatives). Who can blame them? The appropriate response isn't to demonize fund companies; it's to ensure that plan sponsors, participants, service providers, legislators and regulators evaluate all industry claims on their merits.
For example: In a September 10 Wall Street Journal story on ETFs in retirement plans, reporter Diya Gullapalli noted mutual fund companies' insistence that "they already offer plenty of low-cost mutual funds that track stock- and bond-market indexes" in 401(k) plans. Sorry, but that claim doesn't pass the laugh test. As I noted above, investment options in 401(k) plans are overwhelmingly dominated by actively managed mutual funds, both as stand-alone vehicles and wrapped up (horrifyingly) in variable annuity products.
Now, mutual fund companies are right to note that ETFs' tax efficiency and trading flexibility are essentially irrelevant in 401(k) plans. Given that, the question of whether ETFs make sense in defined-contribution plans has to turn on other considerations. Here's Gullapalli in the September 10 Journal:
Some ETF advantages relative to mutual funds line up nicely with a push by the U.S. Labor Department and other federal agencies to improve fund and fee disclosure for individual investors, ETF providers say. The Labor Department's Employee Benefits Security Administration was recently taking comments on the best ways to improve 401(k)-plan administrative and investment-related fee information. Because ETFs track indexes, data on their holdings are available at all times, while many mutual funds run by managers who pick stocks are required to disclose their holdings only periodically throughout the year. U.S. diversified stock ETFs, on average, charge 0.40% of assets as an annual expense, while comparable mutual funds charge 1.37%.
While we think concerns about transparent holdings are often overstated, transparent expenses are more than important: They're legally mandated by the spirit and letter of ERISA itself. But there's more to recent legislative and regulatory changes than transparency. There's also substantial encouragement for sponsors to take a more paternalistic approach to their plans and participants. Here's Gullapalli again:
One way ETFs may wind up in more 401(k) programs is through the booming category of target-date funds. These funds automatically shift to more-conservative holdings from more-aggressive ones as the investor nears retirement, the "target date" of the fund. The Pension Protection Act of 2006 is helping expand 401(k) default investment options to include such funds. In general, these investments are "funds of funds," meaning they invest in a range of mutual funds-or ETFs-rather than individual securities.
In many 401(k) plans, target-date funds are relatively good options—relative, that is, to the expensive mediocrity available in their other options. But as we've done some industry reconnaissance over the last few months, we've concluded that three primary problems affect many target-date funds:
- Strange asset weightings, often overallocated to large-cap domestic equities and domestic fixed income
- Excessive, calendar-driven rebalancing
- The inclusion of weak, underperforming funds alongside a few better performers, which leaves one wondering whether the fund company couldn't sell its lagging funds without packaging them alongside its stronger ones. (This is a prime example of product-driven sales imperatives running directly counter to ERISA's fiduciary principles.)
Gullapalli is right to point to the Pension Protection Act as a force for change in the retirement plan business. By elevating "managed accounts" to a privileged legal position, the PPA opened the way for ETF-based solutions that simplify participants' choices, reduce expenses, ensure pension-caliber investment discipline, and satisfy legal and practical requirements for expense transparency and disclosure.
Given the current environment-heightened litigation risk, legislative and regulatory change, technological progress, and an increasing recognition of the importance of getting these plans right—change is coming to the 401(k) marketplace. To the extent that they can move defined-contribution plans closer to a genuinely fiduciary model, exchange-traded funds should be an important part of that change.