A 401(k) fund most retirement savers still can't have

When ETFs first started appearing in 401(k) plans, I was skeptical. At the time, the whole effort seemed to be more hype than substance. Although ETFs offered fees lower than those of most actively managed mutual funds, their costs were comparable to similar low-cost index mutual funds—after all the implicit and explicit fees required to make ETFs 401(k)-ready were factored in.

Things have changed. ETFs have the potential to help improve retirement outcomes in America. Here's why.

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ETFs, or exchange-traded funds, are effectively a class of mutual funds but have a different structure. The key difference between ETFs and mutual funds is that ETFs can be traded throughout the day (like individual stocks), while mutual funds can only be redeemed or purchased once per day. The first ETFs were introduced in the 1990s; today there are roughly 1,300 ETFs in the U.S., with more than $1.9 trillion in assets. More than 97 percent of ETF assets are passively managed, which means the ETF tracks an index, such as the S&P 500, although there are a few actively managed ETFs (and more to come).

While ETFs themselves aren't new, they are relatively new to 401(k) and other defined contribution retirement plans. They have been slow to catch on for a variety of reasons: For one, you can't buy fractional shares of ETFs. This makes it operationally difficult to own ETFs in 401(k) plans, which have lots of small contributions that must be invested regularly. Commissions, the bid/ask spread, and administrative costs associated with making any type of fund available in plans are other hurdles that must be overcome to make ETFs 401(k)-ready—and more attractive than their index mutual fund counterparts.

But there are at least three characteristics where ETFs may have an advantage.

1. In some cases, ETFs actually cost less than low-cost index funds.

We've reached a point where it's possible to buy ETFs that track the same indexes as comparable mutual funds, but at a lower cost. In other words, ETFs cost less to purchase, hold and sell than comparable "best-of-breed" low-cost mutual funds that track the same portfolio.

There has been a price war in the ETF space among providers such as Blackrock, Schwab and Vanguard that has reduced the cost of owning ETFs. The potential benefits of ETFs are even greater when compared to actively managed investments. Annual ETF fees are usually 0.2 percent or less of assets being managed (usually less for the high-quality providers); that's considerably lower than the average actively managed mutual fund, which has an annual expense ratio closer to 1 percent. I realize comparing a passively managed ETF to actively managed mutual fund is a bit like comparing an apple to an orange, but public sentiment has shifted significantly toward passive investments recently, and ETFs represent a viable option to reduce investment costs for plan sponsors looking to do so.

In some cases, the ETFs are as cheap if not cheaper than existing index fund options, too. For example, the Vanguard S&P 500 ETF has an expense ratio of 0.05 percent. That's less than the typical individual investor share class of Vanguard's S&P 500 Index Fund, 0.17 percent, and equal to the Vanguard S&P 500 Index Fund Admiral Share class expense ratio, which is only available to accounts with at least $10,000 in assets.

"I'm not advocating frequent trading ... but Americans need to save more, and if this gets a participant excited about saving and planning for retirement, I say game on." -David Blanchett, head of retirement research, Morningstar Investment Management

2. Freedom of choice, and you don't have to pay more for it.

While there are lots of great passive mutual funds out there tracking lots of great indexes, there are far more ETFs. There are plenty of mutual funds covering the common style exposures (especially U.S. equity), but if a 401(k) plan sponsor wanted to track a niche index (e.g., the Morningstar or S&P Pure indexes) or include additional passive diversifiers (e.g., in the alternative assets space), an ETF would likely be the way to go.

Now, I'm not suggesting plan sponsors should put leveraged gold ETFs in the core menu (or even if they did that participants should use them), but this greater choice doesn't come at the cost of higher expense.

3. Better engagementor, in other words, motivating more people to take an active role in their retirement.

I don't like the idea of 401(k) participants day-trading their 401(k) accounts with ETFs (an oft-cited danger of ETFs in 401(k) plans), but I think that concern is largely, if not entirely, overblown.

Most participants don't even read their quarterly statements, much less actively trade their accounts. However, for some participants the ability to trade their account may be important. Again, I'm not advocating frequent trading (especially because those participants who didn't buy ETFs in the core menu would likely do something similar in the brokerage window), but Americans need to save more, and if this gets a participant excited about saving and planning for retirement, I say game on.

A few caveats

One area where ETFs aren't any better for participants when compared to index mutual funds is taxes. Because 401(k)s are tax-advantaged, the plans eliminate one of the most-hyped advantages associated with ETF trading compared with traditional mutual funds: their tax efficiency. This is a bit of a no-brainer, but it's something to be aware of.

Another issue I have with some ETFs is back-testing. When an ETF is created, its creator can tout the historical performance of the strategy even though the index is brand-new. Vanguard had a clever piece about how it's possible to build portfolios that have looked great historically but may not look so great in the future. It created a fictional family of new ETFs based on each letter of the alphabet. This is an instance where the common expression "Past performance is no guarantee of future performance" definitely applies, because back-testing isn't even true past performance.

Just because your plan offers (or might offer) ETFs doesn't mean you're better off. Regardless of platform or investment type, it's important to be aware of the total costs associated with the investments available and to make sure you have a portfolio that is suitable for your risk capacity and risk preference. However, there are definitely potential cost savings associated with using ETFs, especially when compared to actively managed funds and potentially even when compared to index mutual funds. Whether ETFs continue to gain traction in the 401(k) space is unknown, but they may be worth another look.

By David M. Blanchett, CFA, CFP, head of retirement research for the Morningstar Investment Management