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.