With accelerating momentum not dissimilar to lemmings racing towards the sea, the explosive growth in ETFs astounds even the most ardent fan. This perfect storm of a product eliminates the conflict-of-interest problem wrought forth by
12b-1 fees, offers virtual mutual funds you can trade anytime during the day (no more waiting until 4:00pm!) and has the allure of low cost. Who could ask for anything more!
Sometimes something that appears too good to be true really is. Professionals have long known the potential pitfalls of ETFs. Only recently have these facts become more widely known.
Both The Wall Street Journal (“Risks Lurk for ETF Investors,” February 1, 2010) and Daily Finance (“Does Your 401(k) Have an ETF in Its Future?” January 19, 2010) have featured stories on the problems a 401k fiduciary might encounter when using ETFs. FiduciaryNews summarizes and expands on them:
1) ETF expense ratios aren’t as low as they seem. Most ETFs represent index funds. Just like their mutual fund counterparts, ETF index funds generally have fairly low expense ratios. However, many in the industry anticipate we will soon see ETF products using active management. Once this occurs, expect ETF expense ratios to increase, taking away one perceived – and highly publicized – advantage of this relatively new product.
2) ETF trading commissions can get quite high. Unlike most mutual funds, investors trade ETFs through brokerage accounts. These transactions create commission costs that rarely exist when using mutual funds. These fees can soar given the large volume of trading activity one often finds in 401k plans.
3) ETF liquidity issues may lead to hidden costs. Investors tend to overlook the bid-spread costs when trading illiquid issues. They might be able to buy at a great price, but what happens when they try to sell a thinly traded stock? They often discover they can’t sell at the higher ask price and must accept the lower bid price. With the exception of highly popular ETFs, many ETFs, like thinly traded stocks, can suffer from low liquidity, adding a hidden opportunity cost and lowering overall investment performance. Worse, what’s liquid today may not be liquid tomorrow.
4) Caveat Emptor! ETFs can trade at a premium or a discount. Like closed-end mutual funds, ETFs do not necessarily trade at the “fair market” value of the underlying assets. This is different than the bid-ask spread issue caused by illiquidity. Here, we have the old-fashioned supply and demand principle taking hold. In other words, you’ll pay more for a suddenly popular ETF and less for an unpopular ETF. As with closed-end mutual funds, the reality of the premium/discount will become especially more apparent as ETFs evolve away from index portfolios. If ETFs mimic their closed-end brethren, a premium and discount will result not just from the popularity/unpopularity of the advertised investment style, but also with the relative attractiveness of the fund family and portfolio manager. In the end, you may or may not get what you pay for, so tread carefully before buying.
5) ETF intraday price fluctuations bring back the unitization nightmare for recordkeepers. Back in the 1980’s, interest in 401k plans and mutual funds simultaneously blossomed. Recordkeepers quickly discovered the unitization problem. This problem occurs when plan participants make buy and sell transactions during the day in portfolios that fluctuate throughout the day. Mutual fund firms convinced recordkeepers, plan sponsors and even plan participants that mutual funds represented a cure-all for the unitization devil. ETFs not only threaten this perfect marriage, they also demand the return of unitization. Plan sponsors could continue to limit employee transactions to the 4:00pm closing price no matter what time during the day the order was place. Of course, that would merely duplicate what happens today with mutual funds and eliminate the primary advantage of ETFs (intraday trading); thus, begging the question, “Is it all worth it?”
The ETF industry will continue to grow, creating more pressure for the 401k fiduciary to consider including such products as an investment option. Some vendors claim to have solved the unitization problem and some brokers have even eliminated, at least temporarily, commission costs associated with ETFs. But don’t be surprised if, like a tube of toothpaste, squeezing one problem away only creates a bulge in a different problem.
Chris, total kudos for this post! I love ETFs and use them extensively for my individual clients and for non 401(k) institutional clients. I’ve often felt that many 401(k) platforms are “hawking” ETFs because of their popularity. The issue which has never been explained to my satisfaction (a LinkedIn discussion I started on the topic a couple of months ago generated many excellent responses to this question) is how are they still cost effective after you add in admin costs, unitization costs, etc. I’m not saying that ETFs will not someday be the or one of the 401(k) vehicles of choice, but I’d be hard-pressed to recommend to a client organization today.
Great article, Chris. I think, if ETFs become “the future” of 401ks that a cost-structure will have to be set eliminating any commissions. Although that is not present for most ETFs, it appears Schwab is (possibly) trying to start that by creating a group of low-cost indexed ETF’s that trade with no commission.
I think the best point of the article is that the bid-ask spread is a cost that most investors do not consider when evaluating the low cost of an ETF.
My company is still attempting an ETF-based structure, with the expectation of purchasing commission-free ETFs. As bullet-point 5 points out, it will be a recordkeeping nightmare until we can figure out a way to trade them (either at the open or close of each business day seems to be the only cure, right now).
There is no reason why ETF’s should not be part of a 401k/403b investment menu lineup for its low cost and transparency. As the Founding Partner of a retirement consulting, administration and record keeping Firm that has, since 2003, been allowing Financial Advisors to offer ETF’s to their 401k/403b Plan sponsors, the arguments against their inclusion were completely addressed. In accordance with on-going pension legislation that will address Plan transparency and disclosure, ‘independent’ type platforms should clearly identify all fees associated with the proper maintenance of a Plan and allow financial advisors the ability to use any ETF’s, including developing managed strategies using those ETF’s. And without trading or commission costs. Unlike mutual fund based only platforms that do not disclose all associated fees, including 12b-1 fee overrides, an independent platform will fully disclose the 4 components of costs associated with these types of 401k/403b: 1) ‘pure’ investment costs where 12b-1 expenses, if any, are used to defray toher expenses; 2) Financial Advisor investment rep fee; 3) Custodial costs without any add’l trading or commission costs; and 4) record keeping and administration costs. In almost any situation that we have been involved in sicne we launched our program, the above 4 costs were always less than a properly disclosed mutual fund based only platform.
Sorry: Corrected for typos as submissions do not include spell check.
There is no reason why ETF’s should not be part of a 401k/403b investment menu lineup for its low cost and transparency. As the Founding Partner of a retirement consulting, administration and record keeping Firm that has, since 2003, been allowing Financial Advisors to offer ETF’s to their 401k/403b Plan sponsors, the arguments against their inclusion were completely addressed. In accordance with on-going pension legislation that will address Plan transparency and disclosure, ‘independent’ type platforms should clearly identify all fees associated with the proper maintenance of a Plan and allow financial advisors the ability to use any ETF’s, including developing managed strategies using those ETF’s. And without trading or commission costs. Unlike mutual fund based only platforms that do not disclose all associated fees, including 12b-1 fee overrides, an independent platform will fully disclose the 4 components of costs associated with these types of 401k/403b: 1) ‘pure’ investment costs where 12b-1 expenses, if any, are used to defray other expenses; 2) Financial Advisor investment rep fee; 3) Custodial costs without any add’l trading or commission costs; and 4) record keeping and administration costs. In almost any situation that we have been involved in since we launched our program, the above 4 costs were always less than a properly disclosed mutual fund based only platform.
I would argue that most of these points are not entirely relevant, and that cost saving and fiduciary responsibility still lean toward using ETFs in plans.
1. Most ETFs are index funds, and they are far cheaper than most mutual fund equivalents. Managed ETFs represent a very small minority of the whole, and they are still cheaper than managed mutual funds. I would argue that index funds are more prudent anyway, because 80% of managed funds meet or under-perform the market.
2. Trading costs are normally included in 401(k) plans offered by ETF-capable recordkeepers, and do not act like brokerage accounts, so plans and participants do not pay for any more for the service.
3. There are so many heavily traded ETFs now, so there is no need to use exotic, thinly traded ones in a plan.
4. NAV is totally irrelevant. Like a stock, it trades at the value people are willing to pay for it. The market sets a price for the shares, at the time of purchase and at the time of sale. Furthermore, for heavily traded ETFs, NAV tends to track almost perfectly.
5. Most ETF-capable recordkeepers do execute trades only once a day. This may negate the liquidity advantage that ETFs offer typical investors, but this simply puts ETFs on equal ground with mutual funds.
What is not articulated in this article is the transparency aspect of ETFs. On top of 12B-1 fees, mutual funds tend to not fully disclose all costs to shareholders. Internal trading fees, and other fees, are rarely disclosed. A very, very large percentage of plan sponsors and participants still think that their plans are “free”. They are simply not aware of huge sums that mutual fund companies are making off them in various fees. With an ETF platform, fees cannot be hidden in the investments. Regulation will surely remedy this, unless the mutual fund companies block it.
From a participant’s perspective: So what?
Keep in mind that 70mm participants out there are lousy asset allocators. We agree with Alvin Rapp that a lousy mix of ETFs is better than a lousy mix of actively managed mutual funds. However retirement security (which is why we are doing this, right?) is not about the style box investment vehicles it’s about what participants do with them. Effectiveness (proper diversification) goes up and sponsor’s fiduciary risk goes down when participants choose/or are defaulted into, managed ETF portfolios. We see about 10bps below the line cost on our Managed ETF portfolios, FYI.
Chris,
It’s time to reconsider the 5 points for 2012.
1) If you want active management use MF’s as the best managers are not on the ETF side, yet. For indexing….. Hands down small and mid size plans benefit from ETFs.
2) The cost for trading an ETF is usually around 1 to 4 cents depending on rebates. Trade costs have come down or have been removed completely on some platforms.
3) With over a trillion in ETF assets there are enough ETFs that can be used in a plan that have no liquidity issues.
4) Open in Mutual Funds have the same issue, just at a different level. Several posts have debunked your point as not understanding the mutual fund trades, however I believe that the topic is still open for debate. It will be solved as trading of ETFs continues to rise and bid and asks narrow. SPY, IVV, IJR, IJR, VWO etc.
5) It is worth it IF plan costs and investment costs come down. A 1% savings in fees for 20 years increases the plan participants balance by 17%.
ETFs in 401k plans are happening now. WisdomTree, Invest N Retire, TD Ameritrade, Schwab, ING’s Sharebuilder 401k and other smaller players are leading the way.