ETFs Coming to a 401(k) Near You!

A recurring query that I get fairly often is with regard to Exchange Traded Funds and their availability in 401(k) plans. Until now ETFs haven’t been widely adopted in 401(k) plans largely because of issues with recordkeeping, specifically relating to owning or buying fractional shares of an ETF. Mid Atlantic Trust Company recently announced that they have resolved the fractional shares recordkeeping issue and will begin marketing this solution to 401(k) plan providers.

There are a number of factors that make ETFs attractive, first among them is cost. Cost is often cited as the number one benefit to investing in ETFs, but not all ETFs are priced the same, nor are they all what I would consider inexpensive. ETFs (with a handful of exceptions that we won’t touch upon here) are largely passive investment vehicles. The holdings within an ETF are not actively traded by a team of investment professionals, like you might see in a mutual fund. They act just like index funds do – by providing broad exposure to the market. Are they cheap? Yes – in relation to actively managed funds. Compared to index mutual funds they are about the same cost.

Price isn’t the only benefit to consider. ETFs are also known for being tax efficient. As passive investment vehicles they don’t trade frequently at all and therefore don’t generate much in the way of capital gains. In this respect they are more tax efficient than actively managed mutual funds, but don’t differ from passive index funds in this manner.

Lastly, ETFs can be traded intra-day rather than at the end of the day like a mutual fund. This allows a savvy investor (in theory) to buy and sell a volatile ETF multiple times throughout the day making a profit along the way even if the closing price doesn’t change from the prior day’s close.

Between lower costs, tax efficiency and intra-day trading you would think that ETFs will be popping up in the only place they haven’t yet… your 401(k) plan. Unfortunately, these characteristics which are largely what has driven incredible growth in the ETF industry for the last decade don’t necessarily translate to the Defined Contribution (DC) retirement plan space.

First, as we established above, ETFs are not cheaper than index funds, which already have been available in plans for years. The idea behind both is identical – broad market exposure at a low cost to the investor, and in many cases index mutual funds are actually less expensive than ETFs (this differs from fund family to fund family so check your prospectus for details).

Tax efficiency, another major benefit of ETFs is not a concern in 401(k) plans as these types of accounts allow for growth on a tax-deferred basis.

Lastly, according to Mid Atlantic Trust Company the ETFs in plans will be bought and sold at end of day prices, just like their mutual fund counterparts, negating the last advantage ETFs have over funds.

I am not a detractor of ETFs. I think they have a place in some portfolios, and while there may have been an unnecessary proliferation of ETFs, the same can be said for mutual funds.

We need to realize that just because something is now available where it wasn’t before does not necessarily make it a good investment or even an upgrade from what was available prior. ETF salesmen will rejoice as they now have a new and large pool of assets to call on, but I’m afraid the average 401(k) investor will be see no net benefit regardless of whether ETFs are now available in their company retirement plan or not.

About the author: Michael Prus is the President and Founder of Scale Investment Group, LLC, a registered investment advisory firm with offices in White Lake and Grand Blanc, Michigan. Scale Investment Group is a leader in providing low-cost institutional investment services, like 401(k) and 403(b) plans, to small and mid-sized organizations and also manages money for private clients. The firm is a champion for small investors promoting low-costs and transparency of the investment advisory industry. For more information visit scaleinv.com or contact Michael directly at mprus@scaleinv.com.