Exchange Traded Funds (ETFs) are empowering individual and professional investors with the power of transparency, diversification, low fees, and, compared to many active fund managers, better performance. ETFs now provide the individual investor access to institutional type investment vehicles.
If you’re new to ETFs, the simple way to explain them is to compare them to mutual funds. A mutual fund manager buys and sells stock throughout the year to try and beat an index, say the S&P 500, which is made up of the 500 largest companies in America. History shows that fund managers have a hard time doing this over the long term. If you buy an ETF of the S&P 500, you are buying and holding all 500 companies in the index with a fee that is much less than a typical active mutual fund’s cost.
There are now over 900 ETFs to choose from, covering everything from domestic large cap to frontier markets. This makes one wonder why these ETFs are not showing up in 401k plans. There are several hurdles that 401k providers have had to overcome in order for ETFs to be available as an investment option. ETFs are structured differently than mutual funds. They trade on exchanges like stocks. The good news is that over the past 18 months, companies that specialize in providing custody and back office services for company plans can now bring ETFs to a 401K plan, as well as traditional actively managed mutual funds.
The debate as to why ETFs should be in 401k plans could be argued on fund performance. The active vs. passive debate has been covered a lot over the years. The winner is usually a mix of both strategies, using low-cost passive instruments, such as ETFs, while actively managing the diversification process by rebalancing. In the interest of full disclosure, our firm uses a diversified indexing approach to investing. This keeps to our investing philosophy of maintaining a diversified portfolio, keeping cost low, and always investing for the long term. Allowing ETFs into a 401k plan would certainly increase diversification and lower cost dramatically.
The cost of investing is something that is very hard for individual investors to follow. Almost all brokers gloss over this issue of cost. Most brokers fail to understand that a mutual fund’s transaction fees aren’t included in the management or 12b-1 fee disclosures. Active buying and selling inside a mutual fund generates substantial commissions. Although these costs are hard to find in the fund documentation, they do exist and they hinder fund performance. The average mutual fund costs 1.42%, and transaction fees can run an additional 1-2% per year, depending on the fund’s asset turnover. The average iShares ETF costs 0.41%. Since most existing 401k plans offer actively managed mutual funds, in this cost comparison, there is a 1.01% difference in cost between ETFs and mutual funds, not including mutual fund transaction costs, which can widen the gap considerably. If an investor had $100,000 in his or her retirement account and switched to an ETF portfolio, growing at 7% per year for 20 years, paying 0.50% in fees, the fund would grow to $387,000. Assuming identical investment performance, if the 401k participant used mutual funds at a fee of 1.5%, the money would only grow to $321,000. This is a 17% difference! Add in the fact that countless studies show that only a small percentage of fund managers beat their assigned index over long time periods, performance is not even an issue; proper asset allocation and low fees are the key to success.
So, why doesn’t rapid change take place in 401k plans across America? If employees can begin to understand what their real cost of investing is, and can understand the power of global asset allocation investing, these changes will begin to take place. Certainly if Congress will realize how insurance companies and America’s large financial companies are chronically overcharging Main Street 401k plans, we might get change that could make a difference for average 401k investors. Current changes in fee disclosures for the 401k marketplace are being debated. Don’t count on change coming easily, since the aforementioned industry players are very well funded and have no desire for increased disclosure. They are making way too much money with the status quo.
There are very few stakeholders in the 401k arena that stand to benefit from educating investors on these concepts. Large plan providers receive revenue from the mutual funds that are in the plan. They in turn share these revenues with the brokers who sell the plans. If a participant purchases a low cost ETF instead of a higher-priced mutual fund, the plan provider ceases to receive this form of revenue sharing. Why would these entities rock the boat of their longstanding income stream?
Within the past year, new and innovative 401k providers have developed the back-office systems to allow ETFs to be used in 401k plans. This causes several things to happen. First, if plan sponsors are serious about their fiduciary duties to their employees, they have a duty to evaluate these plan options and compare them to their existing plans. Secondly, financial professionals who sell 401k plans and then sit back and rake in the fees must reevaluate their business models to remain competitive in the marketplace.
Our firm is a fee-only Registered Investment Advisor. We believe in full and transparent fee disclosure. We use a broad range of ETFs to build diversified portfolio models at much lower cost than actively managed funds. None of the instruments we use pay 12b-1 fees. This results in significant fee savings, and thus better long term performance for our clients. We thoroughly evaluate each individual client’s risk tolerance and place them in the portfolio that matches their needs. We spend a lot of time educating individual investors on how to invest efficiently for the long term. Our goal is to equip investors with the knowledge that keeps them from getting ripped off by high fees and improper diversification.
Any company that continues to allow their plan provider to fill their 401k plan with high priced active mutual funds stuffed with revenue sharing fees without doing the necessary due diligence is doing a disservice to their employees. As fiduciaries, small business owners and HR executives owe it to their employees to study these new options and consider upgrading their plans. Many brokers and plan sponsors fail to understand the concepts of indexing, asset allocation, standard deviation and Sharpe ratio. These are things that someone who selects a 401k plan should know.
Here are some facts about the industry. In 2008, when billions were flowing out of mutual funds, ETFs saw record inflows, gaining assets from the mutual fund business. There are over 900 ETFs on the market offering diversification in virtually any global asset class, many at less than 0.25% a year in fees. I encourage you and your company to do the due diligence and decide if it makes sense to consider changing your plan to a more efficient platform.
Terrapin Capital Management maintains relationships with ETF Advisor k, LLC and Mid Atlantic Capital Group to offer ETF based qualified plan solutions for our clients. We provide total fee transparency, extensive participant education and fiduciary responsibility through an open architecture platform. Please contact us for more information.
ResearchMag.com Article - This article discusses the growing trend of ETFs in 401k plans.