ETF Talk: Change We Can Believe in for Your 401(k)

Although exchange-traded-funds (ETFs) are finding their way into the portfolios of many investors, they have yet to make much headway in 401(k) retirement plans. But that situation could start to change. If current drawbacks to using ETFs in 401(k) plans are resolved, the ETF industry would gain increased working capital, heightened revenues and earnings, and enlarged market share at the expense of mutual funds.

It also would open up the world of ETFs to a much bigger pool of investors. Mutual fund companies recognize the competitive threat and counter that they provide many low-cost, index-tracking funds that essentially perform the same service as ETFs.

It would not surprise me at all if many 401(k) providers were eyeing ETFs to supplement their array of mutual fund offerings. The sheer breadth of ETFs gives asset managers a spectrum of investment possibilities. The vast selection will allow retirement portfolios to be cobbled together that are best suited for the individual circumstances of people across a wide range of ages and income brackets. 

Ideally, a retirement portfolio should have access to funds that mirror all types of market indexes, ranging from the S&P 500 to overseas stock exchanges. If there is anything that the bear market of 2008 taught us, it has been to diversify. Just ask any wealthy investor or hedge fund manager who used Bernard Madoff to manage money. In the wake of industry scandals and poor performance by money managers, ETFs that track indexes and stock markets are becoming increasingly attractive.

ETFs still have hurdles to overcome before their use in 401(k) plans becomes commonplace. A correctable weakness for ETFs is that their use in 401(k) accounts involves the payment of fees by plan administrators that — when used inside a "collective trust" — can be higher than the fees for mutual funds. However, that current disadvantage is limited to the use of ETFs in 401(k) accounts and can be remedied.

A 401(k) record-keeping company, Invest n’ Retire, of Portland, Ore, has developed a technology to trade ETFs cost-effectively in 401(k) plans. The firm’s software allows ETFs to be traded in real-time at institutional pricing. Coupled with lower management fees, ETFs are becoming attractive investments in 401(k) plans. 

ETFs still retain decisive advantages, compared to mutual funds. For example, ETFs offer intra-day trading to allow their purchase and sale throughout a trading day as share prices change. If an investor decides to trade an ETF, the transaction can be processed within seconds to eliminate market risk. In contrast, mutual funds keep the same price throughout a trading day and only revise it the next day after the market closes. That limitation for mutual funds leaves their investors vulnerable to market volatility during the course of a day. Right now, a growing number of mutual fund investors are pulling out their money — driving down fund values for the remaining shareholders.

As always, I am pleased to answer any of your questions about ETFs. To send me your questions, please click here. You may see your question answered in a future ETF Talk.