401(k) Specialist Issue 2 - 2016 - 29

INVESTMENT INSIGHT by David Blanchett & Nathan Voris
ETFs In 401(k)s: 3 Reasons for a Solid Look
WHILE EXCHANGE TRADED FUNDS themselves
aren't new, they are relatively new to 401(k) and other
defined contribution retirement plans. They've been
slow to catch on, but are gaining some momentum.
One key impediment has been that unlike mutual
David Blanchett
funds, you can't buy fractional shares of ETFs. This
makes it operationally difficult to buy and sell ETFs
intraday in 401(k) plans, which have historically operated
in a daily valuation environment. Commissions,
the bid/ask spread, and the cost of pooling are other
hurdles that must be overcome to make ETFs 401(k)ready
(and more attractive than their mutual fund
counterparts).
But there are at least three characteristics where
ETFs may have an advantage.
Nathan Voris
No.1 Lower cost. 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. 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. Particularly for small
DC plans that might not have the scale to demand the
best pricing from traditional passive mutual fund and
CIT options, passive ETFs have the potential to lower a
plan's overall investment management expense. The
potential benefits of ETFs are even greater when compared to actively managed investments,
but so are index mutual funds, so this is a bit like comparing apples to oranges.
No.2 More choice. While there are plenty of mutual funds that cover the common style-exposures
(especially U.S. equity), if a 401(k) plan sponsor wants to track a more niche index
(e.g., the Morningstar or S&P Pure indexes) or include additional passive diversifiers (e.g., in
the alternative space) there is likely to be more options in the ETF space. This isn't to suggest
plan sponsors should put leveraged gold ETFs in the core menu (or even if they did that
participants should use them), but this greater choice generally doesn't come with higher
expense. A good example are the many " smart beta " ETFs in the marketplace, that may track
a broad basket of large stocks passively, but in a less traditional way than the S&P 500 or
Russell 1000 Indexes.
No. 3 Better engagement. Investors are interested in ETFs, and anything that gets them
excited about investing is a good thing. An often-cited concern is that ETFs encourage 401(k)
participants to day-trade their 401(k) accounts, but in practice, few do.
One potential concern around ETFs is historical performance, since the ETF creator can tout
the hypothetical, back-tested performance of the strategy even if the index is brand new. Consultants
and investment professionals will have to become more knowledgeable about the inner
workings of ETF operations and design before
wide-scale adoption of ETFs in 401(k) plans
occurs.
ETFs offer a number of advantages, but
they're not always the best investment
option. Regardless of platform or investment
type it's important to be aware of the
total costs associated with the investments
that are available and to make sure they're
suitable for participants' risk capacity and
risk preference. ETFs can offer potential
cost savings, especially when compared
to actively managed funds and potentially
even when compared to index mutual funds.
Better choice and engagement are other
potential benefits. Whether ETFs continue to
gain traction in the 401(k) space is unknown,
but they may be worth another look.
David M. Blanchett, CFA, CFP, is the head of
retirement research for the Morningstar Investment
Management group in Chicago, IL. Nathan Voris is
the director of sponsor and workplace investment
solutions for Morningstar, Inc in Chicago, IL
''The potential
benefits of
ETFs are even
greater when
compared to
actively managed
investments,
but so are index
mutual funds, so
this is a bit like
comparing apples
to oranges.
''
ISSUE 2 2015 | 401kSpecialistmag.com 29

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401(k) Specialist Issue 2 - 2016

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