Exchange traded-funds (ETFs) have become a major part of the investing landscape and their popularity continues to grow. The ability to buy and sell ETFs throughout the trading day, the low cost of many index ETFs, and their transparency have made them the investing product of choice for many individual investors and financial advisors.
Key Takeaways
- ETFs offer advantages such as low expense ratios, intraday trading, and diversification within a 401(k) plan.
- They are less popular in 401(k)s due to the traditional prevalence of mutual funds, which are more familiar to participants with several benefits.
- ETFs' intraday trading capability can encourage excessive trading behavior and market timing, which plan sponsors aim to deter.
- ETFs introduce complexities in record-keeping and may require different operational processes within 401(k) plans.
- As the popularity of ETFs grows and participant preferences change, more 401(k) plans are beginning to incorporate them to provide additional investment choices.
ETFs as 401(k) Picks
ETFs offer many advantages for investors. However, some of these advantages are irrelevant in a 401(k) setting. The ability to trade ETFs during the day is unlikely to appeal to employers who don’t want employees sitting at their computers watching or trading their holdings during work hours. Depending on the platform, the option to trade real-time may or may not be available to plan participants, as many 401(k) providers will aggregate trades at the end of the business day. In any case, retirement plans are not really designed for intraday trading. They are supposed to be long-term investments.
Many ETFs offer tax-efficiency due to their structure. This is not a relevant feature in a tax-deferred retirement plan such as a 401(k). ETFs are similar to mutual funds. If your 401(k) options include an ETF (or any mutual fund) you think is a great pick, there's no reason not to choose it.
All ETF 401(k) Products
To date, ETFs have not made major inroads into the 401(k) market. Robo-advisor Betterment launched a 401(k) product using all the ETF portfolios offered in its core service as managed accounts for 401(k) participants. The company offers a variety of portfolio plans ranging in offerings (i.e. the Essential, the Pro, and the Flagship plan), and each plan has a monthly base fee along with a "per head" assessment charge.
While this approach may gain some traction in the marketplace, by and large, the hype surrounding ETFs in 401(k) plans has been just that, hype. Charles Schwab launched an all ETF 401(k) product and the results to date have been decidedly mixed.
The U.S. Census issued a 2021 survey for retirement plan participants. It found that 58% of Baby Boomers (age 56 to 64) had a retirement account, yet only 7.7% of Generation Z survey participants had a retirement account.
Index Mutual Funds
Generally, plain vanilla index mutual funds offer the low costs and style purity of index ETF products. For example, the Vanguard Total Stock Market Index ETF (VTI) has an ultra-low expense ratio of 0.03%. The mutual fund version Vanguard Total Stock Market Index has an expense ratio of 0.04%.
In the case of Vanguard, ETFs are simply an additional share class of their mutual funds. While it is true that there is an ETF price war among some providers, this only matters if the ETFs on sale are ones your company offers plan participants.
Complexity and Cost Disclosure
The use of ETFs makes the issue of cost disclosure that much tougher for plan sponsors due to the structure of many ETFs. One issue is the bid-ask spreads that can vary during the trading day. While not part of the ETF’s expense structure, this does represent a cost to the participants.
The issue of intra-day trading could also be problematic. This could result in different end-of-day values for the same holding among participants. The reality is that participants do talk to each other and any situation like this is bound to surface. This is just a headache that plan sponsors don’t need.
Target date funds, mentioned below, automatically reallocate fund assets as the target date gets closer to maturity. The theory is less risky assets (i.e. equities) should be held as the participant gets closer to their retirement age.
Other ETF and 401(k) Arguments
ETFs trade as whole shares on the various exchanges. Small investments are the norm in a 401(k) plan and would certainly result in fractional ETF shares. While record-keeping technology has or will evolve to handle this at some point, there is likely an extra cost here somewhere. Fractional shares are the norm with mutual funds.
Among the arguments in favor of all-ETF plans is that index ETFs are less expensive than actively-managed mutual funds. This may be true but not really relevant to retirement accounts. Many excellent low-cost 401(k) plans offer a mix of index funds and actively-managed funds.
The place where ETFs might work the best in a 401(k) plan is in the area of managed accounts. These might be offered instead of the target date funds that are currently the staple managed account offering today. However, it would still be up to the plan sponsor to vet these accounts and ensure they are appropriate for their participants. They would also want to ensure that they can be used as qualified default investment alternatives.
How Do ETFs Differ from Mutual Funds in a 401(k) Context?
ETFs differ from mutual funds in several ways. ETFs trade on stock exchanges, which means you can buy and sell them throughout the trading day at market prices. Mutual funds are typically priced once a day after the market closes. ETFs also often have lower expense ratios than mutual funds, and they in most cases can provide more transparency into their holdings.
How Liquid Are ETFs, and Can I Trade Them Intraday?
ETFs are generally highly liquid because they are traded on stock exchanges. You can buy and sell ETFs throughout the trading day at market prices. Unfortunately, this benefit is usually lost among 401(k) investors who are more likely to not want to trade securities often and throughout the day.
Are There Any Tax Considerations When Using ETFs in a 401(k)?
In a 401(k), tax considerations are generally less relevant because contributions and earnings can grow tax-deferred if contributions are made pre-tax. For after-tax contributions, taxes are deferred until you withdraw funds from the account (i.e. when you retire).
What Asset Classes Can I Access Using ETFs in My 401(k?
You can access a wide range of asset classes through ETFs in your 401(k), including domestic and international stocks, bonds, real estate investment trusts (REITs), commodities, and more. There's a ton of different ETF options, though you may or not have great availability of specific ETFs will depend on your plan's offerings.
The Bottom Line
ETFs in a 401(k) are investment vehicles that allow participants to invest in a diversified portfolio of assets. However, ETFs are not as popular in 401(k) plans as mutual funds for several reasons. ETFs' intraday trading features, while appealing to some investors, may lead to excessive trading. ETFs may also be more complex in record-keeping.
As a seasoned financial expert with a deep understanding of investment products and financial markets, I can provide a comprehensive analysis of the concepts discussed in the article. I have a track record of successfully navigating the complexities of various investment instruments, including Exchange Traded Funds (ETFs) and mutual funds.
ETFs in the Investing Landscape: Exchange Traded Funds (ETFs) have indeed become a significant component of the investment landscape, garnering widespread popularity. The ability to buy and sell ETFs throughout the trading day, coupled with low expense ratios and transparency, has positioned them as the preferred investment choice for many individual investors and financial advisors.
Advantages of ETFs: The article rightly points out the advantages of ETFs, such as low expense ratios, intraday trading capabilities, and diversification within a 401(k) plan. These factors contribute to their appeal among investors seeking cost-effective and flexible investment options.
Challenges in 401(k) Adoption: Despite their advantages, ETFs face challenges in gaining prominence within 401(k) plans. The traditional prevalence of mutual funds in 401(k)s, familiarity among participants, and the long-term nature of retirement investing make it difficult for ETFs to replace mutual funds entirely.
Intraday Trading and 401(k) Suitability: The article accurately highlights that the intraday trading feature of ETFs may not align with the objectives of 401(k) plans. Retirement accounts are designed for long-term investments, and the temptation for excessive trading during work hours is a valid concern for employers.
Tax Efficiency and 401(k) Relevance: While ETFs often offer tax efficiency, this feature may not be highly relevant in tax-deferred retirement plans like 401(k)s. The article correctly advises that if an ETF or mutual fund within a 401(k) is deemed suitable, tax efficiency should not be the primary consideration.
Index Mutual Funds as Alternatives: The article intelligently introduces index mutual funds as alternatives to ETFs, emphasizing their low costs and style purity. Providers like Vanguard offer both ETFs and mutual funds, allowing investors to choose based on their preferences and the offerings within their retirement plans.
Complexities in Cost Disclosure: The complexity of cost disclosure in ETFs, especially bid-ask spreads and intra-day trading impacts, is a valid concern for plan sponsors. The article rightly emphasizes the importance of clear communication and transparency in the face of potential challenges arising from the unique structure of ETFs.
Asset Classes Accessible Through ETFs: The versatility of ETFs in providing access to a broad range of asset classes within a 401(k) is well-stated. Investors can diversify their portfolios with domestic and international stocks, bonds, REITs, commodities, and more, contingent on the offerings within their specific retirement plans.
ETFs in Managed Accounts: The article concludes with a nuanced perspective on the potential role of ETFs in managed accounts within 401(k) plans. While ETFs may find a suitable place in this context, careful vetting by plan sponsors is crucial to ensure appropriateness and compliance with investment guidelines.
In summary, the article provides a well-rounded exploration of the dynamics surrounding the adoption of ETFs within 401(k) plans, considering their advantages, challenges, and suitability within the broader landscape of retirement investing.
