The ABCs of ETFs

While exchange-traded fund assets have been growing in popularity among individual investors, employers have been slow to include them in retirement-plan offerings. Here's what plan fiduciaries need to know before adding them as an option for employees.

By Carol Patton

As plan sponsors, employers should always be on the hunt for appropriate investment vehicles for their 401(k) retirement plans that help employees reach their retirement goals.

Exchange-traded fund assets have been growing in popularity among individual investors, but not so much in employers' retirement-savings plan offerings for workers. ETFs are pooled investment vehicles similar to mutual funds, except that employees can trade them throughout the day. Exchange-traded fund assets climbed by 32 percent over the last year to $2.9 trillion, according to Investment Company Institute, the national association of U.S. investment companies of mutual funds, exchange-traded funds, closed-end funds and unit investment trusts. Besides intraday trading, their benefits also include tax efficiencies and cheaper fees than some mutual funds. Still, employers sponsoring 401(k) plans are not biting. The ICI states that two-thirds of the $5 trillion in assets in company-sponsored retirement plans are held in mutual funds.

"Plan fiduciaries have real concerns about the way ETFs are traded and a lack of desire to open up intraday trading within their plan," says Lew Minsky, president and CEO at the Defined Contribution Institutional Investment Association in Palm Beach Gardens, Fla. "The question is whether [ETFs] are consistent with a plan that is more about long-term investments than about short-term transactional approaches to investment."

A recent trend in the retirement investment market has been developing investment lineups that support the teachings of behavioral finance, he says, which explains why people make irrational financial decisions. Since a significant portion of plan participants lack financial knowledge or skills to successfully trade funds such as ETFs, they invariably make poor decisions that lead to severe financial losses. He says many employees would be better served by using the plan's default investment structure that's managed by professional investment advisers.

In the future, Minsky says, professional investment managers may be using ETFs as either a diversifier or hedging strategy within a broader investment structure. Until then, he says, many companies will continue favoring traditional retirement investment vehicles.

"As a fiduciary, you're responsible for what's in the best interest [of] all participants in the plan, not just the loudest voice," says Minsky, referring to the handful of plan participants who may support ETFs.

Even five years from now, some predict that the vast majority of assets in retirement plans will still be mutual funds.

"When it comes to pure expenses, there are plenty of mutual funds that have a low cost structure . . . so price is not the reason to do ETFs," says Srinivas Reddy, senior vice president and head of full service investments at Prudential in Hartford, Conn. "Mutual funds are just as good as ETFs, if not better, because they're simple, straight-forward and prevent bad behaviors like people doing knee-jerk reactions in the market."

Since most employees are savers, not experienced investors, HR needs to design retirement plans accordingly. As investment vehicles, he says offering both ETFs and mutual funds requires detailed explanations as to their differences, which can be very confusing, even overwhelming, for many workers.

Another consideration: employees can only buy whole shares of ETFs, but can purchase fractional shares of mutual funds in a retirement plan.

"I can't think of too many circumstances in which mutual funds don't keep up with ETFs in the retirement landscape," says Reddy. "There are additional complexities and costs that come with ETFs that not everyone in the employee base will be aware of or [understand] . . . . Given that this is a long-term investment vehicle, we don't think short-term trading makes a whole lot of sense."

Although ETFs are not set up to work well with traditional record-keeping systems, some retirement plans still enable participants to trade ETFs at their own risk. If HR wants to follow this path, it must first contact its record keeper to ask if the ETFs are accessible via a brokerage window or standard platform, says Keith Clark, partner at DWC The 401(k) Experts in Minneapolis.

If taking the latter option, ask how these funds will be traded: at the individual or plan level?

"If at the plan level, they turn the ETF into a glorified mutual fund that's valued at the end of the day," Clark says. "They take the entire ETF pool and calculate all the shares that were sold that day along with the price of shares that weren't sold to come up with a value. That's what everybody gets at the end of the day."

Many service providers offering brokerage accounts also build in added protections for participants, he says, including limiting their purchases to only buying mutual funds or ETFs or restricting them from buying gold.

Either way, Clark says that enabling participants to trade ETFs on their own poses a higher level of risk and responsibility for fiduciaries that must now protect novice investors from themselves.

Among their fiduciary obligations are monitoring fee levels to ensure they're reasonable and working with record keepers to educate participants about trading, says Kevin Vandolder, partner and defined contribution client practice leader at Aon Hewitt in Austin, Texas.

There may come a time when plan sponsors see unusual activity -- such as half of every dollar invested in a self-directed brokerage vehicle sitting in one investment. Alarm bells should go off then and prompt plan sponsors to take action, Vandolder says, adding that more record keepers are targeting communications that provide education and guidance, not advice, to specific plan participants. For example, an email or letter could explain how someone who's invested 100 percent in healthcare funds could earn higher rates of return over a long period of time with a diversified approach.

It's difficult for employees to individually build a successful investment portfolio during their lifetime, he says. Many tend to chase performance, invest when the market is high based on historical rates of return, and then watch their investment rapidly decline.

"None of our clients use ETFs at all," says Vandolder. "Target date funds and managed account vehicles have better outcomes in terms of rate of return than participants who design their own investment program."

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Aug 30, 2017
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