When Navmar, a naval-engineering company based in Chester, Pa., switched five years ago to a 401(k) plan offering exchange-traded funds, some employees worried that they were being used as "guinea pigs."
Sure, ETFs were becoming hot market investments, but they were relatively unknown in the world of 401(k)s, which is dominated by mutual funds and annuities. Navmar's in-house search committee looked at the options and chose an all-ETF 401(k) plan associated with Portland, Ore.-based Invest n Retire, a record-keeper and pioneer in the field.
"We picked up just about every eligible participant, including a lot of retired military who didn't need this, but came on board," says Michael Kelley, Navmar's director of administration. "We had [received many] questions: 'Why should we jump into something new and untested?' We had a few folks who said, 'Are we guinea pigs?' " They found out why: The fund has grown over five years from $3.2 million to more than $10 million.
If Navmar's roughly 200 employees are guinea pigs, they are richer for it.
Today, as businesses try to recoup market losses in their 401(k) plans, many are giving a serious look at plans that invest in ETFs. It seems a natural step, since these funds have become popular among individual investors in tough times. The combined assets of ETFs grew 19.6 percent to $693.38 billion from September 2008 to September 2009, according to the Washington-based Investment Company Institute.
More major brokers and insurance companies, such as ING Direct and Schwab, are offering 401(k) packages with ETF options.
And companies that produce them, such as BlackRock (which recently bought iShares), Vanguard, State Street Global and WisdomTree; investment advisers such as Avatar; and record-keeping firms such as Invest n Retire are enthusiastically marketing ETF plans.
Yet the trend still appears small. That puzzles ETF-plan advocates, who tout three big advantages: low expense ratios, transparency of fees and customized advice for participants.
"I think it's a secret now. No one knows about ETFs in 401(k) plans," says Joseph Childrey, managing partner at Childrey Investment Partners in La Jolla, Calif. "ETFs are just another wrapper [for stocks and bonds], like a mutual fund -- only a less-expensive, more-efficient wrapper."
A Closer Look
So what exactly is an ETF -- this new, magic bullet of the investment world first introduced in 1993 as Standard & Poor's Depositary Receipts, known today as SPDRs or "Spiders?" And what does this new fund offer a 401(k)?
Essentially, the ETF is a bundle of securities that replicates and tracks the performance of a stock-market index (such as the Standard & Poor 500), a portion of an index, a bond or a commodity. ETF shares are bought and sold in large blocks called creation units. They are traded like stocks on worldwide markets; however, because they track indexes, they have low operating and transaction costs. In a 401(k) plan, they can be packaged as an ETF-only platform, or as pre-allocated asset-allocation funds in a plan with mutual funds.
Wayne Connors, chief investment officer with 3D Asset Management in East Hartford, Conn, associated with WisdomTree, says he's seeing the funds becoming "vehicles of choice over mutual funds because of the low cost and broad diversification."
"Not all 401(k) providers can offer ETFs because the trading mechanism is different," he says. "We're seeing more and more 401(k) service providers are rebuilding their platforms so they can . . . ."
No one has surveyed the popularity of ETF 401(k) plans, says Ed Ferrigno, vice president of the Profit Sharing/401k Council of America in Chicago, leading him to conclude, "It's a very small percentage of the plan world."
Although there are no studies, some observers believe the plans are making greater inroads among small companies than larger ones. There could be several reasons: Large corporations probably have a long, entrenched history with large mutual-fund plans. They have little incentive to try something relatively untested and would find it hard to extricate themselves from an existing plan. A small company would be more likely to try an ETF if it were enthusiastically recommended by an executive or a financial adviser.
Mark Gentzen had invested personally in ETFs, so when he took over Mastercraft of Seattle, a Seattle-based finishing print shop, in 2008, the company switched to an ETF-based plan from a traditional mutual-fund plan.
According to Gentzen, many of the 10 employees had accumulated significant savings over time. "What I learned was they had very little understanding of where they put their money. They had invested in fairly risky funds. ... It was actually quite easy to make the transition." With the ETF-based plan from ShareBuilders, administrative costs have gone from 2 percent to 1 percent. Employees save about $1,100 annually in administrative fees and another 1.2 percent across their investments.
Matt Smith, leader of Aon Consulting's defined-contribution practice in Seattle, concurs there's a size differential.
"My perception is the ETF coming into plans is more of a small-plan thing," says Smith, who works with medium- to large-sized clients. "They are probably more affected by the opinion of the individual adviser."
Smith says they aren't nearly as popular with clients in the medium-to-large market. "I don't think there is a compelling advantage to make the change, and there are more potential disadvantages," he says. For example, while tax advantages are one of their biggest boasts, ETFs become irrelevant with a long-term, tax-deferred 401(k) plan.
The reason ETF-based 401(k) plans are getting some attention is their record of performance on the stock market for personal investors.
"I love ETFs. They're one of the best things to happen in a long time," says Steve Dimitriou, financial consultant with Mayflower Advisors, a Boston-based financial-services firm. "As an individual, I'm all for ETFs. For your own personal account, go for it."
Darwin Abrahamson, president and founder of Invest n Retire, says the "biggest advantage is they're such a great investment vehicle. There's no question, because of the growth, that's what institutions are using," he says.
There also seems to be no question that the expense ratio of an ETF-based 401(k) plan is considerably lower than that of a traditional, mutual-fund plan. One reason, says Dimitriou, is that mutual funds have expenses, such as the costs of printing a prospectus, keeping statements and providing a fleet of workers to staff the 800 number.
Saving money was the main reason Raylon, a wholesale beauty product distributor in Reading, Pa., switched to an ETF plan after years with a traditional 401(k).
"[Before], people were investing, and their balances didn't seem to be growing. A lot of profits were being eaten up by fees," says Chris Raszkiewicz, Raylon's vice president for finance. "A lot of the fees were not really understood by the employees or us. They weren't disclosed. Our plan now is up-front with the fees and able to save us a lot of money."
Transaction costs are generally lower, too. Not only does the ETF typically track a stock index, which keeps costs down, but there are no transaction fees on individually traded shares. In a mutual fund, the shares within the fund are traded individually, so you have those transaction fees. An ETF is a bundle of shares. The ETF is traded as a unit; the shares within it are not traded individually, so you just have the transaction fee on the ETF itself.
"True, ETFs do incur a cost in the form of a spread when an ETF is bought or sold on the open market," says Abrahamson. "[However], mutual funds buy and sell thousands of shares a day on the open market. Each mutual-fund transaction also includes commissions as well as spreads."
Because they are traded like stocks, ETFs have all the advantages of stocks as well: You can trade them throughout the day, sell short, sell on the margin or write options against them. And because they are tied to indices, the portfolio is transparent. Mutual-fund 401(k)s disclose their portfolios quarterly.
"You know exactly what you have [with an ETF] because it's following a specific index. There is a lot more style adherence. With [non-indexed] mutual funds, how often do you lift up the hood and [they] are not invested the way you thought?" says Dimitriou.
With ETF-based 401(k)s, what you see is what you get, according to experts.
Historically and as a matter of course, 401(k) participants select their plans, pay management fees and leave it to the provider to pick the funds and all the administrators. This kind of hands-off approach can certainly explain why complaints of hidden fees have cropped up in the recent past. It's hard not to be unpleasantly surprised by an expense you were never told about when it suddenly appears.
With an ETF plan, the employer itself hires all of the plan administrators and knows exactly where the money is going. That includes lining up the ETF producer, the custodian (who has legal responsibility for the securities), the record-keeper, the financial adviser and the third-party administrator, who handles compliance.
"With most of the [mutual-fund] plans out there ... the only cost the employer sees is the investment, because the other costs are buried in the fund expenses," says Connors of 3D Asset Management. "An ETF has the benefit of being completely transparent; nothing is hidden."
That includes no 12B-1 fees, the controversial mutual-fund broker's commission.
"There is no revenue sharing, no 12B-1s, no trips to Hawaii, no kickbacks. ... The plan sponsor pays the service providers for their services. It's fully transparent," says Childrey.
Abrahamson suggests that some financial advisers won't promote ETFs for just that reason. "There are people out there entrenched in high commissions trying to bad-mouth ETFs. ... We're a threat to the status quo. We disclose all the fees."
One of employees' biggest frustrations with 401(k)s is that they have to choose their own investment portfolios.
"[Participants] are expected to be Wall Street geniuses ... [when] 80 percent to 90 percent want someone to do it for them," says Michael Case Smith, senior vice president for institutional strategies with Chicago-based Avatar, an investment-management company that oversees collective trusts with ETFs.
The Pension Protection Act of 2006 gave employers a "get-out-of-jail-free card," allowing them to offer guidance, Smith says. Since then, "the big focus in 401(k)s is to move away from do-it-yourself to professional managing."
The ETF-based 401(k) plan professionally manages the participant portfolios; it puts each participant in one of a range of pre-built asset-allocation categories, based on age and degree of risk. Every pay period, the individual account is rebalanced to remain in line with the category, and every five years, the account is reallocated, based on age, to a more conservative mix, according to Childrey.
That was a big selling point for Navmar. "[With the former plan], we were left adrift," says administrative director Kelley. "[Employees] monitored their own funds. We did not have advisers, like we do now. That's the big difference. We have the asset-allocation models."
On the negative side, ETF-based plans may not be as cheap as you think. Yes, the expense ratio for such plans is lower than that of most traditional plans. But when you add up the other higher costs of running the plan -- in particular, fees for the record-keeper, custodian and adviser -- your bottom line can be as high as with a mutual-fund plan, says Dimitriou.
It's not a rip-off, he stresses, but "it is not all that it's built up to be. ... The expense ratio is lower, but the costs of administration more often than not [aren't]."
In a large plan, you can drive down the administrative costs, but in a small plan, there can be high custodial fees, which most mutual funds don't have, and high adviser fees.
ETFs may trade like stocks, but the advantage of intraday trading may be misleading, Dimitriou adds. Because trading ETFs in less than 100-share blocks is "prohibitively expensive," many record-keepers cut commission costs by batching ETF trades together across portfolios and selling them at the end of the day anyway.
Even ETF advocates agree that record-keeping for ETF-based plans can be cumbersome and costly, because technology has not yet caught up with them.
The dominant software is designed to calculate mutual funds and the way they trade. For example, an ETF doesn't have a closing net asset value (NAV) at the end of the day, as mutual funds do. ETFs also have to trade as whole shares, such as stocks, which leaves a cash difference that has to be recorded.
"There are too many things to work out before I can look my client in the eye and say, 'An ETF [based 401(k) plan] is best for you,' " Dimitriou says. "For the same price, I can go to the mutual-fund world and buy an index fund, and I get better systems and technology.
" ... The reason ETFs have not caught on is, when you lift up the hood, net/net, there are no cost savings because there is more cumbersome administration" in terms of the record-keeping process that keeps track of the ETF trading, he says.
"There are lots of companies trying to use ETFs with current record-keeping systems. It's a problem for plan sponsors and participants," says Abrahamson, who is tackling the problem by developing new software technology, patent-pending, to trade ETFs effectively.
Once the technology is in place, advocates don't see any reason more companies won't give ETF-based 401(k)s a look, especially with their record of low expenses and transparency.