Long dominated by mutual funds, exchange traded funds (ETFs) are gradually seeping into company-sponsored retirement funds such 401(k) plans and 403(b) plans, Amy Buttell writes.

Long dominated by mutual funds, exchange traded funds (ETFs) are gradually seeping into company-sponsored retirement funds such 401(k) plans and 403(b) plans. With their low fees, intra-day trading availability and transparency, ETFs have the potential to bring some more clarity to the company sponsored retirement plan market for wealth managers and their clients.

However, like any other investment, whether ETFs make a difference in individual employer-sponsored retirement plans depends on what investments are already offered in the plan and what ETFs are included, says Russell Wild, a financial planner with Global Portfolios (click here) in Allentown, Pennsylvania and author of Exchange-Traded Funds for Dummies. “The entirety of the package, of the individual options available to employees, is what matters,” he says.

“For example, if Vanguard’s Large Growth ETF – VUG – was offered, that could be a great addition to some 401(k)s,” he adds. “It’s a reasonable asset class, large growth. It’s low cost and it follows a solid index. But if it’s added to a 401(k) plan that already has six other large-cap growth funds with no international or small cap, it’s a useless move, except it might lower the expense ratio for some.”

While ETF penetration of the 401(k) space has lagged, it will happen sooner or later, says Tom Lydon, publisher and editor of ETF Trends (click here). Many mutual fund asset managers and online brokers, like Schwab, were very nervous about ETFs, but as the popularity of ETFs has grown and the advantages have become more apparent, that has changed, he notes. “Schwab is now the largest custodians of ETFs: 21 per cent of all ETF assets are held in Schwab accounts,” he adds.

Richard Roche of Avatar Associates, a retirement plan investment management firm in Minneapolis, Minnesota, agrees, saying: “Right now, ETFs are only one-tenth or one-eleventh as popular as mutual funds, but they are growing and will continue to have legs. Because of the design of ETFs themselves, they are going to be more and more attractive to 401(k) plan sponsors who are the folks who make the decisions and that’s because of their low costs and transparency.”

The addition of ETFs to 401(k) accounts offers wealth managers more options when managing client portfolios for several reasons, including:

Tactical allocation strategies. For managers who use tactical opportunistic allocation strategies, Lydon says, ETFs are a boon. “10 years ago, the average wealth manager had 70 to 80 per cent of assets under management in a buy-and-hold strategy, with 10 to 20 per cent in a tactical, opportunistic strategy,” he continues.

“Today, those numbers are completely reversed: only 20 to 30 per cent of assets are in a buy-and-hold strategy on the equity side with the rest, 70 to 80 per cent, in a disciplined asset allocation strategy with rebalancing every quarter. ETFs give more flexibility in pursuing strategies like this.”

Diversification into additional asset classes. The use of ETFs allows managers to diversify into additional asset classes that previously weren’t available to many investors, such as commodities, long-short funds and other alternative investments previously only available via hedge funds and other investments, Lydon says. “You can invest client money into various regions around the globe, into commodities, currencies and other types of investments,” he adds. However, as recently reported in Family Wealth Report, caution should be exercised when investing in exotic ETFs (click here).

Additional liquidity. Because ETFs trade during the day, they are much more liquid than traditional mutual funds, providing wealth managers the flexibility to rebalance or tactically adjust a 401(k) portfolio, says Roche.

Lower costs. Lower costs are always beneficial to clients and many ETFs, especially those sponsored by low-cost asset managers such as Vanguard and Fidelity that are based on broad well-known indexes, fall into this category, say Wild. However, many ETFs in specialized categories, such as commodities, currencies, long/short, regional and country foreign funds and actively managed ETFs are, in some cases, more expensive than actively managed mutual funds, he adds.

In addition, because ETF sponsors are allowed to make tax-free exchanges when they need to sell securities, wealth managers and other investors don’t incur the trading expenses they would when trading actively managed funds. There are mechanisms by which wealth managers and retirement plan managers can purchase or sell something known as share creation units to avoid moving the market and incurring trading costs, Roche says.

While these creation units do carry a cost, those costs are far below what it would cost to buy or sell shares in an actively-managed mutual fund in terms of brokerage costs and the expenses incurred when buying or selling shares causes a security’s price to rise or fall, he adds. “It’s a lot cheaper to get shares created than having to go into the market and buy the constituent pieces of an ETF like SPY, because you’re saving money on trading,” he continues. “It’s a big advantage that ETFs have over open-ended mutual funds.”

While investors may incur a brokerage commission to buy and sell ETFs, more brokerage firms are waiving those expenses, at least for a select group of ETFs, and Roche expects that trend to continue. Currently, Vanguard, T Rowe Price, TD Ameritrade and Fidelity waive brokerage commission costs when buying or selling certain ETFs. Ameritrade’s list includes more than 100 ETFs.

Availability of packaged portfolios. While mutual fund sponsors also offer packaged portfolios, the ability of ETF managers to trade intra-day and practice tactical allocation strategies provides an additional option for wealth managers, says Roche. The two main types of packaged portfolios are:

- Target risk funds, which are also a type of lifestyle fund aimed at certain types of investors, such as conservative, moderate and aggressive;

- Target date funds, also known as lifecycle funds, which are pegged to a specific date at which someone plans to retire, go to college or some other life event occurs

Wealth managers can invest client funds into packaged solutions, or they can pick individual ETFs and design a custom portfolio. If you’re picking individual ETFs, you need to have solid knowledge of the ETF market and the construction methodology of individual ETFs, Roche notes. Otherwise, it makes sense to go with packaged solutions constructed by portfolio management, retirement plan and ETF experts, he adds.