Although exchange-traded funds are low-cost investments that can diversify a 401(k) portfolio, there is still uncertainty whether the funds are suitable as a 401(k) investment option.

ETFs hit the marketplace in 1993, and they can be bought and sold throughout the trading day. The funds are individual securities accounting for fractional ownership of a large portfolio and are suitable substitutes for mutual funds.

ETFs don't hold any particular tax advantage within a 401(k) plan because the plan itself is a tax-deferred vehicle, explains Beth McHugh, vice president of market insights at Fidelity Investments.

"Our point of view is that indexed mutual funds are better suited than ETFs as investment options for DC plans. Still, we are seeing interest from plan sponsors about the funds because ETFs are a popular investment option overall," says McHugh. "Plan sponsors are evaluating whether it's appropriate to include them in their 401(k)."

Fidelity offers ETFs to plan participants through its self-directed brokerage. So far, "we have not seen a real push to have the funds offered outside the brokerage office," McHugh adds.

Fee transparency

The desire for more low-cost investment options and greater fee transparency will break the inertia of ETFs getting on the 401(k) platform, says Mike Alfred, CEO and co-founder of BrightScope, an independent data analytics firm that quantitatively rates 401(k) plans.

"The 401(k) world is headed toward a full fee-disclosure system where participants and plan sponsors want to know upfront whether investments come with hidden fees," Alfred says. "ETFs are without hidden fees. As a result, we are going to see their popularity grow in the DC plan space. When you educate plan sponsors about the funds, they become enthusiastic about them."

When 401(k) plan sponsors have full access to funds' fees, they are going to realize ETFs are just a much better deal for plan participants, Alfred believes.

Given the choice between an actively managed large-cap mutual fund and a large-cap ETF with similar features, the investor will pay less for the ETF

Plan sponsors feel better when they can honestly say to participants that these are all of the fees in the fund, Alfred asserts.

"The growth of ETFs in the DC plan market will eventually mimic the growth of the funds outside of that market," which, he notes "has been extraordinary over the last ten years."

Revamping recordkeeping

Some DC plan experts contend that if ETFs hope to gain traction in the 401(k) world, then more recordkeeping systems will have to accommodate intraday trading. ETFs are relatively new, and 401(k) platforms and recordkeeping systems were built around mutual fund trading.

In 401(k) plans, mutual funds, which are traded once a day, reign as the main investment vehicle. That's a different structure than an ETF, which trades throughout the day.

"It's going to take some time before the recordkeepers and ETF producers work out those details. ETFs are kind of a solution in search of a problem when it comes to the large 401(k) plans," says Christopher Jones, Financial Engines' chief investment officer.

Still, what hasn't gone unnoticed by some 401(k) sponsors is the 2009 acquisition of Barclays Global Investors by the investment management firm BlackRock.

The deal made BlackRock the owner of the iShares family of ETFs and one of world's largest asset management firms. Alfred believes that the BlackRock deal may send a signal to some DC recordkeepers that they need to create systems for ETF trading.

According to May 2010 data, the three largest managers in the U.S.-based ETF market - BlackRock, State Street and Vanguard - collectively accounted for approximately 84% of the assets in the sector.

In May, assets held in U.S. exchange traded funds dropped slightly, according to State Street Global Advisors.

For example, the 885 exchange traded funds in the United States had $748 billion in assets, down 5.5% from April 2010. Large-cap ETFs declined $12.1 billion, followed by mid-cap ETFs, which were down $2.6 billion.

Experts explained that funds took a hit because of a decline in global equity markets in May amid concerns over the European debt crisis.

Plan administration costs

A cost analysis on offering ETFs in a DC plan shows that the funds don't necessarily provide a cost advantage, says Steve Utkus, head of the center for retirement research at the Vanguard Group.

For example, a plan sponsor selects an actively managed fund with 20 basis points and a passively managed ETF with 10 basis points. In a 401(k) plan, a portion of the 20 basis points goes toward recordkeeping.

The ETF has the lower expense ratio because most of its money is going toward running the fund and not recordkeeping.

If a DC plan sponsor approaches its recordkeeper requesting to replace a 20-basis-point index fund with a 10-basis-point ETF, the plan administrator realizes that the shift from an active fund to a passive fund will mean a drop in revenue to administer the plan, explains Utkus.

The mutual fund carried with it 20 basis points, and now the plan sponsor is telling the plan administrator that it is going to cut that in half by adding an ETF.

The recordkeeper loses revenue that would have been earmarked for plan administrative services, such as payroll processing, recordkeeping, call centers, legal and compliance services, and participant communications.

Plan sponsors will have to decide whether reduced services in plan administration outweigh the low-cost value of ETFs. "When people say, 'I can get a better deal with an ETF,' the answer is yes, you can, but you have to come up with other money to pay for the recordkeeping," explains Utkus.

After a full accounting of costs, "ETFs are likely to offer savings relative to actively managed funds, but not compared with traditional index options," concluded a Vanguard research brief on ETFs in DC plans.

Small and mid-size plans

Still, ETFs do offer a cost advantage to small and mid-size 401(k) plan sponsors, says Scott Burns, Morningstar's director of ETF, closed-end and alternative fund research.

The funds provide sponsors with a diversified passive index at institutional share-class pricing, he adds.

Large 401(k) sponsors have negotiated institutional or low prices on funds options with their asset management firm fund providers, such as T. Rowe Price, Fidelity and Vanguard, and have established plan qualification requirements for such pricing.

Small and mid-size plan sponsors are not hitting those thresholds, so the cost advantage favors ETFs, Burns says.

For example, a profitable small law firm employing 20 to 25 employees that decides to offer a 401(k) plan may face an uphill battle in negotiating for institutional pricing with a fund provider. "Yet if the law firm goes the ETF route, then it can buy less expensive funds for the investment lineup," Burns notes.

Financial Engines' Jones agrees: "ETFs might offer small plans a cost advantage, given that indexed ETFs can be relatively cheap compared to other mutual funds that you might get in a 401(k) plan. The mutual funds might also have additional fees attached to them. The ETF provider can talk about price as a differentiating factor and therefore set up their products in their plans."

Inclusion in target-date funds

Of course, there are other ways ETFs can wind up in the 401(k) investment lineup, says Morningstar's Burns.

"One of the biggest opportunities for ETFs will be their inclusion in target-date funds. Although TDFs are not without their critics, the funds appear to be the largest asset gatherer in the 401(k) space," according to Burns.

Some fund companies might not have a good mid-cap manager. If that's the case, a fund provider may be better off just opting for a low-cost index and staying neutral in terms of its ability to provide active management. In other words, put the fund in a TDF.

"That is the most ripening area for how ETFs are going to get on the 401(k) platform. We are starting to hear how some TDF providers are requesting that their boards include ETFs in their 401(k) vehicles. The ETF industry is working hard to create platforms for 401(k) solutions," Burns adds.

ETFs primarily benefit institutional investors. But in the context of a 401(k) plan, they lose some of their luster as an investment vehicle. For instance, the tax efficiency of the ETF structure really does not benefit nor apply to the 401(k) plan, says Jones of Financial Engines.

401(k) participants are thinking long-term, so the notion of quick trades on the stock market via intraday trading is not relevant to the typical 401(k) participant. Besides, the 401(k) plan is generally thought of as a long-term investment vehicle, Jones notes.

No advantages for larger plan sponsors

For larger 401(k) plan sponsors, the funds really don't offer any cost advantages over traditional mutual funds or institutionally priced fund products, especially if the plan sponsor is thinking about indexed funds.

"There are low-cost index funds that are available, which are priced competitively with - and are cheaper than - what you find with ETFs" explains Jones.

So far, there hasn't been a huge groundswell in the adoption of ETFs in DC plans simply because of the structural impediments of recordkeeping systems.

DC plan sponsors with sizeable assets carry the clout to negotiate pricing and investment options. They can pretty much get exposure to any part of the market and can do so at a cheap price. This strips away the appeal of bringing ETFs into the plan.

Sponsors of 401(k) plans aim for a broadly diversified portfolio and not a narrow sector exposure.

Mindful of their fiduciary responsibilities, "plan sponsors are reluctant to add investment vehicles [that] participants could potentially misuse in a way that shows their lack of understanding [of] the risks that they are taking," Jones explains.

In weighing the potential benefits of ETFs in a DC plan, sponsors will want to understand all of the costs associated with an ETF offering, including:

* The ETF¹s expense ratio.

* The impact of the ETF's bid-ask spread on performance.

* Additional fees associated with managing or administering an ETF option in a plan.

* The ETF option's share of plan recordkeeping costs.

Source: Vanguard Center for Retirement Research

Follow EBN on: Twitter | Facebook | LinkedIn | Podcasts