If the turbulent financial markets have taught 401(k) participants and plan sponsors anything over the last 18 months, it's the importance of seeking out opportunities to maximize investment efficiency, transparency and diversification.

The pursuit of those goals is causing many to consider the potential role of exchange-traded funds in their 401(k) investment lineup, retirement plan recordkeepers and advisers say.

Specifically, although ETFs today represent a small segment of the overall 401(k) investment universe, their rapid growth outside the qualified plan environment - from approximately $70 billion at the beginning of the decade to $540 billion as of April 2009, according to Financial Research Corporation, may be an indicator of their potential trajectory within the 401(k) space.

The prospect of growth of ETFs in the 401(k) arena has also been impacted recently as more recordkeepers have upgraded their systems to accommodate ETFs' inclusion in plans - although many still lack that capability.

ETFs, of course, are hardly new; a few have been in existence since the early 1990s. ETFs are individual securities representing fractional ownership of a large portfolio, and they are traded on stock exchanges.

These funds typically employ a "passive," or index-based, investment strategy designed to deliver the performance of a specific segment of the stock or bond market, both domestic and foreign. The most frequently traded ETFs, for example, include those tracking the performance of the S&P 500 Index, the Russell 2000 Index, the MSCI EAFE Index (of non-U.S. developed capital markets), and the performance of inflation-indexed protected U.S. Treasury securities (TIPSs), according to NYSEArca.

In addition, some ETFs provide exposure to alternative asset classes, such as real estate. Target date and target risk ETFs are also now available, a staple of the 401(k) world.

Institutional pricing, fee transparency

ETFs' expense ratios average 56 basis points (hundredths of a percent) - significantly less for large ETFs, according to Bloomberg research. For example, at the low end, ETFs that track the S&P 500 Index have annual operating expenses of nine basis points, and ETFs that replicate indices of smaller cap stocks, such as the Russell 2000, may be in the 20 basis-point range.

Over several years, the cumulative impact of lower asset management fees on a retirement investment can be significant - a consideration that has come into greater focus for plan sponsors and regulators in recent years as more attention has been devoted to the topic of 401(k) administration costs.

A report by the Government Accountability Office published in 2006, for example, pointed out that adding one percent to annual plan expenses deducted from retirement accounts, over a twenty-year period, would result in retirement accumulations 17% lower than they would otherwise be.

In addition to offering the prospect of relatively low investment costs, ETFs, as individual securities, facilitate fee transparency by paying no 12b-1 or SubTA fees used to compensate advisers and recordkeepers. Without these fees, the adviser and recordkeeper bill their fees separately from the investment management fee. This separation of the investment management, advisory, and recordkeeping fees encourages fee transparency, helping sponsors and participants know who and how much they are paying.

ETFs' low expense ratios may be most attractive to smaller plans as large 401(k) plans generally benefit from greater access to institutional pricing on traditional investment products.

Since ETFs trade on securities exchanges, brokerage commissions are incurred by participants as they are bought and sold. Those costs, which are either included in the asset based fee or are passed along to the plan or plan participants, must also be factored into sponsors' analysis of the cost of ETFs as 401(k) investment vehicles.

Portfolio transparency

Finally, because index-based ETFs track specific market segments, 401(k) participants can benefit from high investment transparency. ETFs must disclose portfolio holdings throughout the day. "You know every hour, every day, what you're holding," says Mike Narkoff, senior VP of sales for Ascensus, a Dresher, Pa.-based recordkeeper that recently introduced a 401(k) ETF service package distributed via financial advisers.

For plan sponsors, a key consideration in giving 401(k) participants the benefit of that investment transparency and, ultimately, tighter control over their retirement investments, is to strike the right balance between offering too few investment options, and overwhelming participants with a bewildering array of exotic investment choices. Doing so involves knowing their employees' level of investment savvy, as well as maintaining an effective retirement investment education effort.

"I think many sponsors will be staying with the mainstream index-based ETFs," predicts Rick Keast, executive VP of PAi, a De Pere, Wisc.-based recordkeeper for some 13,000 small 401(k) plans - 2,000 of which already offer ETFs to participants.

Adds Tom Hanlon, CEEBS, a partner and director of retirement plans for Courier Capital in Jamestown, N.Y.: "We won't be offering too many choices for people, like an ETF that's just for, say, investing in water," he says. Hanlon advises small and midsize employers on retirement plan investments. His firm is just gearing up to advise clients on incorporating ETFs into their 401(k) plans.

"We saw back in the 1990s when everybody got into tech funds, how they got crushed. We're trying to keep [401(k) investment options] to broader asset classes."

Today there are approximately 839 ETFs trading on various exchanges. Research data from Barclays Global Investors (BGI), FRC and other sources indicate that approximately 29% of the collective market capitalization of ETFs is in ETFs devoted to large capitalization U.S. stocks. The overall allocation of ETFs to U.S. stocks, whether in tracking broad-based indices or particular industry sectors, is about 53%.

The remainder of the ETF universe is allocated, approximately, as follows: 22% to international/global equities, 14% to fixed-income securities, 9% to commodities and 1% to currencies. During the first four months of 2009, net investment in ETFs shifted away from broad U.S. stock-based ETFs, and into those dedicated to bonds, commodities, particular U.S. stock sectors, and international/global stock ETFs.

Based on its own research, BGI estimates the collective value of ETFs held in 401(k) plans today at around $1 billion, but warns that precise estimates are elusive.

Until recently, the potential for plan sponsors to incorporate ETFs within their 401(k)s was constrained by the recordkeeping industry's limited capacity to handle ETFs. Pioneers in this field, including Invest n Retire, RPG, WisdomTree/PCS and ShareBuilder, opened the door as early as 2004, particularly for small employers in scattered geographic markets.

However, more and larger retirement plan administrators and recordkeepers, with support from ETF providers, are coming on line which, working via financial advisers, administer thousands of 401(k) plans. Recent additions include PAi and Ascensus, which offer fully bundled ETF 401(k) service packages, and Mid Atlantic Financial Platforms, a financial services firm based in Pittsburgh, Pa. that enables over 100 administrators across the country to offer ETFs in open architecture 401(k) plans.

Pent-up demand?

"The sense we're getting from advisers is there is some pent-up demand from employers to at least explore how ETFs might fit in" to the investment selection process, according to Ascensus' Narkoff. He says his firm had to make a substantial systems investment to allow 401(k) participants to "trade in pure ETFs," while making the process appear the same to participants as buying mutual fund shares.

Previously, some recordkeepers have had to employ makeshift administrative solutions, such as the use of collective trust funds wrapped around ETFs.

One basic administrative task the recordkeeper must perform to enable 401(k) participants to buy and sell ETFs is to aggregate participants' purchases and sales orders accumulated over the course of a day throughout its client network, then execute collective sales and purchases at the end of the day.

The ETF price received or paid by the participant is typically either the average price of the executed orders or the ETF's closing price. This aggregated trading could, however, expose the plan and participants to trading at inopportune times, such as when the ETF is trading at a premium.

"For the typical participant, it's going to act and look like a mutual fund; it's not an intra-day trade," says Narkoff. In addition to the economic efficiency this approach provides, it prevents 401(k) participants from becoming "day traders."

While ETFs may "look and act" like a mutual fund from the transactional perspective inside a plan, 401(k) participants with access to ETFs may have the benefit of direct investments, or investment packages custom-built from combinations of ETFs.

Customized ETF portfolios

"Using our analytics, we can build aggressive, moderate and conservative portfolio models incorporating particular asset classes so that 401(k) participants don't have to think about whether to put 1% or 3% in a particular sector," notes Hanlon. "We'll keep them rebalanced on a quarterly basis."

Although he shuns the more esoteric ETFs, Hanlon says he might construct a model portfolio using, among other types, an index-based ETF that targets emerging market small-cap stocks.

Also, customized portfolios can be constructed using combinations of ETFs and mutual fund shares, depending on the plan sponsor's goals.

For example, a sponsor might opt for an index-based ETF for a portfolio's emerging markets equity segment, and an actively managed mutual fund for the plan's large cap growth offering.

"We have a lot of experience analyzing the ETFs and their risk and reward characteristics. Some of those," such as ETFs targeting commodities and precious metals, "may not translate over to the 401(k) world real well," Hanlon says.

Today, 401(k) sponsors need to work with fee-based financial advisers to incorporate ETFs in their plans. And, as with the introduction of any new investment, they must also be prepared to educate participants on the most appropriate use of ETFs, which typically are and will be offered side by side with a traditional line-up of mutual fund options. Investment advisers are equipped and expect to play a role in that education process, Hanlon says.

Even their most enthusiastic supporters aren't predicting that ETFs will be embraced by all 401(k) plan sponsors, or overtake the mutual fund investment format in the near future.

But to the extent that sponsors continue seeking to provide new, useful and economical investment options to their employees, the role of ETFs in 401(k)s is likely to grow rapidly in the years ahead. -E.B.N.

Richard F. Stolz, a former editor and publisher of Employee Benefit News, is a freelance financial writer based in Rockville, Md. This article was written with assistance from Barclays Global Investors.