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Get Four
|  | MAY 19, 2005
 FUND INVESTOR By Palash R. Ghosh ETFs' Goal: 401(k) PlansThough popular elsewhere, exchange-traded funds are rare in this area, and their growth efforts here face skepticism -- and interestIt's no secret that exchange-traded funds (ETFs) have caught investors' fancy. ETF assets have soared to about $229 billion as of the end of March, 2005, from just $464 million in 1993. In 2004 alone, ETF assets grew by 50%. They could reach the $1 trillion mark by the end of the decade. Despite this exhilarating growth, the ETF market remains dwarfed by the mutual-fund industry, an $8 trillion behemoth. One crucial area where ETFs may seek to close that gap is the nation's retirement-plan business, particularly 401(k) plans, which are currently dominated by traditional mutual funds. "UNKNOWN RISK." The Investment Company Institute estimates that at yearend 2003 (the most recent data available), 401(k) assets totaled $1.9 trillion, representing about 16% of the total U.S. retirement market. Nearly half of those assets were held in mutual funds, with the remaining business taken by institutions like banks and insurance companies. Clearly, ETFs face an enormous challenge in putting a dent in the 401(k) arena. Experts remain divided over the viability and appeal of ETFs as a 401(k) constituent. "There's very little intrinsic value added by having ETFs in a retirement plan," says Louis Harvey, president of Dalbar, a Boston-based mutual-fund consultant. "With respect to costs, fees, and investment returns, there really isn't a significant differentiation between ETFs and conventional mutual funds in 401(k)s. In addition, plan sponsors face unknown fiduciary risk by replacing the well-established mutual fund with the ETF, which has not been tested in 401(k) plans." ADVANTAGES CANCELED OUT? Mike Hatlee, head of the retirement-services group at Chemung Canal Trust, which manages $1.3 billion in assets and caters primarily to small and midsize plans, says, "I haven't had any requests from plan sponsors about adding ETFs as investment options to their retirement plans." Whatever perceived advantages ETFs enjoy over mutual funds in regular investments -- low expenses, low turnover, short-selling, trading options, buying on margin, tax-efficiency, transparency, and intraday trading, among others -- either disappear or become irrelevant under the bubble of a 401(k) or any qualified retirement plan, according to Hatlee. For example, while ETFs can be bought or sold throughout the trading day to take advantage of equity price movements, "this is certainly not something that a long-term investor in a retirement plan should be doing anyway," he says. In addition, Hatlee says, the low expenses offered by ETFs get canceled out by their associated trading costs and brokerage commissions. "Many vendors, including [us], are very careful to include funds with below-average expense ratios, no 12(b)1 fee allocations, and no sales loads of any kind," he says. "Our fees are fully disclosed and not hidden in the mutual-fund structure. I think more vendors should follow this up-front approach to pricing rather than rush to jump on the ETF bandwagon." TRADING VOLUME NEEDED. Another hurdle for ETF entry into the retirement markets: Most plan sponsors don't have record-keeping abilities in place to handle ETFs in their 401(k) products. "The platforms for 401(k)s are currently built only for mutual funds and the way funds are priced daily," Dalbar's Harvey says. "For the plan sponsor, it's more expensive to trade ETFs since they have to create a whole new mechanism for them since they trade intraday, like stocks." Hatlee proposed that, assuming a 401(k) product for ETFs can be easily developed, it would likely have to feature high trading volume, substantial assets, and a large base of participants, "so you can spread out the trading costs." Harvey noted that while participants can access ETF's today through brokerage windows, they don't constitute part of the core investment options in 401(k) plans. "I think ETFs are great investment products -- but not in a qualified retirement plan," Hatlee says. SCANDALS HELP. However, with mutual-fund fees running higher than those of ETFs and equity markets flattening, others believe ETFs make a viable, less expensive 401(k) investment alternative, at least for smaller retirement plans. "There's more interest being shown in ETFs for retirement plans, but it's still relatively small," says Rick Meigs, founder and president of 401khelpcenter.com, an Oregon-based provider of 401(k) information. "The reason behind the interest seems to be a direct result of the mutual-fund scandals -- market-timing issues, trading irregularities, expensive fees, etc. Plan sponsors have been looking at alternative investments." Gerry Rocchi, director of Americas iShares Ventures at Barclay Global Investors, says he has noticed an increasing amount of interest in iShares in retirement plans. "We've had discussions with more than 10 plan sponsors to facilitate the usage of ETFs in 401(k) plans," he says. TRANSPARENT FEES. As for the technology needed and the expense of adding ETFs to retirement plans, Meigs says, "some providers are creating modified record-keeping mechanisms to use ETFs quite economically, which reduces the cost dramatically to the plan." One company doing this is Invest-n-Retire, a record-keeping firm based in Portland, Ore. "We're definitely seeing more interest in having ETFs in retirement plans," says Darwin Abrahamson, founder and CEO of Invest-n-Retire. Abrahamson's company offers 30 Barclay Global Investors iShares ETFs, 4 Nasdaq ETFs, 13 Vanguard VIPERs, and 18 Dimensional Fund Advisors funds in about 25 retirement plans, with assets ranging from $1 million to $10 million. Abrahamson says the biggest attraction of having ETFs in retirement plans is lower fees. "Participants are currently paying exorbitant fees for their 401(k) plans," he says. "We estimate that 70% to 90% of the cost of any 401(k) plan is tied to the associated mutual-fund fees. For the fiduciaries, the No. 1 advantage with having ETFs in a 401(k) plan is the transparency of fees -- that is, they won't have the problem of all the hidden fees, like 12b-1 fees. With ETFs, fees are 100% transparent." Invest-n-Retire's Abrahamson says by using ETFs, his firm can significantly reduce the costs associated with managing 401(k) plans, resulting in expenses 30% to 60% below plans associated with conventional 401(k) service providers. ETFs not only help reduce costs and, in turn, generate higher returns for investors but also allow advisers to design more efficient asset-allocation models within a retirement plan, Abrahamson says. Srikant Dash, global equity index strategist at Standard & Poor's, agrees that one big advantage with ETFs is their use in asset-allocation models. He expects to see more ETF assets in 401(k) retirement plans "because of lower cost, convenience, and the availability of a wide variety of investment options and growing awareness of this asset class." AGGRESSIVE MARKETING KEY. Abrahamson is highly optimistic about the future growth of ETFs in retirement vehicles. "Over the next two to three years, we will see huge inflows of ETF assets into 401(k) plans," he says. Meigs takes a more cautionary stance. "I think ETFs in 401(k) plans will be, at best, a niche product. I don't think the plan-sponsor industry will aggressively pursue ETFs in place of mutual funds," he says. "However, perhaps if we witness another major scandal or blowup in the mutual-fund industry, [it] may increase the attraction of ETFs. At the moment, most plan sponsors aren't that interested. ETFs don't pose much of a threat." In the end, most agree that for ETFs to make any headway into the 401(k) market, transaction/brokerage costs have to decline, investors need to better familiarize themselves with ETFs, and the ETF industry has to market itself more aggressively as an attractive retirement asset.  Ghosh is a reporter for Standard & Poor's Fund Advisor All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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