401(k) Plans: The Next Frontier for Exchange Traded Funds

by Parijat Cheema, CFA, and Stuart Eadon
J.P. Morgan Investment Analytics & Consulting
parijat.x.cheema@jpmorgan.com
stuart.b.eadon@jpmorgan.com

The financial crisis of 2008 and subsequent market downturn marked a defining chapter in the history of global financial markets. It was an event characterized by huge declines in practically all asset classes, a time when most asset allocation and diversification strategies failed to stop the bleeding in investor portfolios. Individual investors at or near retirement suffered significant declines in their retirement savings. As more Americans enter retirement, more emphasis is being placed on retirement savings and the ability of 401(k) plans to meet investment objectives.

In this article, we seek to provide insight into the use of ETFs in 401(k) plans. The attraction for plan participants is the low and transparent fees, diversification, and new investment opportunities. On the other hand, challenges exist with legacy accounting and recordkeeping systems and some of the unique features of ETFs, which can make them difficult to apply in 401(k) plans. ETF price divergence from the NAV may also exist in volatile markets, signaling inherent risk.

ETFs have been very popular with individual and institutional investors, averaging 35% YoY growth since 2003 (see Exhibit 1). A recent Greenwich Associates survey of 70 institutions on the use of ETFs in the institutional space reported that approximately half of them employed ETFs for tactical purposes, including cash equitization, transition management and rebalancing.¹

The ETF industry is largely concentrated, with the top few ETF providers dominating the market. Of the roughly $776 billion in assets as of 2009, approximately 84%, or $652 billion, was held in the ETFs from the top three providers². BlackRock’s iShares family of ETFs has the largest market share, followed by State Street and Vanguard.

The Investment Company Institute estimates that, of the $2.7 trillion invested in 401(k) plans as of Q3 2009, approximately $1.4 trillion, or 53%, was held in mutual funds³. The phenomenon of using ETFs in 401(k) plans, however, is relatively recent.

Despite the momentum demonstrated by ETFs in recent years, they have not managed to loosen the grip of traditional mutual funds on the 401(k) market.

Exhibit 1: ETF Industry Asset Growth Trends

Source: 2009 ETF Year End Review and 2010 Outlook by John Cronin, State Street Global Advisors. www.spdru.com

Challenges to using ETFs in 401(k) plans

Research indicates that the hurdles to greater acceptance and use of ETFs in 401(k) plans have been technical as well as financial.

In the past, 401(k) accounting and recordkeeping systems were designed mainly to accommodate investments in mutual funds, which trade once daily at the end-of-day Net Asset Value (NAV) and can be traded in fractional units. ETFs, on the other hand, trade continuously throughout the day and can only be traded in whole shares.

401(k) plan participants fund their contributions through periodic payroll deductions, and such periodic contributions rarely equal the cost of buying whole ETF shares. This has placed a huge burden on legacy accounting and recordkeeping systems.

ETF trades are executed through brokers, unlike mutual funds, and the transaction costs of regular purchases in small quantities can have a substantial impact on the returns; in addition, best execution cannot be ensured. High transaction costs associated with trading ETFs are often cited as a reason why ETFs are not appropriate for 401(k) plans. A recent Bloomberg article stated that some of the largest 401(k) plan administrators in the U.S. consider trading costs to be higher for ETFs due to brokerage commissions⁴.

Another challenge with investing in ETFs is the treatment of dividends and capital gains. With mutual funds, plan participants can choose to reinvest dividends and capital gains. However, ETFs generally distribute dividends in cash.

ETF prices are determined by supply and demand factors and the fund NAV. Therefore, the possibility of the ETF price deviating from the NAV exists due to market volatility. 401(k) plan participants looking to add ETFs to their portfolios face the risk of buying ETF shares trading at a premium to the NAV.

Highly liquid products such as ETFs tracking broad market indices such as the S&P 500 or Russell 3000 are generally observed to have a very low tracking error. However, less liquid products could potentially have higher tracking errors and wider bid-ask spreads.

Exhibit 2 compares the trend in daily returns of the SPDR Barclays Capital High Yield Bond ETF (ticker: JNK) against the trend in daily returns of the Barclays Capital High Yield Very Liquid Index (ticker: LHVLTRUU). The data focused on a time horizon of high market volatility between September 2008 and December 2008.

During that time interval, the SPDR High Yield ETF had relatively more return volatility than the Barclays High Yield Very Liquid Index.

Exhibit 2: Daily Return Comparison between ETF and Index

Source: Bloomberg

Over a longer period from December 2007 to March 2010, the returns on the SPDR Barclays Capital High Yield Bond ETF tracked closely with the returns on the index.

The analysis suggests that, within short time intervals, there could be a greater divergence between an ETF and the underlying index and consequently a higher tracking error. As a result, ordinary 401(k) plan participants could unknowingly take on short term return volatility. Over the long term however, ETFs tend to track their benchmarks closely.

In addition, ETFs have not made significant headway into large 401(k) plans because large 401(k) plans are better able to negotiate lower fees for index mutual funds that can offer many of the benefits of ETFs at low costs. Large plans can qualify for institutional share classes in mutual funds at very competitive pricing.

Expansion of ETFs into the 401(k) Space

Despite the aforementioned hurdles to the use of ETFs in the 401(k) space, ETFs nonetheless have been gaining favor of late in 401(k) plans.

BlackRock launched the iShares in 401(k) program in 2009. It is targeted toward small 401(k) plans with less than $100 million in assets. It seeks to identify preferred administrative providers that can offer ETF 401(k) solutions and assist small 401(k) plans in offering ETFs as investment options. WisdomTree is another ETF provider that has launched a similar initiative.

According to Greg Porteous, head of Sales for the iShares 401(k) initiative, 401(k) plans held roughly $2 billion of iShares ETFs as of the end of 2009. According to Porteous, the three principal issues impacting the use of ETFs in 401(k) plans – fractionalizing ETF shares, alignment of settlement cycles from T+3 to T+1, and the transaction costs related to buying and selling of ETFs – have now largely been resolved.

Plan participants can trade ETFs once daily. A majority of the providers use the end-of-day ETF price for trade execution. Transaction fees charged vary, with some providers charging asset-based fees that cover all transaction costs while others charge a per share fee ranging between two to three cents. Transactions are executed at an omnibus level across plans to lower transaction costs.

Some providers have also introduced a suite of target date and target risk ETFs that offer tailored portfolios geared towards the plan participant’s risk tolerance and retirement date. Target date funds have historically been very popular in 401(k) plans.

Benefits to small 401(k) plans of using ETFs primarily include:

• Low Fees: ETFs are low cost alternatives to mutual funds with expense ratios below those of most active and index mutual funds. Exhibit 3 provides a comparison of average expense ratios for ETFs and index mutual funds across major asset classes. Small 401(k) plans are less likely to get the more competitive management fees that large 401(k) plans are able to negotiate for mutual funds and are also less likely to be solicited for sales by the large asset management firms.

Exhibit 3 – Average Expense Ratio Comparison by Fund Type

• Transparency: Plan sponsors sometimes may not fully understand the fees charged to the plan. Often there are cross-subsidy arrangements between plan advisors and administrative service providers including recordkeepers, custodians and trustees, wherein a portion of the investment advisory fee is used to offset administrative costs. Mutual fund expense ratios also tend to include 12b-1 fees to compensate for fund distribution. These fees are ultimately passed on to plan participants, which blurs the actual cost paid by plan participants and impacts investment performance.
  
  A Deloitte survey for the Investment Company Institute found that small 401(k) plans typically pay much higher all in fees (including investment, recordkeeping and administrative fees) than large 401(k) plans⁵. Exhibit 4 shows the average and median all-in fees charged to plans of varying asset sizes. The median all-in fee for all plans included in the survey was 0.72% of plan assets.
  
  In a 401(k) plan with ETFs, recordkeeping and fund management costs are transparent and separately charged to plan participants. There are usually no cross-subsidy or revenue share arrangements. This allows plan sponsors and participants to better understand the fees that are charged to the plan. Further, mutual funds disclose their holdings quarterly, whereas ETF holdings are disclosed daily, thereby facilitating greater transparency.

Exhibit 4: All-in Fees by Plan Size (fees as % of plan assets)

Source: Defined Contribution / 401(k) Fee Study conducted by Deloitte for the Investment Company Institute, June 2009. www.ici.org

• Diversification: ETFs offer broad diversification across all major asset classes and track virtually all broad market indices. By trading a single ETF, participants can gain exposure to a broad index to achieve optimum diversification.

Although ETFs have demonstrated a tremendous growth trajectory over the last several years, their share of the 401(k) pie currently is a small fraction. Mutual funds have a long history in retirement plans and continue to remain the investment of choice. Given the current focus of ETFs in the small plan segment, larger plans will continue to remain invested in mutual funds mostly, and ETFs are unlikely to pose a significant threat to mutual funds in that segment in the near-term.

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¹“ETFs Gain Foothold in Institutional Market,” Greenwich Associates. www.greenwich.com
²Cronin, John. “2009 ETF Year End Review and 2010 Outlook,” State Street Global Advisors. www.spdru.com
³“Research Fundamentals,” Investment Company Institute, February 2010, Vol. 18, No. 5 - Q3. www.ici.org
⁴“Blackrock Uses ETFs to Expand in $2.7 Trillion 401(k) Market,” Bloomberg, April 2010.
⁵Defined Contribution / 401(k) Fee Study conducted by Deloitte, Investment Company Institute, Spring 2009. www.ici.org

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