Plan and Prepare – May 6, 2011
By Patrick Rudy CFP® CPA AIF®
At Cascade, we use our depth and breadth of industry knowledge and experience to filter through the emerging trends in investment products. Indeed, with over 100 years of combined experience, we have seen our fair share of what works…and also what doesn’t. It is helpful to have this foundation when evaluating new and emerging trends. ETFs inside of 401(k) plans are one such trend that seems to be growing in popularity very quickly, so we thought it would be good to go over pros and cons to see when, if ever, it makes sense to include an ETF inside your 401(k) plan.
ETFs have evolved very rapidly over the past several years and have an increasing appeal to more and more conventional applications where traditional mutual funds used to be the norm. The three areas we will consider here are costs, liquidity and transparency.
The first positive that is usually mentioned about ETFs is that they cost less than mutual funds. This is generally true but not always. Some ETFs at 150 bps cost considerably more than many mutual funds. The bigger issue however is that it is not an apples-to-apples comparison. When considering ETFs vs. mutual funds, you have to consider the benefits received for the costs as opposed to just the costs. The majority of ETFs currently on the market are designed to track an index (i.e. SPY tracks the S&P 500), whereas the majority of mutual funds are designed to beat the index. An ETF gives you access to a broad basket of securities. Presumably, you have done research and analysis as to which asset class or market segment you want to own and then you find an ETF that gives you access. In an actively managed mutual fund, a portfolio manager is seeking to significantly outperform that same index that an ETF represents. Also, in the context of a 401(k) plan, a material amount of the costs that you pay in a mutual fund will usually go toward other services provided to your 401(k) plan. This is called revenue sharing and an ETF doesn’t work the same way. The two products are hard to compare for these reasons and it is somewhat of a misrepresentation to just indicate the difference in costs, without talking about the difference in benefit or value that you receive.
Another significant difference is liquidity. Regular ETFs trade on an exchange throughout the trading day and settle in the usual 3 day period. They are therefore very liquid, by comparison, to mutual funds. Mutual fund purchases and sales are processed at the end of the trading day and settle in 1 day typically. This was one of the hurdles that the industry had to overcome so that ETFs could be included alongside mutual funds inside a 401(k) plan investment lineup. An ETF that is included as a part of your 401(k) doesn’t, in fact, offer that liquidity advantage, but rather trades at the end of the day like a mutual fund. There are many technical and administrative reasons why that is the case, but they are beyond the scope of this letter.
Transparency is another point of differentiation for mutual funds and ETFs. Mutual funds typically report on a monthly or quarterly basis, whereas, ETFs report on a daily basis. This additional transparency in ETFs is valuable in that you can always evaluate where your portfolio is at any given day. The other side of that coin is that behavior psychology tells us that when an inexperienced investor has too much information, emotion drives the decision to buy or sell and for the average individual investor it is usually results in a “buy high, sell low” scenario. There is still another major difference which has to do with tax efficiency in portfolio construction, but it does not apply in a tax advantaged or deferred accounts like an IRA or a 401(k).
In summary, ETFs have several valuable features to contribute to a 401(k) and indeed, I believe there are circumstances where an ETF only platform can make good sense. The biggest factor is demographics of the plan participants and how they plan on using the plan. For a plan with uninterested or inexperienced participants, ETFs are probably not a good solution. For a plan with a mixture of participants’ experience and interest levels, a combo plan with ETFs and Mutual Funds can be a great solution. This is where our consulting and advisory services regarding retirement plan construction, the personal touch, come into play and can make the difference between a successful plan and an unsuccessful plan.
Tip of the Month:
Part of the concept behind ETFs is transparency. As such, there is a wealth of information at your fingertips which provide you with up-to-the-day information on fund holdings, premium/discount information and various other fundamental data points about an ETF. Here are some of the online resources I have found to be helpful:
Patrick Rudy CFP,® CPA, AIF® is a Senior Investment Consultant with Cascade Investment Group, member FINRA & SIPC. Cascade Investment Group is not a tax or legal advisor. You should always consult with your tax advisor or attorney before taking any actions that may have tax consequences.