Are ETFs a Good Fit for 401(k) Plans?

Exchange-traded funds (ETFs) are a popular investment choice for many investors because of their benefits and low costs. They are also part of some retirement plans, which gives retirement planners more options so they can diversify their holdings.

There are advantages and disadvantages to using ETFs in a 401(k) making them a good fit for your retirement planning. But if your goals, strategies, and financial circumstances don't align with ETFs, they may be a risky bet. Here are some finer points to help you decide whether ETFs fit your 401(k).

What Are ETFs?

An exchange-traded fund is a pooled investment vehicle. It is a basket of securities that is designed to track the performance of an index, commodity, currency, asset class, or any other security like cryptocurrencies. For instance, an S&P 500 index ETF may buy the same weight of the stocks listed in the index to mirror its returns. Similarly, a gold mining ETF may contain the stocks of gold miners and try to mimic their returns.

ETFs trade on stock exchanges, which means investors can buy and sell ETF shares just like stocks. One of the benefits of investing in ETFs is the low cost. Low expense ratios and broker commissions make ETFs an attractive option for investors who want to keep more money in their pockets. They also give investors exposure to the assets they want to own at a low cost.

Although they trade like stocks, ETFs can also be compared to mutual funds. Both pool investors' money to invest in a basket of securities. This allows investors to diversify their portfolios and meet their investment objectives without having to buy individual assets, such as large caps or government securities. ETFs offer as much diversification as mutual funds because they are securitized baskets of funds.

There are different types of ETFs from which investors can choose. These include:

• Bond ETFs: Track government (federal, municipal, local) and corporate bonds
• Commodity ETFs: Track various commodities like oil, grains, and precious metals, which are sold through futures contracts
• Currency ETFs: Track one or a basket of currencies
• Cryptocurrency ETFs: Newer ETF class that track the performance of virtual or digital currencies like Bitcoin and Ethereum
• Equity ETFs: Track different types of equity classes, such as large caps and blue chips
• Fixed Income ETFs: Track different types of fixed-income products, including bonds, T-bills, and securities
• Index ETFs: Track market indexes, such as the S&P 500 and Dow Jones Industrial Average (DJIA)
  

ETFs in 401(k)s

There are generally two types of ETFs: passively managed and actively managed funds. Many ETFs are passively managed because they track an index or benchmark, which keeps activity—and thus costs—from the fund managers to a minimum.

For example, the actively managed Vanguard U.S. Minimum Volatility ETF (VFMV) has a low expense ratio of 0.13%. VFMV doesn't track an index but is benchmarked against the Russell 3000 Index. The Vanguard Russell 3000 ETF (VTHR) is passively managed and has an expense ratio of 0.10%.

These low fees make a difference in the overall returns of the ETF to investors and are one of the primary reasons ETFs became available in 401(k)s. Another reason for their availability is that they have been gaining in popularity since they were first introduced, so there is a demand for them. Plan sponsors, therefore, designed plans with ETFs to give participants more choices in their retirement planning.

Advantages and Disadvantages of ETFs in 401(k)s

Advantages

Among the popular arguments favoring ETF plans is that index ETFs are less expensive than actively managed mutual funds. This may be true, but many excellent low-cost 401(k) plans offer a mix of index funds and actively managed funds.

Passively managed exchange-traded funds offer tax advantages because there is less trading activity within the fund. Minimal activity means there are fewer capital gains events triggered, which directly affect the fund's profitability. The fewer taxable events there are in a fund, the lower the overall cost is to the investor.

The place where ETFs might work in a 401(k) plan is under their managed accounts. These might be offered instead of the target date funds that are the staple managed account offering. However, it would still be up to the plan sponsor to vet these accounts and ensure they are appropriate for their participants. They would also want to ensure they can be used as qualified default investment alternatives.

For retirement planners who prefer to have nothing but ETFs in their plans, some sponsors developed plans that accomplish this. For example, robo-advisor Betterment launched a 401(k) product using all the ETF portfolios offered in its core service as managed accounts for 401(k) participants. The company offers a variety of portfolio plans ranging in offerings (e.g., the Essential, the Pro, and the Flagship plan), and each plan has a monthly base fee along with a per-participant assessment charge.

Disadvantages

The use of ETFs makes the issue of cost disclosure that much tougher for plan sponsors due to the structure of many ETFs. One issue is the bid-ask spreads that can vary during the trading day. While not part of the ETF’s expense structure, this does represent a cost to the participants.

The issue of intraday trading could also be problematic. This could result in different end-of-day values for the same holding among participants. The reality is that participants do talk to each other, and any situation like this is bound to surface, as participants could view it as unfair.

Concerns about ETFs in 401(k)s

Some ETF advantages are irrelevant in a 401(k) setting. For example, the ability to trade ETFs during the day is unlikely to appeal to employers who don't want employees sitting at their computers watching or trading their holdings during work hours.

Additionally, the option to trade in real time may or may not be available to plan participants, as 401(k) providers are likely to aggregate trades at the end of the business day to alleviate intraday trading expenses and employer concerns. In any case, retirement plans are not designed for intraday trading. They are supposed to be long-term investments.

Many ETFs offer tax efficiency due to their structure, but this becomes irrelevant in a tax-deferred retirement plan such as a 401(k). It might be more tax-efficient to choose non-tax-deferrable investments to use in a 401(k) and keep ETFs in the investing portion of your portfolio.

The Bottom Line

ETFs are investment vehicles that allow 401(k) participants to invest in a diversified portfolio of assets. However, ETFs lag behind mutual funds in 401(k) plans because their intraday trading features and tax benefits, while appealing to some investors, seem to appear less attractive to others.