A reader recently asked if I was “for or against” ETFs in 401(k)plans. I’ve spoken on this issue for several years at variousnational conferences. I’ve reported on the topic from still otherconferences. But, rather than merely repeat pre-existing publicrecord, I decided to dip further back into a piece of my writingportfolio that has yet to find its way into the digital world. Myresponse: “A better question might be whether I was for or againstmutual funds in 401(k) plans.”

My 1999 book "DueDiligence: The Individual Trustee’s Guide to Selecting andMonitoring a Professional Investment Adviser" spoke of ascenario whereby a 401(k) fiduciary needed to select investmentoptions. Using an example with only a growth fund and a value fund,I wrote

“Though consistently sticking to either ‘growth’ or ‘value’ overthe long haul can provide adequate returns, unsophisticatedinvestors attempting to time between either can lead to disastrousresults. As a fiduciary, you prefer to create a structure thathelps the beneficiaries avoid making this mistake.”

Given the demand for unitized portfolios, there was a shift awayfrom managing individual portfolios in 401(k) plans towards the useof mutual funds. As a result of these conflicting realities, Irecommended

“because you want to encourage employees to have a long termapproach and you want to help them avoid doing anything close tomarket timing, you limit their ability to switch between investmentoptions to semi-annually.”

Remember, retirement investing is for the long haul and you justwant to point the ship in the right direction, you don’t want torun out of fuel by zigging and zagging all the way to your ultimatedestination.

Ironically, that same unitized accounting structure has hamperedthe use of ETFs in 401k plans. Administration is perhaps the mostsignificant impediment identified in 5 reasons why a 401k plan fiduciary should reconsider usingETFs. As more recordkeepers have restructured their systems tosolve this unitization issue, other trading issues have becomeapparent. Unlike mutual funds, for example, ETFs cannot tradefractional shares, making the often smaller trade amounts of many401(k) plan participants difficult to administer.

Worse, unlike the set price of mutual funds, ETFs, like theirclosed-end fund cousins, can often experience liquidity problems.These produce large bid-ask spreads, a hidden and hard-to-documentcost to using even “commission free” ETFs.

The challenge of trading ETFs can confound professionaladvisers, too. At a recent conference, a group of these expertslisted the top 10 reasons 401k professionals fear ETFs are not ready forprimetime. Most ETFs are index funds. As a result, whereasprofessionals usually use ETFs to fill specific voids in managedportfolios, they suspect it might be more difficult for 401(k) planparticipants to exhibit the sophistication to employ ETFs in thismanner. Similarly, to avoid the downside of a potential liquiditysqueeze, a professional almost always enters an ETF trade as alimit order, not as a market order. Will 401(k) plan participantsbe able to place limit orders?

Like the Wild West, the ETF world sees innovation and perilaround every corner. In the end, when considering whether ETF innovations are good or bad for ERISA plansponsors, it comes down to the specific use. As an option forprofessional portfolio managers, ETFs can often supplement existingpositions in a traditional pension or profit sharing managedportfolio. This assumes the adviser has experience trading in bothilliquid securities and the type of underlying assets making up theparticular ETFs they choose to invest in.

With 401(k) plans, ETFs may not be a perfect fit right now.Since most 401(k) assets are invested in actively managed funds,there aren’t many comparable ETFs with adequate track records. Thatleaves ETFs for the index portion of the 401(k) plan – and it’s notclear ETFs can effectively compete with the lowest cost indexfunds.

But all this fails to address the issue addressed in my 1999book: Are plan participants better served by higher frequencytrading? Mutual funds allow participants to trade every day. ETFscan allow participants to trade every minute. Does theencouragement of day-trading reflect the best interests ofunsophisticated employees? Is it in the best interests of theiremployer? And who’s going to fund the employee’s retirement whenthey inevitably crap out in the day trading casino?

If, ultimately, we move away from the unitized world of themutual fund, then perhaps everyone is best served by returning tomanaged portfolios as default options in 401(k) plans. Without theregulatory burden of commingled products and without the tradingrisks of ETFs, plan sponsors can rely on tried-and-truepension/profit sharing procedures to perform their fiduciaryduties.