Are ETFs the right thing for a 401(k)?

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As exchange-traded funds become more popular, many wonder whether or not these investments are too risky. Because of the way they are set up, most investors can day trade within their ETF accounts. Many question whether that is a good idea, especially for those ETF funds included in 401(k) plans.

John Ameriks, a Vanguard principal who leads Vanguard Investment Counseling & Research Group, said that there aren’t as many differences between ETFs and mutual funds as people believe. The biggest difference is that the ETF structure “implicitly places the burden of any transaction costs on the individuals doing the trading. To some extent, that’s what people are worried about. They focus costs on the people trading. Pair that observation with the belief that ETFs cause people to trade more and you get the story that ETFs could be bad for people,” he said. “We don’t see them trading more than they are trading with other vehicles. It just means they are bearing the freight of transactional activity and liquidity services they would get from a fund.”

[Also read: Investors maintaining calm with ETF trades]

Vanguard’s ETFs are share classes of the company’s mutual funds. The actual investment holdings and underlying portfolios are similar, if not identical, Ameriks said. In some cases the ETF may be less expensive than the fund, but with purchased amounts over $10,000, they are going to have the same expense ratio.

“ETFs offer you the ability to buy and sell at a market price during the day, where a fund does not. Mutual funds allow investors to make one trade per day, which is executed at 4 p.m.,” he said. “For some people who value having immediate liquidity, this can be a service.”

Ameriks questioned the trend of including ETFs within 401(k) plans because day trading your 401(k) is not the best way to build retirement savings.

While Stuart Robertson, general manager of Sharebuilder 401k, agreed that day trading within a 401(k) can be detrimental, he said that his company uses ETFs within 401(k) plans to help clients save money. “We were pioneers. We were one of the first to offer ETFs in 401(k) plans.”

The company got into the space seven years ago because it wanted to come into an established marketplace with something compelling to help people save money, Robertson said. It evaluated low and high-expense funds and settled on index funds.

Sharebuilder has proprietary technology that allows it to not charge transaction costs within a 401(k). “Lower expenses equal higher performance equals more in retirement,” he said.

ETFs also “allow us to get into some asset classes you don’t find in 401(k) plans. Important ones, like commodities [and] foreign fixed income funds.”

One risk of ETFs in 401(k) plans is if you have an advisor that builds you a portfolio using narrowly defined ETFs, like buying just Brazil. “Something limited in scope may not be a good fit for a 401(k). They don’t have a good track record and are too risky,” he said.                        

As long as ETF investors stick with the four main asset classes: stocks or equities, fixed income or bonds, money market or cash equivalents and real estate or other tangible assets, they will lower their risk, he said.

Having a good investment policy in place and choosing appropriate low-cost funds will help employers have a better plan in place, Robertson said.

“In our plan, the way we ensure there are no transaction costs pushed out to employees is we limit it to one trade a day and aggregate those trades,” he said. “Some platforms may include intraday trading, which can add cost, but that’s not the best way to save money. Generally, for a long-term saving strategy, set up an asset allocation and graduate it over time as you get closer to retirement. We don’t encourage active trading.”

If investors have ETFs as part of their 401(k), Ameriks encourages them to make sure there are no commissions charged for purchases and sales. “If a fee is assessed every time you want to make a deposit, it could be a problem.”

He added that “people generally are not day trading their 401(k), and I think that is a good thing. I don’t see the need to have intraday liquidity in 401(k)s. Some of the platforms that offer this will aggregate the transactional activity and will execute it a couple times a day, but if you are aggregating all your activity, you are scratching your head. You do have a fund. It is a little bit of a solution in search of a problem. There are no tremendous advantages for people with similar investments at low cost per funds. There is no reason to add ETFs.”

Sharebuilder 401k says that even though it only allows 401(k) participants to trade once per day, just like mutual funds, there is still a cost benefit to them. ETFs typically charge lower fees than mutual funds, and the difference between 1 percent and 2 percent in fees, over time, is a great deal.

Historically, ETFs have been a brokerage vehicle that more savvy investors would have access to, Ameriks said. “As time goes forward, you will see a broadening of appeal of ETFs because they are similar to funds and arguably more convenient.”

Vanguard believes both ETFs and mutual funds are effective ways to attain diversified exposure in a low cost way to lots of investment markets out there. “We are fans of broad-based indices that help build diversified portfolios,” he added.

In a recently released white paper, Vanguard found that out of its 3.2 million retail investors, hyperactive investors were not the only ones using ETFs. “We are seeing long-term buy and hold investors using it to have a diversified portfolio. The costs are the same or lower than mutual funds and there is more trading flexibility,” he said.


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