No Need to Switch to ETFs for Most Plan Sponsors

April 11, 2012 (PLANSPONSOR.com) – When you look at the big picture, there is no reason for retirement plan sponsors to switch from index mutual funds to exchange-traded funds (ETFs) in their plan’s investment lineup, said Steve Utkus, head of Vanguard’s Center for Retirement Research.

Utkus told PLANSPONSOR the guiding consideration for plan sponsors is that indexing is much cheaper than active management. But, before they decide they want an all-ETF plan, thinking that is the cheapest mode for indexing, they should dig deeper into ETF costs.   

Utkus made the point that most 401(k) plans have access to index mutual funds that are cheaper than or as cheap as ETFs. Larger plans have access to institutional share classes that are cheap for index mutual funds, so there is no reason to switch to or adopt ETFs since most major providers offer low cost index funds.  

The other way to look at it, most individuals in a 401(k) plan are at mid- to large-size companies.  

When considering the costs of ETFs, plan sponsors need to look at both the fund’s expense ratio and what is called the “bid risk spread”—the difference in the market value and the price the trader can get for each transaction, Utkus explained. With mutual funds, all the costs are represented in the price at the end of the day, when the net transaction for the fund is traded.  

Because ETFs can trade throughout the day, traders may get a price higher than the actual market value of the share, meaning participants’ contributions may not purchase as many shares in that particular trade. Utkus said it is hard for plan sponsors to know these cost drags on participants’ assets because traders do not typically provide this information throughout the day.

In addition, Utkus noted that recordkeepers have not spent much on technology and support for trading ETFs because the demand has not been high. If demand grew, there would be infrastructure costs for the recordkeeper that could get passed to retirement plan participants, he adds.  

There is however an interesting argument for ETFs within the small plan market (plans with less than $50 million in assets), according to Utkus. Vanguard offers small plans cheap index funds, but not many providers do, so ETFs may be the answer. It is a good way for small plans that do not qualify for institutional share classes to get indexing.  

“The way we see it, if you’re a smaller plan and have a provider that doesn’t offer low cost index funds, and want to switch to ETFs, you should do so, but understand all the costs,” Utkus stated.  

One thing Utkus noted was that it is better to stick with non-specialty ETFs. Bidding on an asset class that is not commonly traded will cost more for trading, but offering, for example, and S&P 500 ETF will feel more like an index fund. Bigger providers, that are better at trade management and trade execution, offer these types of funds.  

“If there were some overwhelming cost reason to switch to ETFs, Vanguard would be urging clients to do so,” Utkus concluded, adding that Vanguard is currently having discussions about the ETF opportunity in retirement plans.

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