Exchange traded funds have yet to be included in most defined contribution (DC) plans due to their unique structure. A defined contribution plan was originally designed to incorporate funds that are priced once a day, a technical issue that isn’t ETF-friendly.
“A traditional fund platform isn’t really open or designed to trade on exchange. Most of them at the moment are designed to interact with active funds and custodians to create or redeem on an end-of-day basis. What they need to do is to put in place a mechanism or a pipe to a broker that can execute for them on-exchange, then deliver the requisite units,” Nizam Hamid wrote for Financial News. [New 401(k) Fee Disclosure Rules Would Give Low-Cost ETFs an Edge]
Size matters when it comes to a DC plan and ETFs. A DC plan uses cash flow that is made up of small transactions, and from the viewpoint of an ETF provider, these are simply too small and inefficient to manage. The trading patterns of an ETF, which are traded frequently, and at varied prices, are difficult for the record keepers to aggregate while keeping costs down. The different pricing and trading times are a lot to keep under control and this has been the biggest hurdle for most DC plans using ETFs.
The challenges are not an end-all, be-all obstacle. Rather, it is up to the ETF providers to use a platform that makes ETFs DC-friendly. For example, Fidelity Investments has set up with an investment bank for its FundsNetwork platform to offer ETFs on its DC platform, reports Christine Senior for Financial News. [Heavyweight ETF Providers Lobbying for 401(k) Inroads]
“We gather all our ETF orders for the day and fire them over to JP Morgan. JP Morgan will strike a price on all of those deals at midday. They will then send a price back for that deal. There are quite a few technicalities under the skin in that. Liquidity in some of the ETFs is not huge. JP Morgan effectively undertakes to fill the whole order at once,” Richard Parkin, head of DC workplace savings at Fidelity said.
The demand for ETFs in DC plans is still limited. There is a small market for these types of plans and only certain asset classes are used. There are a few funds that give investors in DC plans better coverage than ETFs and at this time they can be simpler and cheaper to use. ETFs providers are not going to give up trying to break into this area of the market, but there are certain obstacles that need to be resolved before any market share can be gained.
Tisha Guerrero contributed to this article.