We spoke with Darwin Abrahamson, the CEO of Invest n Retire, and asked him about why ETFs should be in 401(k) plans and what his firm is doing to make it happen.
Aside from the usual reasons (transparency, liquidity, low cost, etc.), why are ETFs better investment options for managed accounts (asset allocation models) than mutual funds?
There are several advantages ETFs have over mutual funds as investments for asset allocation models. Primarily, ETFs are required to maintain a 99% correlation to their index. Mutual funds average 4-5% in cash, which creates a cash drag on the returns and have style drift from the index.
As an example, the AIM Mid-Cap has only 73% of its assets in mid-cap stocks, 6% in cash and 21% international stocks. Therefore, the fund has different returns (style drift) than the mid-cap index. Using mutual funds in asset allocation models corrupts the asset allocation model.
Do ETFs reduce the fiduciary liability for fiduciaries?
Yes. Language contained in the American Law Institute’s Restatement of the Law Third, Trusts, which serves as the basis for the Uniform Prudent Investor Act states: “A trustee’s departure from valid passive strategies may actually increase the trustee’s burden of justification and continuous monitoring.”
Don Trone, president of the Foundation for Fiduciary Studies stated, “One could argue that the failure to at least consider ETFs could be deemed a breach of fiduciary responsibility.”
With the GAO report, congressional hearings, the DOL 408 project and class action suits on revenue sharing with mutual funds, what advantage do ETFs have?
(In November 2006, the United States Government Accountability Office (GAO) published a report titled Changes Needed to Provide 401(k) Plan Participants and the DOL Better Information on Fees. The GAO did the study because of concerns about the effects of fees on participants’ retirement savings. The GAO recommended that Congress should amend the Employee Retirement Income Security Act (ERISA) to require fee disclosure to participants and plan sponsors by 401(k) service providers.
The DOL 408(b)(2) project requires plan sponsors to disclose indirect compensation on their 5500s starting in 2008 and require service providers, such as advisers and record-keepers, to disclose indirect compensation to plan sponsors and will mandate disclosure of indirect compensation to plan participants.)
ETFs do not have any of the baggage of hidden fees that mutual funds have. The hidden fees include 12(b)1 fees, revenue sharing (sub-TA fees), multiple share classes and internal brokerage costs. Therefore, disclosure and cost of disclosure of hidden fees is eliminated.
Target date funds – a fund that matures by a target date of your choosing and, as you near that date, becomes incrementally more conservative – are the hottest investment option in 401(k) plans. What is creating this growth?
Mutual fund companies are increasing their fees and increasing assets by limiting the funds in the target date funds exclusively to their own funds. The average target date fund has a fee of 0.93% compared to 0.50% on the core funds. Example: the BGI LifePath 2040 portfolio’s total expense ratio is 1.19% and the ETFs used in this fund have an expense ratio of 0.35%. Therefore, a participant in the LifePath 2040 fund is paying BGI 0.84% more in fees. LifePath funds are a great cash cow for Barclay’s, but not for the investor.
Why are current providers such as Vanguard and Fidelity not offering ETFs in 401(k) plans?
There are two reasons. The first and foremost reason is revenue stream to the mutual fund companies and providers is much greater with mutual funds. The second is that other providers – except for Invest n Retire – do not have the technology to trade and record-keep with ETFs in 401(k) plans.
Gus Sauter, chief financial officer at Vanguard stated in an interview, “Our ETFs typically have a lower expense ratio than our conventional share classes. If a record keeper just offers ETFs alone, how will the record keeper get enough?”
The press continually quotes mutual fund companies that claim there is no demand from plan sponsors for ETFs. It is the mutual fund companies that do not want to offer ETFs in 401(k) plans, not the plan sponsors. Mutual fund companies have every reason to discourage ETFs in 401(k) plans.
The low cost of ETFs, which makes them very attractive to investors, makes their distribution into 401(k) plans unattractive to mutual fund companies. ETFs do not generate cash flow to their preparatory funds, nor can they receive revenue-sharing from other fund companies.
The way business is done in the mutual fund industry is to add fees to the “traditional” mutual funds in order to compensate intermediaries for distributing the funds. Distribution fees are paid in the form of 12b-1 fees, sub-transfer fees and find’s fee – known collectively as revenue-sharing fees. ETFs do not have any built-in structures for payment of revenue-sharing.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.