Mutual Funds Vs. ETFs In Retirement

September 23, 2019

[This article appears in our October 2019 issue of ETFR.]

Since the birth of the 401(k) in 1978, mutual funds have been the dominant investment choice in defined contribution plans.

ETFs have made some inroads, but for the most part, they represent a very small part of investors’ retirement portfolios. Reasons are varied—part of it is the plan’s structure, part of it is plan sponsors’ comfort with using mutual funds over ETFs, and part of that is the mutual fund industry’s size.

The story is a little different when looking at individual retirement accounts. Mutual funds continue to hold most of the U.S. investment assets, but ETFs are gaining market share, as it appears that people who are more comfortable making their own investment decisions are selecting more ETFs.

When talking about ETFs only capturing a small part of the retirement ecosystem, a little perspective is needed. The Investment Company Institute’s 2019 Factbook, reflecting data as of the end of 2018, reported total U.S. retirement market assets reached $27.1 trillion in regulated open-end funds, which include mutual funds, ETFs and institutional funds. Of that total, there was $8.2 trillion in mutual funds in IRA and defined contribution plans, about 30% of the market.

Although the group did not break out ETFs and institutional funds, the size of mutual funds in retirement plans alone is more than twice as big as the entire ETF universe, which it estimates at $3.4 trillion.

Advantage: Mutual Funds
Sources familiar with mutual funds, ETFs and retirement plans say that, right now, it’s unlikely ETFs will become bigger parts of 401(k) plans. When looking at the pros and cons of these two instruments for retirement plans, a few structural factors give mutual funds the edge.

The plumbing is set for mutual funds, for one thing.

Just because mutual funds dominate doesn’t mean they will forever, but basic 401(k) architecture favors mutual funds, observes Greg Friedman, head of ETF management and strategy at Fidelity.

“Could the ETF conceivably fit into the 401(k) platform one day? Absolutely. I think some of the challenges to date have been the plumbing—some of the systems and the technology” have hindered adoption, he said.

One of those “plumbing” issues is pricing, he remarks. The 401(k) platform is designed to price end-of-day net asset value. Since ETFs trade all day, they’re priced at the last-traded price.

 

 

Intraday Trading Problem

Jack Towarnicky, executive director of The Plan Sponsor Council of America, concurs. He points out that most plans aren’t set up to administer intraday trading, as most plans preclude daily transactions or multiple transactions in a single day.

“Using an ETF that permits intraday trading could be a detriment in terms of fund performance to those participants where a plan trades only at the end-of-day NAV,” he said.

Rich Powers, head of ETF management, Vanguard, elaborates, noting ETFs settle at T-plus 2 (trade date plus two days), whereas mutual funds and collective investment trusts settle at T-plus 1. “There’s a complexity from a system standpoint,” he noted.

There’s another way ETFs’ intraday trading aspect makes plan sponsors cautious. Friedman says that plan sponsors may have an impression their 401(k) clients would trade more often if they had ETFs. Since the average 401(k) plan likely comprises people who might not be investing savvy, Powers suggests plan sponsors may feel a fiduciary responsibility to keep easily tradable products out of the plan.

Towarnicky points to ICI data showing households that invest in ETFs are more likely to accept greater investment risks. One response that some plan sponsors have made to the individuals who want more options in their 401(k)s is to provide access to ETFs through self-directed brokerage accounts. These are “subject to greater disclosures, and often (require) a specific participant acknowledgment that they are investing in (products) … that do not receive regular review by plan fiduciaries,” he said.

PSCA data shows greater ETF usage in these self-directed brokerage accounts, accounting for 14% of fund structures in 2017, up from 12.8% in 2016. Mutual funds still dominate this fund type, at 64.7%.

 

 

 

 

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