ETFs And 401(k) Plans

August 25, 2008

 

vs.
Darwin Abrahamson   David Blanchett Gregory Kasten

 

Editor's Note: David Blanchett and Gregory Kasten's article, "Why ETFs And 401(k)s Will Never Match," which appeared in the July/August 2008 issue of the Journal of Indexes, elicited a lot of discussion in the exchange-traded fund industry. Blanchett and Kasten argued that the extra costs associated with incorporating ETFs inside a 401(k) program far outweighed any cost savings from the funds' lower expense ratios.

Darwin Abrahamson took exception to that argument. Abrahamson is the CEO of Invest n Retire, the leading provider of software that allows ETFs to function in an ETF platform. His position is not just that ETFs can work inside 401(k)s, but that they represent a dramatically better solution for the 401(k) market.

Abrahamson submitted a letter to the editor disputing Blanchett and Kasten's article, which follows below. Because it is such an important discussion, we invited Blanchett and Kasten to respond.

Debunking The Myth that ETFs Have No Place In 401(k)s
by Darwin Abrahamson

The authors of the white paper, "Why ETFs And 401(k)s Will Never Match," David Blanchett, internal consultant, Unified Trust Co.; and Gregory Kasten, president, Unified Trust Co., N.A. purport to explore the benefits and costs associated with using exchange-traded funds in 401(k)s. The authors also give a veiled attempt at providing guidance as to whether ETFs represent a better indexing option than traditional index mutual funds.

Technology

Unfortunately, instead of basing their analysis on facts, the paper relies on the myth that the technology required to add ETFs to 401(k) plans has not been developed.

For the past decade, the entire financial industry has lamented that ETFs cannot be added to 401(k) plans due to the prohibitive cost of trading ETFs on the open market throughout the day, and the industry's inability to record-keep ETFs in 401(k) plans. If the authors had fully researched these challenges, they would have discovered that Invest n Retire, LLC, (INR), a recordkeeping firm in Portland, Ore., has been trading and record-keeping ETFs in 401(k) plans, on a cost-effective basis, for over five years.

Prior to the publication of their white paper, neither David nor Gregory called me to discuss our platform. In fact, INR has a patent pending on its technology for trading and record-keeping ETFs in 401(k) plans.

In their conclusion, David and Gregory state: "Given current technology, the cost savings from ETFs in 401(k) plans appear to be minimal. …"

Debunking The Myth

Debunking the myth that the technology necessary to trade and record-keep ETFs has not been developed requires a re-examination of Blanchett and Kasten's white paper. In their conclusion, they further give the impression that even if the technology were available, the cost of trading ETFs would remain as an insurmountable obstacle to adding ETFs to 401(k) plans.

"…While the expense ratios for ETFs may be less than their respective indexed mutual fund peers, this lower cost is materially eroded by the explicit and implicit costs associated with making the ETFs ‘401(k)-ready.' In fact, it is likely that an ETF 401(k) strategy would end up being more expensive than a mutual fund strategy after all the costs are considered."

Transaction Costs

To support their conclusion, they present an argument that ETFs should be avoided due to transaction costs in the form of a bid/ask spread and commissions: "There are two primary transaction costs associated with purchasing an ETF. … The first cost is the bid/ask spread (or spread) and the second is commissions."

True, ETFs do incur a cost in the form of a spread when an ETF is bought or sold on the open market. What David and Gregory fail to mention is that the stocks and bonds, which are the investment components of mutual funds, are also bought and sold on the open market.

This oversight demonstrates that their theories are flawed by their preconceived beliefs. In case you miss my point, let me be very clear: The white paper includes misleading information regarding the cost of purchasing and selling mutual funds: "Commissions, similar to the bid/ask spread, are a cost paid each time an ETF is bought or sold, since unlike mutual funds, ETFs cannot be redeemed at NAV and must be purchased on the open market."

Invisible Costs

Mutual funds buy and sell thousands of shares a day on the open market. Each mutual fund transaction also includes commissions, as well as spreads. In a white paper commissioned by The Zero Alpha Group (ZAG), "Mutual Fund Brokerage Commissions," the researchers examined the magnitude of brokerage commissions paid by mutual funds and concluded that brokerage commissions are significant, averaging 27 basis points.

In 1994, John Bogle, founder of The Vanguard Group, coined the term, "invisible costs," in reference to the high costs of trading shares in a mutual fund.1 Bogle was referring to the fund's expenditures for trading the securities in the portfolio. In contrast to fund fees, which are reported as the expense ratio, trading costs within a mutual fund are invisible because they are not included in the expense ratio, which makes them difficult to assess.

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