ETFs And 401(k) Plans

August 25, 2008


In the white paper, "An Analysis of Mutual Fund Trading Costs," by John Chalmers, Roger Edelen and Gregory Kadlec, the researchers directly estimated the annual trading costs for a sample of equity mutual funds and found that trading costs are large and exhibit substantial cross-sectional variation. Abstract: "Trading costs average 0.78% of fund assets per year and have an inter-quartile range of 0.59%. Trading costs, like expense ratios, are negatively related to fund returns and we find no evidence that on average trading costs are recovered in higher gross fund returns. ..."2

Using data from Morningstar Principia, the researchers of the paper, "Mutual Fund Brokerage Commissions," illustrate that the Fidelity Growth fund had an estimated total cost of 1.2259 bps after adding the implicit trading and commission costs (explicit expense ratio 0.85 bps plus the implicit trading cost which includes the trading cost for the securities within the fund, based on turnover with an expense ratio of 0.2484 bps and commission cost of 0.1275 bps).3

Empirically, the researchers make it clear that mutual funds pay trading costs for the securities traded within the fund, and those costs are substantial.

Index Funds Vs. ETFs

Blanchett and Kasten also attempt to make a case that choosing a more costly index fund makes more sense than choosing a lower-cost ETF since they wish their readers to conclude, from their research, that index funds are a lower-cost option once you add the expense of trading the ETF.

"In the aggregate, since the expense ratio differences between the ETF and mutual fund strategies were so small (at most, 14 bps for Investor-share classes), it is unlikely that any material benefits are going to be obtained from unitizing an ETF, once considering all the costs (both explicit and implicit)."

Again, Blanchett and Kasten fail to mention the implicit trading and commission costs within the index mutual fund. However, the white paper, "Mutual Fund Brokerage Commissions," debunks the myth that index funds are free of trading and commissions costs.

Using the Vanguard 500 Index as its example, the paper illustrates that the fund's estimated total cost is 0.2155 bps (explicit expense ratio of 0.18, plus the implicit trading cost, which includes the trading cost for the securities within the fund based on turnover, with an expense ratio of 0.0324 and commission cost of 0.0031).4

When you consider the fact that an ETF receives shares in-kind—that is, the securities within the ETF are not traded on the open market, unlike traditional mutual funds—the implicit trading costs of ETFs are actually lower than traditional mutual funds. For example, the Vanguard Large Cap ETF has an expense ratio of .07 bps and .000 bps in trading cost for receipt of shares in-kind within the ETF.

Revenue Sharing

Blanchett and Kasten even defend the practice of revenue sharing and attempt to illustrate that by paying a higher fee for a traditional mutual fund, a plan will actually reduce its costs if the revenue-sharing fee is used to pay plan expenses.

Blanchett and Kasten rationalize, "If the revenue share monies from mutual funds are returned to the plan to offset fees … revenue share can actually decrease the total net cost of the mutual fund. In some cases, this can make an index mutual fund that has a higher expense ratio than an ETF actually be less expensive than the ETF."

In my view, that is the most preposterous justification for including investment options that pay revenue sharing. In my opinion, relying on revenue-sharing fees to pay plan expenses only encourages a lack of scrutiny of the fees being charged and who is getting paid. Case in point, how many times have you heard a plan sponsor say the plan doesn't cost us anything—it's free?

It is interesting to note that Unified Trust discloses on its Website (60/40 Asset Allocation Newsletter 10/31/06) that Unified charges a fee for revenue [sharing] collection.5

In an article, "The Legality of Kickbacks: How 401(k) Vendors are Paid on the Eve of SEC and DOL Investigations," another employee of Unified Trust, Pete Swisher, vice president and senior institutional consultant, stated: "Kickbacks is perhaps an unfair term since it suggests that revenue sharing payments are somehow illegal or unethical when in fact they are a perfectly reasonable practice. … payments typically take the form of rebates of fund expense ratios in amounts ranging from 0.25% to 0.50%, though the full range is more like 0 to 1.00%."

Mr. Swisher does admit that revenue sharing can be used for good or evil. "In a perfect world, revenue sharing would simply be a number subtracted from expense ratios to determine the true cost of money management. A fund costing 1.00% but refunding 0.50% is still more expensive than a fund costing 0.40% and refunding none. …net cost is the number to target when evaluating fund and plan expenses."6

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