In another white paper, "Revenue Sharing Aspects of Qualified Retirement Plan Management," Kasten states, "The practice of revenue sharing in the retirement and investment management businesses is here to stay."
I guess this helps us understand why both Blanchett and Kasten believe high-cost mutual funds are appropriate investment vehicles for 401(k) plan participants.
Darwin Abrahamson is the CEO of Invest n Retire LLC; Portland, Ore. He can be reached at [email protected].
The Rebuttal: Why ETFs Just Don't Make Sense On A 401(k) Platform
By David Blanchett and Gregory Kasten
Abrahamson's critique largely misses the entire point of our article: that low-cost, high-quality, passive open-ended mutual funds are a better solution than ETFs for 401(k)s when the total costs of making ETFs "401(k) ready" are considered.
It is standard knowledge that ETFs cost less than the average mutual fund. Most mutual funds are actively managed and ETFs are passively managed, and active management tends to cost more than passive management. Therefore, the issue is not whether the average ETF costs less than the average mutual fund (they do), but whether ETFs are a better solution than mutual funds to obtain a passive exposure to the markets. This issue is much less clear and was the underlying purpose for the original research that resulted in a paper published by these authors titled "Why ETFs And 401(k)s Will Never Match," which appeared in the July/August 2008 issue of the Journal of Indexes.
While Abrahamson rebuts our point on transaction costs, he ignores the "total cost" issue of making ETFs 401(k)-ready. ETFs in their traditional form cannot readily be used in 401(k) plans. Instead, a variety of implicit and explicit "costs" must be incurred in order to make an ETF 401(k)-ready. For example, each time an ETF is purchased, the buyer incurs the bid/ask spread and pays a commission—two fees that are not paid when purchasing a mutual fund. While mutual fund portfolio managers incur the bid/ask spread and commissions when they buy and sell stocks, the most common passive indexes have very little turnover, and such turnover tends to have a very small impact on the net performance of the fund.
Abrahamson also asserts that we "fail to mention" the "invisible costs" associated with portfolio turnover. This assertion is incorrect at both a practical and realistic level. Both of the authors (Blanchett and Kasten) have independently written and published research on the costs associated with turnover (one was an empirical study published in the Journal of Indexes "Tracking Error And The Efficient Frontier, November/December 2007); the second was a review of past literature published in the Journal of Pension Benefits). We are both incredibly familiar with the issues surrounding turnover. Also, in reality, the returns of the larger, well-run mutual funds tend to precisely mirror the performance of the benchmark index minus the explicit fee (i.e., expense ratio).
Just because an ETF has a lower expense ratio doesn't mean an investor will realize a higher return. Let's compare the largest ETF and the largest index fund based on assets as of June 30, 2008, which are both based on the same underlying benchmark, the S&P 500. The largest ETF is the SPDR Trust Series 1 (AMEX: SPY), with $71.7 billion in assets; and the largest index mutual fund is the Vanguard S&P 500 Investor Share Class mutual fund (VFINX), with $54.8 billion in assets. Since the ETF is cheaper, we would expect the ETF to have the better performance, right?
As of June 30, 2008, the net asset value (NAV) performance (according to Morningstar) of SPY was -13.58%, 4.14% and 7.36% over the preceding 1-year, 3-year and 5-year periods, respectively, while the NAV performance of VFINX was -13.19%, 4.28% and 7.45% over the same respective periods. The S&P 500 Index returned -13.12%, 4.41% and 7.58% over the respective periods. VFINX outperformed SPY by 39 bps, 14 bps and 9 bps, over the preceding 1-year, 3-year and 5-year periods, respectively, despite the fact the expense ratio of VFINX was 7 bps higher (than SPY as of June 30, 2008).
The relative outperformance of VFINX over SPY would increase further if the additional costs associated with making SPY 401(k)-ready were incorporated into the analysis, not to mention the fact that Vanguard has cheaper share classes available for larger investors. Unlike mutual funds, though, ETFs cannot be purchased in fractional shares unless they are unitized. The unitization process is not free, and the costs associated with unitization reduce the net return realized by the investor. The vast majority of platforms that offer ETFs utilize them in a unitized fashion, a point wholly ignored in Abrahamson's critique.