The current ETF market has been built on the backs of savvy advisors and institutional traders. The next trillion is coming one payroll at a time.
Back at the dawn of time, I was the sales manager for a big bank’s 401(k) business. The pitch we had was simple: We offered medium-sized businesses—which is where a tremendous amount of the wealth in this country resides—a way to make their employees pay for their own retirement.
The secret sauce was mutual funds. Prior to the mutual fund revolution of the 1980s, retirement money was overwhelmingly defined-benefit. You put in the years, and the company took care of you, based, usually, on your final salary. Defined contribution plans—specifically the now-famous 401(k) plan—didn’t exist in their modern form until the 1978 tax laws invented them. They really kicked into gear in 1986, when tax reform cleaned up a lot of the confusing bits.
The truly magical thing about 401(k) plans wasn’t that they let employers get rid of their old defined benefit plans, which saddled the industry with massive pension liabilities; the true magic was that they paid for themselves.
Deep inside most mutual funds, even the cheap no-load variety, you’ll find a fee called a 12(b)1 fee. This fee lets mutual funds recoup expenses used for distribution or servicing. In practice, what happens is that the 12(b)1 fees are rebated back to the company that is out selling the 401(k) plan, to pay for everything involved in making that plan work (record-keeping, participant education, CEO yachts, etc.).
For the most part, this has been a win-win for investors. The 401(k) market now has roughly $3 trillion in assets (extrapolating from ICI numbers), with well more than half of that in mutual funds. The money that’s not in mutual funds is in separate accounts, company stock or—fairly rarely—self-directed brokerage accounts. If you do the math, that means about $4 billion is being collected in 12(b)1 fees and feeding the record-keeping and 401(k) sales efforts.
But investors aren’t stupid. Time was, the funds in 401(k) plans were often indescribably bad. There were S&P 500 Index funds that charged 1 percent, and underperforming actively managed funds with expense ratios north of 2 percent. These plans—and these funds—still exist, but the assets have moved, inexorably, to more efficient investments. In 1996, the average dollar invested in equity mutual funds in 401(k)s was paying 0.84 percent in annual expenses. In 2009, that number had dropped to 0.74 percent—still massively too high, but a movement in the right direction.
So where do ETFs fit into this? Simple. ETFs are disaggregation vehicles at their core. They strip out all of the things that make pooled vehicles troublesome (embedded transaction costs, embedded tax issues) and put the investor in control. People like line-item breakdowns in their purchases. Without a line-item breakdown, how do you know if you got overcharged for your Grand Marnier after dinner, or if Bob paid his share of the tab?
It’s time for the 401(k) industry to disaggregate its fees too, and start giving investors the real truth. That real truth is that the crappy investments in a 401(k)—the high-fee active funds—are quite often subsidizing the guy who’s smart enough to know better, and picks the handful of funds he might have available to him that are low-fee index funds.
The right thing to do is charge everyone an administration fee, and let the investments stand on their own. And there are signs that that is exactly what’s happening with ETFs.
The only reason ETFs haven’t kicked funds to the curb in 401(k)s is really record-keeping. 401(k) accounting systems are designed for end-of-day batch transactions and fractional shares. That way, employees can know that $500 goes to their favorite fund, without worrying about how many shares that gets them. It’s kind of the whole point of regular investing—fire and forget. ETFs confound this: They trade intraday, and they trade in whole shares.
The simple way around this is to “re-pool” the ETFs, so that investors can make their whole-dollar contributions at the end of the day, when payroll gets processed. And that’s exactly what iShares is doing with its partners SunGard (a monster in 401(k) record-keeping) and MidAtlantic Financial. They’re rolling up pooled trust accounts (I assume) and placing closing-price trades, presumably with MidAtlantic taking the frictional risk of the few partial lots or market moves that go against them day to day.
It’s not clear how much they are charging individual clients for their “ETF Exchange” platform, and I’m sure that’s hugely negotiable, but people are picking up on it. ING Bank and WisdomTree have offerings of their own, and several small record-keepers are piling on as well.
And there’s traction: United Airlines, HP and Samsung have all added ETFs to their 401(k) plans. In the “me too” world of risk-averse retirement plan administrators, I see a world where low-fee ETFs become a best practice, and that’s where the next trillion comes from.