The ‘Smart Beta’ Way To 401(k) Investing

June 24, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Mike Venuto, co-founder and chief investment officer of New York-based Toroso Investments.

In 2015, ETFs have continued to capture market share from mutual funds. But one area where mutual funds remain the dominant product choice is in 401(k) retirement accounts, and specifically in target-date funds.

Today nearly 75 percent of all new 401(k) assets are allocated to target-date funds that have average expense ratios of 0.84 percent, or $84 for each $10,000 invested, according to Morningstar's 2014 research study. By the way, when 401(k)s using index funds are eliminated, and when you measure only active target-date funds, that average expense ratio jumps to 1.13 percent.

What's more, 401(k) platforms charge other administrative fees that bring the average cost of a small 401(k) plan to 1.4 percent—and that's without the inclusion of the cost of retaining a financial advisor or independent fiduciary.

Enter A 'Smart Beta' Option

I believe that the advent of "smart beta" strategies provides an opportunity for ETFs to provide enhanced goals-based solutions for 401(k) investors. However, this is not as simple as replacing expensive active management with intelligent ETFs.

Edhec sites the nexus of smart-beta indexing as a response to the findings of Herfindahl and Hirschman. Their work was focused on anti-trust law, but also highlighted the unintended concentrations created by market-cap-weighted indexing as well as the tendency to overweight size and growth factors.

Smart-beta ETFs attempt to address some of these inefficiencies, but before I explore the selection of these products, let's discuss the unintended consequences created by traditional risk-based glide paths.

Asset Allocation: Is It Time To Get 'Smart' Here Too?

To begin, most target-date funds are based on a traditional modern portfolio theory glide path. The chart below illustrates the basic changes over time, and the simple description is that the arc of an investment lifetime begins with overweighting high-risk assets (equities) and ends with overweighting low-risk assets (bonds).

The entrenchment in the minds of advisors and investors of this glide path likely comes from its ease of understanding and, no less important, the fact that its building blocks dominate the mutual fund landscape.

Find your next ETF

Reset All