ETFs Better Than Mutual Funds For 401(k)

December 22, 2015

“On the one hand, fund companies are hired by plan sponsors to create menus that serve the interests of plan participants. On the other hand, they also have an incentive to include their own proprietary funds on the menu, even when more suitable options are available from other fund families.”

The Salesman’s Cut

But the conflict of interest doesn’t stop with the mutual fund managers. Investment advisors who are compensated by the soft dollars previously mentioned are incentivized to distribute funds that are going to result in such a commission.

That means that some (not all) investment advisors could be acting with their own interests in mind.

This rarely happens with ETFs. Because ETFs are traded on an open market, there’s no way for the fund company to track the shareholders.

If there’s no way to track the shareholders, there’s no way to give compensation for sales, or know who should be compensated with a 12(b)-1 fee. So it’s very uncommon for that fee to exist with ETFs.

Additionally, advisors are not compensated by the fund managers for selling ETFs (again, because there’s no way to track who’s buying and selling them). So with ETFs, advisors can provide unbiased advice to plan sponsors and participants about what funds are truly best for them.

ETFs Are Passive And Usually Cheaper

These costs and conflicts of interest aside, most ETFs have expense ratios that are as low as, if not lower than, those of the retail class of mutual funds (minimum investment of $10,000 or less), and their cost savings are apparent. According to Morningstar, with the exception of long government bonds, the equal-weighted expense ratio of ETFs was cheaper in every single category.

Another key difference is that most ETFs are index-tracking, meaning that they try to match the returns and price movements of an index, such as the S&P 500, by assembling a portfolio that matches the index constituents as closely as possible. While mutual funds sometimes track index funds, most are actively managed. In that instance, the fund managers pick holdings to try to beat the index.

That can get expensive. Actively managed funds must spend money on analysts, economic and industry research, and company visits, among other things. That typically makes mutual funds more expensive to run—and for investors to own—than ETFs. Not to mention, they don’t perform as well. While active managers claim to outperform popular benchmarks, such as the S&P 500, research conclusively shows that they rarely succeed in doing so.

Why Aren’t ETFs More Prevalent in 401(k)s

Mutual funds continue to make up the majority of assets in 401(k) plans for various reasons, not despite these hidden fees and conflicts of interest, but because of them.

As the industry saying goes, 401(k) plans are sold, not bought. Plans are often sold through distribution partners, which can include brokers, advisors, record-keepers or third-party administrators. It’s difficult for these partners to market ETFs for 401(k)s if their traditional financial incentives are based on revenue-sharing associated with mutual funds.

Another reason why it’s rare to see ETFs in a 401(k) is the existing technology limitations. Most 401(k) record-keeping systems were built decades ago and designed to handle once-per-day trading, not intraday trading (the way ETFs are traded)—so these systems can’t handle ETFs on the platform at all. In fact, those that do allow ETFs oftentimes repackage the security so that, from a trading perspective, it behaves like a mutual fund.

So while ETFs have gained traction in the general marketplace, where people are more likely to independently research their funds, ETFs haven’t caught on in 401(k)s.

As the average employee and plan sponsor become more aware of hidden fees inside 401(k)s, an all-ETF 401(k) becomes more attractive.

And while a mutual fund-only 401(k) can have some serious conflicts of interests, a managed ETF portfolio offers all of the benefits of mutual funds, with none of the participant risks.

Betterment is the largest, fastest-growing automated investing service, helping people to better manage, protect and grow their wealth through smarter technology. It is a CNBC Disruptor 50 and Webby award winner, and has been featured in the New York Times, Forbes and the Wall Street Journal. Learn more here.

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