Not Every Good Investment Idea Works In An ETF

As we approach 2,000 ETFs listed in the U.S. (currently at 1,931) we have seen new funds offer a dizzyingly array of investment exposures, because all obvious pockets of the investment world have already been thoroughly covered.

From thematic ETFs that cover niche pockets of the market like drones and “Catholic values,” to a cavalcade of multifactor ETFs that have taken the term “smart beta” to a new level, there has been no shortage of ETF ideas.

And yet, even as we ask whether there are too many ETFs on the market—keep in mind there are 11,000 mutual funds—there is one ETF product that has come and gone in a relatively short period.

Target-date ETFs fell off the ETF landscape more than a year ago, when Deutsche Bank announced in April 2015 that it would be shuttering its family of five target-date ETFs, all of which had less than $50 million in assets. The last day of trading for these ETFs that targeted 10-year intervals was May 27, 2015.

In August 2014, BlackRock’s iShares unit, the biggest ETF company in the world, closed its nine target-date funds with a combined $300 million in assets at the time.

All-In-One Portfolio

These funds are an all-in-one portfolio that combine equities and fixed income in varying amounts depending on how close or far a given investor is from retirement. The concept, once considered innovative and alluring, never resonated in an ETF package, and that’s a shame. The vehicle is a great idea in or outside a 401(k).

There are hundreds of billions of dollars of assets in target-date mutual funds, a large majority of which sit in 401(k) accounts, which is the last stronghold for the mutual industry when it comes to ETFs.  

My appreciation for target-date funds has grown recently, after I added one such mutual fund to my own 401(k), and it struck me what a good idea these are for buy-and-hold investors who do not want to manage asset allocation adjustments—rebalancing, moving in and out of cash, etc. It also struck me as odd there are no target-date ETFs on the market. It’s rare to find an investment idea that is offered in a mutual fund but not in an ETF wrapper.

The concept is simple. A typical target-date fund offers stocks and bonds, and the allocation is based on when you expect to retire. That allocation changes as time goes by into a more conservative stock/bond split. For the fund I own, the allocation is 74% stocks and 26% bonds, with an expense ratio as low as 0.15%. There’s nothing else for me to do but direct savings into it.

Why It Didn’t Work In An ETF

Being the editor of ETF.com, I did begin to wonder why this retirement fund was absent in the ETF industry. The concept is good in or out of a 401(k). One of the biggest mistakes investors make is not being properly diversified, and this concept goes pretty far in doing just that.

But there were two key factors that undermined target-date ETFs—beyond the fact that ETFs aren’t often included 401(k) plans, according to Paul Britt, senior ETF analyst at FactSet. Britt wrote for us when he was an analyst at ETF.com in 2014 on the heels of iShares closing down its target-date suite:

“First, while ETFs can be traded like a stock, their tradability is something of a nuisance in the context of regular contributions to IRAs or 401(k)s. For each contribution, the plan administrator must worry about best execution of the ETF shares relative to their fair value (net asset value). In contrast, mutual funds get “executed” at end of day, which means at fair value, period.

Over the long haul, the fair value of the mutual fund reflects trading costs too, since the mutual fund manager has to trade the underlying securities. This “friction” is buried in the mutual fund, but worn on the sleeve of the ETF.

Second, the ETF’s tax efficiency is less relevant here. ETFs avoid most capital gains distributions thanks to their creation/redemption mechanism. In contrast, when a big mutual fund investor sells out, it can produce a cash distribution—labeled as capital gains for tax purposes—for the shareholders that remain in the fund. In a tax-deferred account—such as an IRA or a 401(k)—however, this cash flow has no impact from a tax perspective.”

ETF Cost Advantage Fades, Too

“With respect to costs—particularly for all-indexed target-date funds—there isn't really a cost advantage to ETFs in defined contribution plans, particularly for investors in mid- and large-sized employer plans that benefit from institutional mutual fund or collective trust pricing,” said Emily Farrell, a spokesperson for Vanguard, one of the largest issuers of target-date mutual funds.

“Even for individual investors outside of employer plans, bid/ask spreads and trading commissions can eat into, and potentially overwhelm, any small cost advantage that a theoretical target-date ETF may have over the target-date mutual fund,” she added.

The head winds these funds face make sense, but it still seems the concept should be viable in an ETF wrapper regardless, and provide a simple tool for investor to be diversified as they save for retirement.

Whether these funds will come back to the ETF scene is unknown. There are no filings for target-date ETFs sitting in the regulatory pipeline that I am aware of. That’s a shame, because they make a whole lot more sense for ordinary investors than a whiskey-related ETF or bio-threat ETF.

Drew Voros can be reached at [email protected].