Are ETFs a Good Fit for 401(k) Plans?

Exchange-traded funds are a popular investment choice for many investors because of their benefits and low costs. For this reason, they have also been added to some retirement plans so that retirement planners have more to choose from.

There are advantages and disadvantages to using ETFs in a 401(k), so they might be a good fit for your retirement planning; however, they may not, depending on your goals, strategies, and financial circumstances. Here are some finer points to help you decide whether ETFs fit your 401(k).

Understanding ETFs in 401(k)s

There are generally two types of ETFs: passively managed and actively managed. Many ETFs are passively managed because they track an index or benchmark, which keeps activity—and thus costs—from the fund managers to a minimum.

For example, the actively managed Vanguard U.S. Minimum Volatility ETF (VFMV) has a low expense ratio of 0.13%. VFMV doesn’t track an index but is benchmarked against the Russell 3000 Index. The Vanguard Russell 3000 ETF (VTHR) is passively managed and has an expense ratio of 0.10%.

These low fees make a difference in the overall returns of the ETF to investors and are one of the primary reasons ETFs became available in 401(k)s. Another reason for their availability is that they have been gaining in popularity since they were first introduced, so there is a demand for them. Plan sponsors, therefore, designed plans with ETFs to give participants more choices in their retirement planning.

Advantages of ETFs in 401(k)s

Among the popular arguments favoring ETF plans is that index ETFs are less expensive than actively managed mutual funds. This may be true, but many excellent low-cost 401(k) plans offer a mix of index funds and actively managed funds.

Passively managed exchange-traded funds offer tax advantages because there is less trading activity within the fund. Minimal activity means there are fewer capital gains events triggered, which directly affect the fund’s profitability. The fewer taxable events there are in a fund, the lower the overall cost is to the investor.

The place where ETFs might work the best in a 401(k) plan is in the area of managed accounts. These might be offered instead of the target date funds customarily the staple managed account offering. However, it would still be up to the plan sponsor to vet these accounts and ensure they are appropriate for their participants. They would also want to ensure they can be used as qualified default investment alternatives.

For retirement planners who would prefer to have the choice to include nothing but ETFs in their plans, some sponsors have created plans that accomplish this. For example, robo-advisor Betterment launched a 401(k) product using all the ETF portfolios offered in its core service as managed accounts for 401(k) participants. The company offers a variety of portfolio plans ranging in offerings (e.g., the Essential, the Pro, and the Flagship plan), and each plan has a monthly base fee along with a “per participant” assessment charge.

Disadvantages of ETFs in 401(k)s

The use of ETFs makes the issue of cost disclosure that much tougher for plan sponsors due to the structure of many ETFs. One issue is the bid-ask spreads that can vary during the trading day. While not part of the ETF’s expense structure, this does represent a cost to the participants.

The issue of intra-day trading could also be problematic. This could result in different end-of-day values for the same holding among participants. The reality is that participants do talk to each other, and any situation like this is bound to surface, as participants could view it as unfair.

Concerns about ETFs in 401(k)s

Some ETF advantages are irrelevant in a 401(k) setting. For example, the ability to trade ETFs during the day is unlikely to appeal to employers who don’t want employees sitting at their computers watching or trading their holdings during work hours.

Additionally, the option to trade in real time may or may not be available to plan participants, as 401(k) providers are likely to aggregate trades at the end of the business day to alleviate intraday trading expenses and employer concerns. In any case, retirement plans are not really designed for intraday trading. They are supposed to be long-term investments.

Many ETFs offer tax efficiency due to their structure, but this becomes irrelevant in a tax-deferred retirement plan such as a 401(k). It might be more tax-efficient to choose non-tax-deferrable investments to use in a 401(k) and keep ETFs in the investing portion of your portfolio.

The Bottom Line

ETFs are investment vehicles that allow 401(k) participants to invest in a diversified portfolio of assets. However, ETFs lag behind mutual funds in 401(k) plans because their intraday trading features and tax benefits, while appealing to some investors, seem to appear less attractive to others.