Exchange-traded funds, or ETFs, are smart investment picks for many reasons, including portfolio diversification, their lower risk and transparency. And, ETFs often have lower fees vs. mutual funds and can trade on exchanges like stocks.
Although there are significant benefits of ETFs, there are also technological barriers for companies that manage the plans, which can prevent ETFs from being intertwined in 401(k)s.
Why mutual funds fare better for 401(k)s
“For plan sponsors, mutual funds have a couple advantages over ETFs. Mutual funds allow for fractional share ownership, such that allotting 401(k) contributions is easier,” Bryan Armour, Morningstar’s director of passive strategies research for North America, tells FOX Business.
Armour also says mutual funds also include 12b-1 fees, which can fund things like recordkeeping, while ETFs do not.
“And there are significant technology and operational challenges for plan sponsors to switch from single-point NAV trading for mutual funds to intraday trading for ETFs,” Armour notes. “Handling trading, clearing, and fractional shares is a tough challenge for traditional recordkeeping platforms.”
ETFs are regulated differently
ETFs tend to come with lower costs than mutual funds, although many index funds on 401(k) menus are just as cheap, says Armour.
Instead of ETFs, he says, high-cost mutual funds have been increasingly swapped out for collective investment trusts (CITs).
“CITs tend to be managed the same way as mutual funds, and they’re offered by many of the same household names as the mutual fund strategies they’re replacing,” says Armour. “The key is that they’re regulated differently than mutual funds.”
Armour says that mutual funds fall under the Investment Company Act of 1940, while CITs are regulated under the Employee Retirement Income Security Act of 1974.
“This matters because, unlike mutual funds, CITs can negotiate fees on a plan-by-plan basis. By contrast, the ’40 Act requires all holders of a share class to pay the same fee. As a result, CITs are becoming the dominant fund wrapper in the biggest 401(k) plans – a win for investors who pay less 80-90% of the time for CITs than mutual fund share classes of the same strategy,” he explains.
The dynamics of 401 (k)s can be a barrier
Jim Colavita, managing director at wealth management firm GenTrust, says many of the advantages of ETFs vs. mutual funds are somewhat lost inside a typical 401(k) plan.
“For example, the tax advantage that ETFs provide over mutual funds is unnecessary inside of a 401(k) plan, since the 401(k) itself is tax-deferred. Also, says Colavita, since many 401(k) plans now offer index/low-cost funds as an option, the fee advantage normally associated with ETFs isn’t as pronounced when compared to index funds in a 401K.
Furthermore, Colavita says that the intraday trading flexibility of ETFs is another popular feature over mutual funds, however, since 401(k)s are more so viewed as long-term wealth-building accounts, and not trading accounts, plan providers likely don’t see value in that trade flexibility feature.