ETFs Cross 401(k) Barrier

Changes are helping ETFs overcome a bias against their use in retirement plans.
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Exchange-traded funds have been a smash hit in every realm but retirement accounts, where the going has been more like a real-world version of

Mission: Impossible

. But a new crop of companies is seeking blockbuster results by bringing ETFs to a 401(k) plan near you.

The ETF success story is fairly well known by now. ETFs are index funds that trade continuously during market hours like stocks. The first ETF, the

Standard & Poor's Depositary Receipts

(SPY) - Get Report

, commonly known as the "Spyder," was introduced in 1993. Since then, nearly 250 ETFs with a total market value of $350 billion have come to the market, including popular commodity ETFs like the

streetTRACKS Gold

(GLD) - Get Report

and the

U.S. Oil Fund

(USO) - Get Report


The low costs and transparency of ETFs have made them popular among individual and institutional investors alike. Nevertheless, because ETFs trade like stocks, excessive trading costs have played a part in keeping ETFs out of the vast 401(k) market. Record keeping issues also have raised problems, since ETFs, like stocks, settle in three days, while traditional mutual funds offer a net asset value at the end of each day.

"As for ETFs being a core 401(k) investment option in all plans, there have been certain platform barriers to overcome," says Lance Berg, spokesman for

Barclays Global Investors

, the ETF industry giant with close to $200 billion in assets spread across more than 100 funds. "However, with investors and advisers embracing the many benefits of ETFs, we feel it is inevitable."

BGI would be a big beneficiary if ETFs take even a minor foothold in the nation's retirement accounts. According to the Investment Company Institute, at the end of 2004, mutual funds accounted for $3.1 trillion, or 24%, of the $12.9 trillion U.S. retirement market. The remaining $9.8 trillion of year-end 2004 retirement-market assets were managed by pension funds, insurance companies, banks and brokerage firms.

Until recently, only a few companies were able to overcome the structural bias against ETFs in 401(k)s. One of them was Portland, Ore.-based Invest n Retire, which was founded in 2000 and now oversees close to $50 million in retirement assets. The firm created proprietary record-keeping software to process the trading and tracking of individual ETFs on a participant level. The company bundles trades together on a daily basis to achieve economies of scale in order to lower costs.

Lately, some companies have attacked the problem via the use of collective funds. These are investment trusts similar to mutual funds, but available exclusively to qualified retirement plans such as 401(k)s. Collective funds can only be issued by banks and are not regulated by the



"The availability of collective funds means that ETFs and ETF-based portfolios are now available on retirement-plan platforms, which may result in lower costs vs. actively and passively managed mutual funds," says Sander Gerber, chairman and CEO of XTF Advisors, a financial services company looking to bring the benefits of ETFs to investors.

XTF was recently chosen by Phoenix-based AST Trust Co. as a subadviser to actively manage ETF portfolios available to retirement-plan participants. Under this arrangement, AST acts as trustee to the funds, while XTF implements the portfolio creation, asset allocation and ETF selection as guided by the risk profile -- conservative, moderate growth or growth -- of its three so-called TACK portfolios.

For example, the TACK 60 conservative-growth portfolio holds nine ETFs covering multiple asset classes, including REITs and fixed income. The fund has a target benchmark of 60% equity exposure, but can range from 48% to 72%, according to XTF's models. Right now, the TACK 60's equity holdings include the State Street SPDR,

Viper Midcap 450 Index

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iShares Russell 2000 Index

(IWM) - Get Report

and the

iShares MSCI EFA Index

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for international exposure.

According to XTF, the cost of the portfolio depends on the size of the plan, but generally ranges between 1% and 1.5% of assets under management. Other industry products, like insurance company and mutual fund offerings, tend to fall between 1.5% and 2.5%.

"In the past, if somebody wanted to buy an ETF for their 401(k) they had to do it in their brokerage account," says Dan Carlson, managing director at Avatar Associates, another company subadvising ETF-based portfolios for AST. "Now, with collective trusts, they can be purchased like mutual funds."

Unlike mutual funds, however, plan participants will not be able to look up the NAV of their collective fund on their computer at day's end. After AST calculates the final NAV for the fund, they send it to a record keeper, who in turn reports it back to fundholders.

"We have not seen ETFs in 401(k)s because the technology has not been there," says Jeremy Kish, vice president at BenefitStreet, which does record keeping for AST. "But we've overcome that obstacle with a scalable model, so the sky is the limit."

The sky may be the limit, but at this point the structural bias still favors traditional mutual fund companies when it comes to retirement plans. And the task of educating plan sponsors about the safety of ETF-based portfolios is a gigantic one.

Nevertheless, the groundswell must be growing, because Avatar's Carlson says he is seeing new firms "start up almost every day because the infrastructure is finally starting to support it."

"The key is distribution," says Carlson. "You need to be able to sell it to plan sponsors."