Exchange-traded funds are starting to make inroads into 401(k) plans, creating the potential for explosive growth in these baskets of securities that trade throughout the day like stocks. But some people are skeptical that ETFs will -- or should -- ever play as big a role as mutual funds in helping Americans plan for retirement. The market for ETFs rose to $432 billion at the end of 2006 from $464 million in 1993, the year they were launched, according to fund tracker Morningstar. But the industry is still tiny compared with the $10 trillion in mutual funds. That could change over the coming years as more defined contribution plans offer ETFs as investment options alongside mutual funds and individual stocks. "The ETF market would explode," says Darwin Abrahamson, chief executive of Invest n Retire, a Portland, Ore., company that has designed and runs retirement plans capable of trading ETFs. As a result, he says, "there would be a negative outflow of open-ended mutual funds" as investors switch the assets in their 401(k) plans into ETFs. "It will be very damaging to mutual funds." The mutual fund industry is certainly benefiting as corporate America forces more of its employees to save for their own retirement. At the end of 2005, 23% of individual fund owners held the investment products in an employer-sponsored retirement account of some kind, according to the Investment Company Institute, a mutual fund industry trade group. Half of the assets in 401(k) plans alone, or $1.2 trillion, were in mutual funds.
Although 401(k) plans can't take all the credit for the popularity of mutual funds, there's no doubt the industry wouldn't be the behemoth it is without them. When 401(k) plans were introduced in 1981, the mutual fund industry had been around for almost 60 years but had just $135 billion under management. Over the next 25 years or so, the industry's assets increased more than 74-fold. Small wonder ETF providers are looking for a piece of the action. David Wray, president of the Profit Sharing/401(k) Council of America, says these plans are becoming more open to the idea of offering ETFs as investment options, although relatively few actually do so. "People are looking at different approaches than what was traditional," he says. "At the moment, most companies are in the talking stage, but a lot are certainly thinking about it." Not everyone believes ETFs will -- or should -- become as prevalent in retirement plans as mutual funds, however. "When you think about it -- and I don't think most people do -- ETFs are index funds with one difference: They can be traded all day long," says John Bogle, founder and former chief executive of the index fund giant Vanguard. "Why would anyone want to do that in their 401(k)?" Bogle, who now heads the Bogle Financial Markets Research Center, says the experience of 401(k) plans that let participants actively trade stocks isn't encouraging. "It gives people more choice than they can handle," he says. "And the evidence is overwhelming that people are performance-following."
Bogle acknowledges that, as a long-time proponent of the buy-and-hold strategy, he may be perceived as having a bias against ETFs. But he says it's not ETFs that are the problem. "An investor is their own worst enemy," he says. "There are some very good ETFs out there, and they are inexpensive to operate. But you have to pay a commission every time you trade them." He points out that "what we all earn is our return minus the cost of playing the game." And the more frequently investors trade, the less likely they will be able to cover those costs. "It's exactly like gambling." ETF providers don't believe the investment vehicle should be excluded from 401(k)s just because it permits investors to meddle too much with their retirement savings. "We're not encouraging active trading within a 401(k) account," says Lance Berg, a spokesman for Barclay's Global Investors, the largest ETF provider in the U.S. "The advantages of ETFs are their low fees and transparency, and we think there can be strong demand in non-taxable areas." One of the biggest obstacles to making ETFs available through 401(k)s isn't philosophical but technical. That's because many employer-sponsored retirement plans were designed to accommodate open-end mutual funds and other pooled investment vehicles that can only be bought or sold once a day and can be traded in fractional shares. They don't have the infrastructure to track and keep records of more frequent trading. Moreover, ETFs can only be traded in whole shares, a complication for investors who contribute a fixed dollar amount from each paycheck. Abrahamson, the Invest n Retire executive, says his company has found a way around the technical difficulties. While most 401(k) providers use third-party software for record keeping, Invest n Retire handles it in-house. "Our answer is that we can record keep the ETFs," he says. "All this software out there for 401(k)s is old and has been repatched. But we built our own software that is capable of keeping track of mutual funds, ETFs and stocks."