Like getting eight hours of sleep a night and donating blood, contributing to your 401(k) is both sensible and virtuous. It's hard to argue against ensuring your financial security in your golden years, but the retirement vehicle gets a bad rap because of expensive mutual fund fees.
So is adding exchange-traded funds (ETFs) to your retirement portfolio instead an intelligent move? There are plenty of advantages but still some draw-backs to consider.
ETFs, as a whole, are lower cost investments, a fact that allows you to keep more money in your pocket over the long-term. Expensive mutual fund fees can snowball and take away 10% or 20% of the potential portfolio you'll tap into roughly 45 years after you start your 401(k). In fact, the average American household will pay $155,000 in 401(k)s over the course of a career, according to think tank Demos.
"It's still a fundamental fact that no one wants to trade their retirement funding for the bottom line of a mutual fund company," said Charles A. Ragauss, director of product management at ACSI Funds in Ann Arbor, Mich.
Compared to mutual funds, ETFs have lower fund expenses, because they tend to be passively managed funds that track a particular index, said Stephen Rischall, a 401(k) expert and founding partner at 1080 Financial Group in Sherman Oaks, Calif.
"Furthermore, fund expenses from ETF's do not include 12b-1 fees like mutual funds," he added. "These 12b-1 fees are used to pay for things like marketing materials, commissions to brokers and other tertiary costs -- it is also the source of revenue sharing from investments inside a 401(k) plan." In other words, your 401(k) provider is taking a cut of the money you put into the mutual funds it recommends. That takes cash out of your retirement fund and costs you upside potential overtime that the power of compound growth can provide.
Even though we're increasingly seeing lower-cost, passively managed index-based mutual funds, they're still typically a few basis points more expensive than the equivalent ETF that tracks the same index. As a comparison, Rischall pointed to an ETF vs. mutual fund match-up from Vanguard.
The mutual fund here is 0.10% more expensive than the equivalent ETF, but with other providers, the difference can go much higher.
"All other things being equal, almost any ETF has an opportunity to outperform a comparable mutual fund of similar style, simply due to a lower expense ratio," said Kip Meadows, CEO and founder at Nottingham in Rocky Mount, North Carolina.
But gravitating toward ETFs is not just about cost.
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Tactical Brilliance And Clarity
ETFs offer particular advantages when it comes to strategic planning and flexibility.
For starters, ETFs can trade intra-day, whereas mutual funds are transacted only at the end of the day.
"Intraday trading may not seem important to the average 401(k) participant who is typically buy-and-hold; however, it is senseless to prohibit investors from re-balancing and/or allocating their investments during market hours," said Eric Ervin, CEO of Reality Shares in San Diego.
Some ETFs are designed for ultra short-term holding periods - looking at you, levered or inverse ETFs - and don't make sense for your 401(k) given their tactical short-term trading nature and high fees, but most other ETFs make sense.
"ETFs are simply a more modern form of mutual funds which offer investors additional choices - they can hold forever, or sell whenever they want," Ervin said. "There will come a day in the future where traditional mutual funds will be a thing of the past."
Many consider mutual funds as somewhat anachronistic.
"Those seeking innovative investment strategies will not find them in the mutual fund space," said Ragauss, whose company's flagship product is an ETF. "Investment thought leaders have long since forgotten mutual funds when it comes to delivering new and relevant investment strategies."
Of course, the different types of ETFs, or mutual funds for that matter, are determined by your employer, the plan sponsor. So it's not as if the individual employee has a pick of the litter when it comes to ETF options. But think of ETFs as a way to gain exposure to various areas in a diverse portfolio that may include emerging markets or high yield-bonds -- adhering, of course, to a person's risk tolerance.
ETFs also simply offer a higher level of transparency than mutual funds.
"Given that many investors view their 401(k) as a 'set it and forget it' portfolio, it's important to have investment options that are easy to understand and cover broad exposure from an asset allocation perspective," Ragauss said.
Of course, not everyone thinks ETFs belong in your 401(k).
Drawbacks of ETFs in Your 401(k)
"I'm not of the opinion that ETFs in 401(k) plans is a net positive," said Greg McBride, chief financial analyst for Bankrate.com. "The ETF advantage of lower costs versus mutual funds would more than likely be offset by a tendency for increased trading among participants that can watch the fluctuating intraday value of their 401(k) investments."
That active, often emotional trading can be dangerous, especially for long-term investors.
"Individual investors do themselves a disservice the more they trade," he added. "ETFs in 401(k) plans would only exacerbate the underperformance of retirement savers versus the broad market."
Of course, those who include ETFs in their retirement portfolio need to be wary of other mechanisms that suck blood from their savings. For example, assuming both mutual funds and ETFs are passive index or asset class funds, one disadvantage of the ETFs is that they trade through the day and trade close, but not at Net Asset Value (NAV), says Scott Salaske, CEO of Firstmetric, LLC in Detroit. That means each time a trade is placed, the plan participant is either purchasing a particular ETF a little above or below NAV, and since plan participants are typically investing in a 401(k) each time they're paid (26 or 52 times a year), those spreads can add up.
What's more, actively managed strategies are not abundant in the ETF space. If you're an investor who likes your portfolio managed by stock pickers and the like, you'll find your options more limited.
"Many mutual funds are actively managed so their managers may be able to offer some downside protection as opposed to directly following the index," said Michael Cirelli, a financial planner at SAI Financial in Warrenville, Ill.
Perhaps more damning, 401(k) are not really structured to have the versatility to holds ETFs and mutual funds like a traditional brokerage account is.
"Many 401(k) offerings are built on archaic investment infrastructure and would not harness the power of ETFs," Ervin said.
Many 401(k) providers that offer ETFs simply bundle all orders, regardless of the time they're entered intraday, and hold them until the end of the day. That way all mutual funds and ETFs are grouped together, a disadvantage for ETFs.
Then there can be limited options. Because fees are low on most ETFs, many 401(k) providers are less incentivized to include them in their plans and thus may have a lack of high-quality offerings. To boot, many 401(k) custodians charge a commission to purchase or sell ETFs, said Salaske, and that hits plan participants in the pocket book at each paycheck.
Though ETFs offer plenty of advantages as low-cost, versatile funds to help grow your retirement savings, the architecture of the current 401(k) plan and the in cahoots relationship between 401(k) providers and mutual funds have prevented ETFs from reaching their potential for investors.