New regulations require greater fee and expense transparency from employer-sponsored retirement plans such as 401(k)s. As a result, we may see more plans experiment with lower-expense investments such as ETFs (exchange-traded funds). Though they’re already featured in some plans, ETFs could increasingly become part of the retirement plan conversation.
What is an ETF?
Much like a mutual fund, an ETF owns a particular type of investment, such as stocks, bonds, or commodities (or a mix of various asset classes). For instance, you can buy an ETF that attempts to mimic the performance of an index such as the S&P 500 or Russell 1000.
There are two main differences between mutual funds and ETFs:
Taxes. If you own mutual funds in a taxable account, you pay taxes on the earnings/losses based on when the fund manager buys and sells the investments held by the fund. In other words, you can’t control when a taxable event occurs. Conversely, with an ETF you pay taxes (excluding any dividends that the ETF may issue) only when you sell the ETF.
Trading. Whereas mutual funds trade and set their price once daily (at the end of the day), ETFs trade and update their price continually throughout the trading day and are traded on an exchange.
As part of a wealth management portfolio, ETFs have noteworthy strengths. Among them:
Taxes. ETFs give investors more control over their taxes. Since you only pay taxes (excluding taxes related to dividend payments) when you sell the ETF, you are able to avoid paying short-term capital gains that you will likely encounter with a traditional mutual fund.
Cost. As mentioned above, ETFs often tend to follow a specific index and as a result tend to have lower management expenses than actively managed mutual funds.
Specialization. Though both mutual funds and ETFs are capable of extreme specialization, the functionality and structure of ETFs lend themselves to some narrow investing specialties. For example, it’s more common to see an ETF:
- invest in a single commodity
- follow a very specific index
- have a design that aims to move in the opposite direction of a specific index (i.e. increase when an index decreases, or vice versa)
ETFs and employer-sponsored plans
Most employer-sponsored plans don’t currently feature ETFs among the primary investing options. Though ETFs are often cheaper than mutual funds, there are several reasons why they haven’t been widely used in 401(k)s and other employer-sponsored plans:
- The tax advantages of an ETF in a taxable account are nullified by the fact that most work-based retirement plans already offer tax advantages that are similar to those found in ETFs.
- ETFs may have cheaper management fees, but there are trading costs which increase the overall cost of holding the investment.
- Employer-sponsored plan recordkeeping is structured to price daily. Coping with multiple daily pricings would involve significant changes for many in the industry.
ETFs continue to receive a tremendous amount of interest from many investors. Currently, much of the interest is from investors who want to receive the tax advantages or specialization of ETFs. Increasingly, however, many investors are starting to consider using ETFs in their retirement accounts. Time will tell if they are able to grab significant market share away from index-based mutual fund competitors in employer-sponsored plans.
Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal. Keep tabs on Scott on Twitter and Facebook.