What’s Holding ETFs Back From The 401(k) Market?

Eager to snatch a greater piece of the investment world’s market share, exchange traded fund (ETF) providers are turning to the trillions held in 401(k) retirement accounts as the next frontier.

More than $3.6 trillion is held in 401(k) retirement accounts, but total ETF assets in 401(k)s account for only $4 billion industrywide, writes Vaughan Scully for Investment Advisor. Only a few 401(k) plan providers currently offer ETFs as an option, and most just target small to medium-sized businesses.

Target-date ETFs - funds that anticipate contributions will stop and withdrawals begin at a specified date - are now available. Target-date mutual funds are make up a significant portion of many 401(k) plans, but target-date ETFs have only gathered around $180 million in assets.

ETFs attract investors in taxable accounts, tax efficiency and intraday pricing. So, it is no surprise that ETF providers couldn’t manage to get a foothold in the 401(k) market. 401(k) accounts aren’t subject to capital gains tax and they do not allow participants to engage in intraday trades. Additionally, the Internal Revenue Service doesn’t allow 401(k)s to be used as collateral loans, basically prohibiting short selling and margin buying, and the Supreme Court has ruled that employers are responsible for losses caused by mismanagement, which dissuades employers from using the more exotic ETFs.

Cost would also become an issue since investors need to pay a brokerage commission to buy ETF shares and 401(k) accounts usually involve frequent purchases of a small number of shares. Furthermore, some ETFs subsidize management fees by including 12(b)-1 “marketing” fees so as to maintain a perceived ultra-low annual expense.

Individual investors have not been well-served by the 401(k) market as it stands today. Millions of investors were badly burned in the financial crisis and saw major losses in their portfolios. Until ETFs become a standard option in such plans, investors will need to be on their guard and be their own advocates for change. Ask your employer to push for ETFs to be incorporated into your company’s plan.