The Case For ETF's in your 401(k)

February 09, 2015

Exchange traded funds (ETF's) offer lower costs, provide unique diversification strategies, and have less restrictions when it comes to investing employee deferrals into company sponsored profit sharing plans, such as the 401(k).  The 401(k) market is ripe for ETF's, yet current technology and old school methods of operation have stood in the way of ETF's for years.  ETF's provide investors with unique investment strategies, often not available within mutual funds.  With transaction costs of buying and selling securities on the decline, new platform provider firms are able to offer employees ETF's more cost efficiently, and ultimately help those plan participants grow their money in  smarter ways.   

Lets first begin by explaining the difference between a mutual fund and an ETF.  Mutual funds are either open-ended or closed-ended.  The distinction between the two types is vast, and for purposes of advocating the use of ETF's within 401(k)'s, this discussion will be limited to open-ended mutual funds.  Mutual funds (open-ended) are actively managed, priced through NAV (net asset value), and offer an unlimited number of shares (open-ended).  Mutual funds  are not traded on organized exchanges (as are ETF's),  and they issue an infinite number of shares (ETF shares are finite).  The term "actively managed" means a portfolio manager relies on both emotion and rules in managing his/her portfolio.  In contrast, an ETF is strictly "rules based," in its management style, with no emotion.   Exchange traded funds are traded on organized exchanges, are typically passively managed, and have a finite number of shares outstanding.  When ETF shares are bought/sold on an  organized exchange, the price an investor pays is based on supply and demand.  When purchasing shares on an organized exchange,  the price a willing buyer pay's per share is based on what a willing seller would sell his or her shares for.   Therefore, an ETF's market value can trade at a premium or discount to its actual NAV (Net Asset Value/true value).  Net Asset Value (NAV) is calculated by taking the current market value of a funds specific holdings, and dividing by the number of shares outstanding.   The ETF effectively has two values, one based upon the forces of supply and demand, called "market value," and the other based on NAV (real value).  When purchasing an ETF, you'll likely either pay a premium or discount to NAV.    

Detractors of including ETF's in 401(k) plans often argue that low cost indexing mutual funds are better suited alternatives.  This argument has merit when an index can be replicated by both an ETF and mutual fund, and its expense ratio can be held below that of the ETF (and its additional trading costs).  At what point does an ETF,  switch from being passively managed to a form of active management?  One might argue, ETF's offer significant diversification through investment strategies that border on a "hybrid" rules based management system.  Note, "rules based" management takes the emotion out of investing, thus lowering the overall cost of management.  In today's world, active management is associated with emotion and due diligence - something the average investor most likely will pay a premium for.     

 Exchange Traded Funds belong in 401(k) line-ups.  Lower fees and additional diversification typically improve one's performance over time.  Distinct "rules based" investment strategies offer employees investment options not available within the mutual fund universe.  Additionally, ETF's provide a lower cost alternative to building diversified portfolios.  My next article will focus on one specific ETF that provides a unique strategy designed to increase your retirement portfolio's return - all while taking less risk in the process.    Should you have any questions concerning this topic, feel free to contact the author via the contact information located on this website.    

By Gregg F. Himfar CFP®