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Getting ETFs In 401(k)s
Although ETFs have been around for over a decade, only recently have they been considered as potential investments for the mass 401(k) public. While ETFs have long been available through 401(k) self-directed brokerage accounts (along with other investments like individual securities), ETFs have not been available to plan participants as part of the core investment lineup. There are a variety of reasons for this, but transactions costs (the costs incurred buying and selling ETFs on the open market, such as commissions) and fractional share issues (since ETFs can only be purchased in whole share amounts) have been two of the largest obstacles.
There are two primary transaction costs associated with purchasing an ETF, since, unlike mutual funds, ETFs are purchased on the open market. The first cost is the bid/ask spread (or spread) and the second is commissions. The "bid" price is the price at which you can sell an ETF, while the "ask" (or offer) price is the price at which you can purchase an ETF. The bid price is typically lower than the ask price, which creates the spread. For example, if we assume the ask (or purchase) price of ETF ABC was $50.10 and the bid price for ETF ABC was $50.00, if an investor were to instantly purchase and sell ETF ABC, ignoring commissions and any market movement, he or she would lose $0.10, which represents the spread. While the actual bid/ask spread is going to vary by ETF, the average 30-day bid/ask spread for Vanguard’s 33 ETFs (as of 11/02/07, data obtained from Vanguard’s Web site) was .08% (or 8 basis points), or 4 bps for each buy or sell transaction. The spread is an important consideration in ETF investing because it represents a cost that reduces long-term performance.
The second transaction cost associated with purchasing an ETF is the commission. A commission must be paid each time an ETF is bought or sold. Unlike the spread, which is typically a constant percentage of the underlying ETF (e.g., 4 bps each way), commissions typically vary based upon the size of the transaction. Commissions are incurred each time an ETF is bought or sold, so higher levels of trading activity increase the total commissions paid. One method that minimizes the per-participant cost of trading ETFs has been the introduction of pooled accounts, where buy and sell orders are submitted in blocks. By pooling ETFs into single orders, it is possible to trade less frequently and therefore pay less in commissions. While the spread still exists with pooled accounts, pooling also alleviates the issues associated with fractional shares, which will be discussed next.
A key problem with ETFs is that they cannot be purchased in fractional shares. This is especially important for 401(k)s since participants do not typically defer the exact cost of the ETF (which is especially difficult given the fact the price of an ETF is always changing). While mutual funds can be bought and sold in fractional shares (e.g., 5.673 shares), ETFs can only be purchased in whole share amounts. By pooling ETFs into a common fund (or trust), it is possible to overcome this problem by allowing participants to buy units or shares of an overall pool that purchases the underlying ETFs. The two primary methods of pooling ETFs for use in 401(k) plans are at the plan level or in an aggregate account (such as a collective investment fund, or CIF).
If an ETF is pooled at the plan level, the pooled account is not required to have the same type of oversight (i.e., audit requirements) associated with mutual funds or CIFs (which will be discussed next). Pooling at the plan level is less costly than a CIF and allows a plan sponsor to introduce ETFs in a relatively cost-effective manner. CIFs are currently the most popular method of using ETFs in 401(k)s because they allow for greater economies of scale than pooling at the plan level. A CIF is a bank-administered trust that holds commingled assets that meet specific criteria established by 12 CFR 9.18. Unlike a mutual fund, a CIF can only be used in retirement plans (i.e., not taxable accounts or IRAs). CIFs are created by banks that act as a fiduciary for the CIF and hold the legal title to the fund’s assets. Participants in a CIF are the beneficial owners of the fund’s assets. While each participant owns an undivided interest in the aggregate assets of a CIF, a participant does not directly own any specific asset held by a CIF [Collective Investment Funds: Comptroller’s Handbook].
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