A June survey conducted by State Street Global Advisors and Knowledge@Wharton determined that financial advisors think the biggest potential growth area for the exchange-traded fund industry is in 401(k) plans. Of the survey's 840 respondents, 43% said that 401(k)s would be the biggest area of growth for the ETF industry going forward, compared with 27% for actively managed ETFs and 20% for unified managed accounts.

Ironically, this perspective was soundly rebutted in a July 2008 article in Journal of Indexes. The article, "Why ETFs And 401(k)s Will Never Match" (by David Blanchett and Gregory Kasten), outlined a variety of reasons why ETFs may never gain a large foothold in the 401(k) industry. Among the reasons listed were transaction costs, including the bid/ask spread and the brokerage commission associated with every purchase and sale of ETF shares. Another disadvantage noted was the inability to buy fractional shares of ETFs. The fact that the tax advantage ETFs offer in taxable accounts disappears in a tax-deferred plan such as a 401(k) was another highlighted drawback.

It's been nearly two and a half years since I first reported that the industry is devoting resources to the idea of incorporating ETFs into the 401(k) platform. It seems like a perfect time to evaluate the current state of ETFs in defined contribution plans in general, and in 401(k)s specifically.

Early In The Game 

The big conclusion? Let's just say the game is still in the early innings ... like the bottom of the first.

Last year, I reported that the total number of ETF assets in 401(k) plans was so small that the Investment Company Institute—the mutual fund industry trade group—didn't even keep records. That hasn't changed. However, whether the number is still so small is unknown because there is neither a requirement for plans to disclose what kind of products they use, nor how the plan assets are invested. And people who have those numbers aren't talking. It would be inappropriate to assume that a lack of reporting means there is nothing to report, but let's just say it's hard to have a fire without smoke.

Robert Nestor, head of product management for Barclays Global Investors' iShares, says BGI has anecdotal evidence detailing that more than $2 billion in 401(k) plans is in ETFs. That's miniscule compared with the $4.5 trillion held in employer-sponsored defined contribution plans at the end of 2007, and also represents a tiny fraction of the $600+ billion invested in ETFs overall.

Alvin Rapp, the founding partner of RPG Consultants—a record keeper and consultant for retirement benefits plans—says more than 100 of RPG's clients use ETFs in their 401(k) plans and hold assets in the range of $125 million to $150 million. Over the next 12 months, he expects that figure to double.

Company By Company

Vanguard and WisdomTree Investments are the only two ETF providers selling 401(k) plans. Neither Vanguard, nor mutual fund giant Fidelity Investments-the nation's two largest providers of 401(k) plans-have expressed any interest in offering ETFs in the plans. Even though Vanguard sells ETFs, it doesn't believe ETFs are a good fit for 401(k)s, for reasons similar to those mentioned in Journal of Indexes:

• ETFs tend to appeal to investors who want intra-day trading, which is not important to most investors in 401(k) plans.
• The tax advantages of retirement plans make ETF's tax efficiency moot.
• Small contributions would be eaten up by brokerage commissions.
• Institutional share classes of pooled index funds are likely to be cheaper than most ETFs.

While this may be true, Jill Iacono, director of national accounts at SSgA, says demand for ETFs in 401(k)s is coming from financial advisors who understand that ETFs give access to markets around the world and to alternative assets that haven't been available before.

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