ETFs as Investment Options in 401(k) Plans

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1 T. ROWE PRICE ETFs as Investment Options in 401(k) Plans Considerations for Plan Sponsors By Toby Thompson, CFA, CAIA, T. Rowe Price Defined Contribution Investment Specialist Retirement Insights EXECUTIVE SUMMARY While the exchange-traded funds (ETFs) market has experienced increased demand and heavy new issuance over the past two decades, these investment vehicles have had limited success in penetrating the nearly $3.1 trillion 401(k) market. 1 They offer proven benefits outside the 401(k) market, but many of these benefits are not realized in the context of retirement plans. Plan sponsors must weigh the benefits and risks of introducing ETFs in terms of how it may or may not help participants save and invest for retirement. Additionally, sponsors must consider the practical issues of offering ETFs and how the use of ETFs may impact their fiduciary responsibilities and plan costs. The ETF market has made significant progress in many ways and can be expected to evolve further. However, certain shortcomings suggest that ETFs will not replace mutual funds dominance within the 401(k) market any time soon. TWO DECADES OF GROWTH AND STILL EVOLVING It s hard to believe that the ETF industry has been around for nearly two decades. First launched in 1993 in the U.S., the ETF market has experienced explosive growth. The Investment Company Institute (ICI) estimates that ETF assets reached $1.05 trillion at the end of 2011 with the number of individual ETFs totaling 1, Although assets gathered by the ETF market are not even close to the estimated $11.6 trillion in U.S. mutual fund assets, the growth rate has been amazing. Just over the last 1 Investment Company Institute, 2012 Investment Company Fact Book. decade, ETF assets have grown by nearly 29% per year. This is over a time period while the U.S. equity market, as measured by the S&P 500 Index, posted an annualized increase of just 2.9% per year. Today, ETFs are offered in a variety of asset classes, across nearly every equity market capitalization, sector, and industry. Recent trends in the industry have seen the addition of currency- and commodity-focused ETFs that are engineered to provide exposure to the commodity spot and futures markets. Leveraged ETFs are available to provide directional exposure (long or short the market) and some even offer multiples of exposure (two or three times the market). 3 2 ibid. 3 In the context of investments, leverage is the use of borrowed money (margin) or derivative instruments (options, futures, and forward contracts) to multiply exposure to investment assets.

2 A more interesting trend has been the introduction of actively managed ETFs. Although their popularity has been slow to take off since their introduction in 2008, many notable asset management firms are anticipated to be entering this market. The attributes driving the growth of the ETF market are prompting plan sponsors to take a look at how these investment vehicles might fit into their retirement plans. This paper examines each of the key attributes in the context of qualified plans. 4 Morningstar, as of 8/2010. PRIMARY ETF BENEFITS AND THEIR VALUE IN 401(K) PLANS LOWER EXPENSE RATIOS A key advantage that ETFs have over mutual funds is lower expense ratios. The average active equity mutual fund s expense ratio is 1.51%, passive mutual funds average 0.64%, while the universe of active and passive equity ETFs average just 0.80% and 0.51%, respectively. 4 ETFs benefit the most from their lower underlying operating costs. Unlike mutual funds that process shareholder transactions and bear the costs of recordkeeping shareholder information, ETFs can avoid these costs. WHAT ARE ETFs? Exchange-traded funds (ETFs) are typically registered investment companies whose shares are publicly traded on stock exchanges and are priced by the market. Today ETFs hold stocks, bonds, commodities, currencies, derivatives, and even other ETFs. Although the market continues to be dominated by index-based ETFs that are designed to passively track a specific index or commodity, the SEC has granted exemptions for the creation of actively managed ETFs. An ETF is designed by a sponsor who develops the investment objective of the ETF. This entails choosing passive (index-based) or active management and selecting the representative benchmark index. The sponsor publishes a creation basket each day, which is a list of securities and weights that seek to replicate the underlying target portfolio. The ETF is created when an authorized participant, typically a large broker-dealer, deposits the securities composing the creation basket with the ETF. In turn, the authorized participant receives a creation unit, consisting of a specified amount of shares of the ETF. The authorized participant can then hold the ETF shares or sell them into the secondary market. It is in the secondary market (stock exchanges) where retail investors can buy and sell ETF shares. This structure plays an important role in assuring that the market price of the ETF shares does not trend too far from its published net asset value (NAV). Broker-dealers and other arbitrageurs play an active role by trading in ETF shares and creating baskets, which have the effect of narrowing any pricing differences between the ETF and the basket of the underlying securities. Leveraged and Inverse ETFs Unlike traditional ETFs, leveraged and inverse ETFs are not designed for buy-and-hold investors who seek to track an index over a long period of time. Rather, they are intended for more aggressive, sophisticated investors who actively manage their investments on a daily basis. Due to the effect of compounding, the returns of leveraged and inverse ETFs can differ significantly, both positively and 2 T. ROWE PRICE RETIREMENT INSIGHTS

3 While ETFs for the most part are lower cost in terms of expense ratios, they potentially become less attractive when one considers the additional commissions that are paid to buy and sell the ETF shares. Further, some lowvolume ETFs trade at wide bid/ask spreads that negatively impact returns. Two additional issues related to the costs and practicality of using ETFs within a 401(k) plan relate to dollar cost averaging of contributions and reinvestment of dividends. Dollar cost averaging. Typically, participants contribute to their plans each pay period over the life of their employment. This discipline has proven to be beneficial by spreading the cost basis over market cycles and by promoting consistent investing habits. Using ETFs to implement a dollar cost averaging strategy is less practical, given the transaction fees charged, especially for smaller dollar amounts. Although recordkeepers may be able to partially offset these costs by pooling assets and trading ETFs in larger blocks, these costs will remain a disadvantage versus mutual funds. Dividend reinvestment. Most 401(k) plans offer mutual funds that allow for automatic dividend (and capital gains) reinvestment that occurs at the NAV price, with no added transaction cost or expenses. ETFs, however, would require negatively, from that of their benchmark index, especially over longer investment periods. Although potential returns are increased by leveraging, so are the potential losses, so these securities carry significant risk. As a result, leveraged and inverse ETFs are intended only for sophisticated investors with an aggressive tolerance for risk. Risks of leveraged and inverse ETFs include: Most leveraged or inverse ETFs utilize swaps as an underlying investment. Swaps are a form of derivative instrument in which two counterparties agree to exchange one stream of cash flows for another stream. The use of swaps may not always be successful. Using them could lower fund total return, their prices can be highly volatile, and the potential loss from the use of swaps can exceed a fund s initial investment in such instruments. Also, the other party to a swap agreement could default on its obligations or refuse to cash out a fund s investment at a reasonable price, which could turn an expected gain into a loss. Leveraged or inverse ETFs are not intended to be used by, and are not appropriate for, investors who intend to hold positions for any period longer than the rebalance cycle of the ETF, which is typically one day (or as much as a month, depending on the particular ETF). If you decide to hold these positions longer than the rebalancing period, you should understand that their returns can significantly deviate from the index. You should only purchase an inverse ETF if you understand the risks associated with shorting and the strategy of inverse performance, where the investment goals of the ETF are inverse to the performance of its benchmark, a result opposite of most ETFs. Index volatility can have a major effect on a leveraged or inverse ETF s performance due to the daily or monthly rebalancing of the ETF. In a volatile market, where there is little consistent movement in one direction or the other, compounding can be a significant drag on the return of these types of ETFs. In markets in which there are no clear trends, the impact of daily rebalancing can be harmful to performance over time. 3

4 recordkeepers to execute market orders, which would incur commission costs. To combat these added costs, many brokerage firms offer discounted or commission-free reinvestment programs for common stocks and ETFs. INTRADAY LIQUIDITY ETFs trade intraday in the secondary markets, on centralized stock exchanges (NYSE and AMEX), and on the Nasdaq market. They can be traded at current market prices, and limit and stop-loss orders can be used. While the intraday trading flexibility is attractive for shortterm investors, 401(k) plans are long-term investments. Intraday trading is not necessary and may even be counter to a plan sponsor s intentions to discourage participants from engaging in short-term speculation and markettiming activities. Further, while ETFs have been touted for their liquidity, volume is primarily concentrated in a few of the largest ETFs. Many new ETFs have very low volume, resulting in wide bid/ ask spreads, which negatively impacts performance. TAX EFFICIENCY ETFs tend to have lower capital gain distributions due to their low portfolio turnover and the benefit of not having to raise cash to meet redemptions like open-end mutual funds. ETFs, like passively managed index mutual funds, tend to have lower capital gain distributions than actively managed funds. But 401(k) plans are tax-deferred investment accounts. There is no added benefit from reducing capital gain distributions. HEDGING POTENTIAL ETFs can be sold short and purchased on margin, and many have options available on them. Being able to buy ETFs on margin, sell them short, and buy or sell options on them is a clear benefit for investors. However, the IRS prohibits the use of leverage within a 401(k) plan. Buying on margin, selling short, and trading options are all forms of leverage. Several ETFs have degrees of leverage within their underlying strategies (e.g., short strategies, two and three times the market exposure) that could provide investors access to hedging vehicles that could bypass the IRS rules. Even so, these tactics are not normally available to qualified plans, and it does not seem practical from a fiduciary standpoint to offer them within a 401(k) plan. TRANSPARENCY The SEC requires ETF sponsors (those who create and administer them) to publish both index and actively managed ETF holdings on a daily basis, unlike mutual funds that report their holdings quarterly. While added transparency is generally perceived as a positive for investors, there are practical reasons why investors should not want their actively managed mutual funds or ETFs to provide daily holdings to the public. Revealing holdings on a daily basis would provide open access to the active manager s portfolio decisions and may lead others to attempt to capitalize on the positioning, thus potentially harming the existing shareholders. The point is moot for passive (index) strategies as they replicate indices that publish their holdings on a real-time basis. 4 T. ROWE PRICE RETIREMENT INSIGHTS

5 VARIETY While ETFs originally focused on passive replication of the U.S. large-cap equity markets, ETFs that track nearly every sector of the global equity, bond, currency, and commodity markets are now available. Leveraged ETFs are also available that track the markets inversely, and some strategies offer multiples of market exposure (two or three times), referred to as bull and bear funds. Many of the newer ETFs have proven attractive by providing the ability to gain targeted market exposures through vehicles that can be traded intraday. While these attributes are appealing, there are other issues that investors need to consider, particularly diversification and costs. Diversification. Sector- and region-specific ETFs often have outsized country and individual stock exposures. Take, for example, the popular ishares MSCI Mexico Investable Markets Index Fund with $1.55 billion in assets. 5 Like most other ETFs, it tracks a market capitalization-weighted benchmark; and, as a result, one very large telecommunications stock, America Movil, represents nearly 27% of the ETF s total assets. This is a very large single-company exposure within an ETF that on the surface many investors would think was a diversified exposure to the Mexican equity market. Investors would be hard-pressed to find a professional money manager that would consider it prudent to invest 27% in any single company stock. Costs. This concern relates to the illiquidity and the resulting wider bid/ask spreads where many of these more narrowly focused ETFs trade. Investors should focus on net returns, which include expense ratios, commissions, and most importantly, the size of the bid/ask spread. Thinly traded ETFs can be very costly for investors to trade in and out of. While providing more choices may be appealing in many respects, much of the variety offered by the ETF markets more narrowly focused strategies do not fit well in the context of a 401(k) plan that seeks to provide welldiversified, low-cost investment options. KEY PLAN SPONSOR CONCERNS An important consideration for plan fiduciaries in deciding to offer ETFs through their retirement plans is whether the potential advantages of such products compensate for some of the risks, all-in costs, and technology hurdles. ETFs have struggled in the 401(k) market because the features of retirement plans neutralize some of their key advantages (e.g., tax efficiency and liquidity). Fiduciary risks. Sponsors considering the addition of ETFs to their 401(k) lineups need to be aware of potential underlying portfolio risks and relative diversification. Further, many of the newer ETFs are still relatively untested in the marketplace, and plan fiduciaries should use caution in making wholesale shifts from established mutual funds to a full lineup of ETFs. This is especially important in light of the recent flash crash experienced on May 6, 2010, when several ETFs share prices plummeted far below their NAVs. Many unfortunate investors who had stop-loss orders in place saw their shares sold at prices far below the stop price. Similarly, plan sponsors need to understand the implications of participants making panic sales from such products only to see the markets rebound as they did on May 6. This concern is heightened for ETF products that trade intraday. All-in costs. For ETFs to gain traction in 401(k) plans, they will need to prove that all the associated costs, including commissions and administrative expenses, truly make them the economical choice. Plans have traditionally held mutual funds that charge an expense ratio that covers both management and other fees for such items as recordkeeping, legal, and accounting expenses. ETF expense ratios currently do not cover recordkeeping and administrative fees. This means plans will need to explore additional ways to cover these expenses if they are to include ETFs. Technological issues. Most current recordkeeping systems are built specifically for mutual funds that are priced daily; therefore, significant investment may be needed to build or update current systems to handle the intraday trading of ETFs. These added costs are yet another hurdle before ETFs gain a larger foothold. 5 ishares MSCI Mexico Investable Markets Index Fund 6/30/10 Fact Sheet. 5

6 CONCLUSION While ETFs have proven to be a viable investment option, they have yet to provide enough benefits to displace mutual funds as the predominant investment vehicle for 401(k) plans. Despite the explosive growth that the ETF market has seen thus far, there is recent evidence that the market is rationalizing. Several ETF developers have had to shutter recent offerings due to lack of participation. That being said, there is no doubt that ETF developers and marketers will continue to push for asset growth at the expense of mutual funds. But for now, given their current structure, ETFs do not appear likely to replace no-load mutual funds as a more economical and proven choice for 401(k) plan fiduciaries. 6 T. ROWE PRICE RETIREMENT INSIGHTS

7 Call to request a prospectus, which includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. This material has been prepared by T. Rowe Price Retirement Plan Services, Inc., for informational purposes only. T. Rowe Price Retirement Plan Services, Inc., its affiliates, and its associates do not provide legal or tax advice. Any tax-related discussion contained in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this communication. 7

8 T. Rowe Price Investment Services, Inc., distributor, T. Rowe Price mutual funds /