Mutual Funds vs. ETFs: The 401(k) Format War

With elections just around the corner, I could just see this negative ad.

“There are two ERISA attorneys named Ary Rosenbaum. One invests in exchange traded funds (ETFs) for his personal investing. The other one claims that ETFs will only be a niche player in the 401(k) plan business. Ary Rosenbaum, he thinks ETFs are good for him and not for your 401(k).”

ETFs are slowly getting more traction in the 401(k) business and I don’t think it’s a bad thing. I just don’t think that with the way the 401(k) industry is run that ETFs will ever get major play as a suitable 401(k) plan investment.

I liken the whole ETF vs. mutual fund debate in 401(k) plans as a format war. As you know, a format war is when there is a competition between mutually incompatible proprietary formats that compete for the same market. We saw a format war between Blu-ray and HD DVD for high definition DVD technology, but the most remembered format war is VHS vs. Betamax for video tape dominance.

As most people don’t remember, Betamax was actually the better technology. VHS won the format war because its originator, JVC licensed its technology to competitors which lowered the price for VHS video recorders (VCR) while Sony was the only purveyor of Betamax VCRs. The other major difference was that VHS offered two hour recordings on its tape while Betamax only offered one hour. The lesson of this format war is that many times, the inferior product will win.

The reasons that I believe that ETFs will only be a niche player because the 401(k) plan business is dominated by the mutual fund industry. The 401(k) daily trading platforms in the way it operates, strip many of the benefits of ETFs namely because it won’t let participants buy ETFs throughout the day (unless they have a self directed brokerage account) and since participants pay the bulk of 401(k) fees, it will add substantial fees to what is a financially transparent product. ETFs’ main strength is its low fees and fee transparency, these are drawbacks in an industry where fees are still hidden and mutual fund companies pay revenue sharing fees to third party administration firms that remind me of payola and kickbacks. Let us also not forget that many of the daily 401(k) trading platforms are dominated by mutual fund companies like Fidelity, Schwab, Nationwide, John Hancock, American Funds, and ING, companies who would lose out if ETFs became a more dominant form of 401(k) investment. Do you think these companies have any interest in lowering the fees for ETFs when they allow the trading of their mutual funds for free? I highly doubt it.

Do I think ETFs are a proper form of 401(k) investment? Absolutely. While I think more choice in 401(k) investments is better, the pessimist in me thinks that ETFs will still remain a niche player. Perhaps IShares will start its own daily trading platform for 401(k) plans which might be a game changer. Unless something as seismic as that takes place, I think mutual funds will still dominate this format war. Just remember, the best product doesn’t always win.

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11 Responses to Mutual Funds vs. ETFs: The 401(k) Format War

  1. Pingback: Tweets that mention Mutual Funds vs. ETFs: The 401(k) Format War | The Rosenbaum Law Firm P.C. Blog -- Topsy.com

  2. Michael says:

    Ary –

    I like most of what you’ve written over time but this post inspires me to comment on two areas that I think bear clarification.

    1. 408(b)(2) – the regulations driving fee transparency are effective in 2011 – so your concern about hidden fees in mutual funds and perhaps insurance vehicles is short-lived.

    2. Intraday Trading – is not particularly valuable in a long term retirement capital accumulation environment. Not enough of the population has the skills or time to make intraday trading work out well for their retirement.

    The clarity of the fund charter (no style drift) plus the upcoming fee disclosure regulations will make the ETF a viable contributor to the evolution of retirement savings – I think on greater than a niche basis.

    Keep in mind that the K service was once dominated by group annuity contracts from insurance companies – the mutual fund companies displaced them and evolution may bring a new leader along the way.

    Thanks for all you’re doing with your posts. It’s a very good thing.

    Michael

    • admin says:

      Michael:

      Thanks for the comments.

      While we know that the regs are effective in 2011, we shall see its effect and whether plan sponsors realize the real difference between a transparent product like ETFs and the hidden fees of mutual funds. I am an optimist in life and a pessimist in the 401(k) business, too much time working for the wrong TPA.

      I mention the intraday part of it, because without it, what is the difference between ETFs and index mutual funds? I know fees, but assume you are getting index funds from Vanguard and not some expensive fund family.

      I really hope ETFs can catch on and your analogy to the old annuity laden products will repeat itself.

  3. Rich H says:

    Well thought out and accurate discussion

  4. Mike Alfred says:

    I’ll take ETFs in this argument. Just had some more high level discussions this week with some of the largest recordkeepers, providers, and fund families that just reinforce my view that ETFs will continue to explode in to this market.

  5. Paul Carmichael says:

    Thanks Ary, very interesting points. The main drawback I see for ETF’s is that the low-cost benefit is lost in a 401(k) Plan due to the record-keeping expenses involved (I mostly deal with the small-micro market). Most products I see with ETF’s have heavy wrap fees or added fees making them almost as expensive as managed mutual funds, based on that point, I prefer the active mutual funds.
    If the ETF’s were NAV with no extra expenses (like I would do with my personal investments), then I think they would have more of a stake in the 401(k) market.
    Thanks,
    Paul

    • Craig Hawkins says:

      Small plans actually benefit more than larger plans, which have access to institutional shares. With regard to NAV, you are better off trading the ETF intra-day and getting best execution, than waiting till end of day. Remember, when allocating the cost of trading the ETF’s to the individual participants, it’s actually cheaper. Also, you have to take into consideration, that trades are places institutionally, vs retail (i.e. – Self-Directed Brokerage Accounts).

      1 cent/shr. vs. $6.99 per trade.

  6. Craig Hawkins says:

    I’ll take ETF’s as well.

    When you take a look at the true cost of trading ETF’s, it actually cheaper and provides far more transparency that that of the mutual fund world. There is no simple way of reverse engineering, the trading cost in the SAI. Give me ETF’s any day.

  7. Craig Hawkins says:

    I’ll take ETF’s as well.

    When you take a look at the true cost of trading ETF’s, it actually cheaper and provides far more transparency that that of the mutual fund world. There is no simple way of reverse engineering, the trading cost in the SAI. Give me ETF’s any day.

  8. Jane Dempsey says:

    This person is claiming to make TEN K a week with his plan. Thoughts? Is this for real, or improbable? See here

    What type of approach would you advise to get this outcome, say starting with $20K?

    Thanks! -Jane

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