With Low Fees, ETFs Rival Mutual Funds

401(k) Providers Could Add Option

NEW YORK -- While mutual funds are a staple of many 401(k) and other retirement plans, exchange-traded funds are likely to become serious competitors in the coming years.

An ETF is a security that tracks an underlying benchmark much as an index mutual fund does, but that trades like a stock on an exchange. Because ETFs are linked to indexes, they are known for low costs -- something that can benefit investors with 401(k) plans, in which assets accumulate over a long time and low fees can help boost returns.

That advantage is expected to help ETFs become part of more 401(k) accounts.

"Over the next 24 months, the growth is going to be huge," said Darwin Abrahamson, chief executive of Invest n Retire, which has designed a system that allows funds like 401(k) plans to offer ETFs.

He said ETFs' low expenses have attracted interest from boards overseeing retirement plans.

"They're really creating a huge, huge awareness with fiduciaries and plan sponsors that they had better be aware of what the fees are in their investment options," Abrahamson said of grumbling by some investors who say fees for their retirement plans take an unreasonable bite out of returns. In addition, litigation and legislation are making available more information about fund expenses, he said.

But there may be some resistance to ETFs from companies that operate mutual funds. The more traditional funds can bring in more money for fund companies because many have managers who try to outrun a simple index; investors often have to pay for that kind of stewardship through higher fees.

"A lot of providers do not want ETFs in 401(k) plans because they're trying to gather their own assets under management in their own funds," Abrahamson said.

Beyond the motivations of mutual fund companies, many of which also offer ETFs, there are logistical hurdles.

ETFs can be bought and sold throughout the trading day, rather than once a day as with mutual funds. While that could appeal to some investors, it makes it harder for 401(k) overseers. Imagine the difficulty faced by a company with thousands of employees who might want to place trades at various times during the day.

"The problem with the 401(k) providers out there is that they don't have the software where they can offer ETFs. All of the record-keeping systems out there were built to trade mutual funds," Abrahamson said.

But the potential benefits of having an ETF as an option in a 401(k) plan mean it is likely that the funds will become available for retirement accounts, observers said.

"I think ETFs can be a benefit in the 401(k) space like index funds have been beneficial. It's a good, inexpensive way to get exposure to different markets at very low cost," said John Thompson, portfolio manager at Ibbotson Associates.

Thompson said investors could move into more unusual parts of the market, such as Eastern European stocks, without the extra fees that usually come with active management.

There can be tax advantages with ETFs, which generally don't make big capital gains distributions the way some mutual funds often have to.

But Thompson said that because ETFs are less familiar to many investors than mutual funds, there may be questions about how to best employ them. Employers with workers who are savvy investors could be among the first to adopt ETFs.

Thompson said the thinks that interest in ETFs will spread.

"I think the investment ideas are pretty simple behind the ETF and people will embrace that. It may be the mechanics that take a little work at first," he said. "I see ETFs still growing and becoming more and more popular with investors, and they may start demanding them for their 401(k) plans."