ETFs have been gaining popularity in the investment world, capturing around $10 trillion in assets since their debut in the early 1990s. While mutual funds still hold about $20 trillion, ETFs have gained significant market share, accounting for 32% of total assets compared to 14% a decade ago. This shift towards ETFs is primarily driven by their novel structure and benefits, such as tax advantages and intraday trading capabilities, making them attractive to wealth-management-type accounts. However, despite their success in the broader investment landscape, ETFs have yet to make a significant impact on 401(k) plans, which hold a massive $7.4 trillion in assets and have over 70 million participants.
Philip Chao, a certified financial planner, believes that workplace retirement plans represent the final frontier for ETFs, as they offer access to a substantial pool of untapped assets. Currently, the majority of 401(k) assets (~65%) are invested in mutual funds, with a negligible portion allocated to ETFs. The relative unpopularity of ETFs in 401(k) plans can be attributed to various factors, including regulatory constraints, technological challenges, and employer discretion in choosing investment options for participants. Despite the potential benefits of ETFs, such as tax efficiency and intraday trading, these advantages may be perceived as irrelevant in a long-term investment vehicle like a 401(k) plan.
According to a report from the Plan Sponsor Council of America, ETFs are primarily used in 401(k) plans for sector and commodity funds, accounting for just 3% of the total share of investment structures. The widespread adoption of mutual funds, collective investment trusts, and separately managed accounts in workplace retirement plans reflects the traditional preference for these conventional investment vehicles. ETFs face hurdles in penetrating the 401(k) market due to entrenched practices, including payment and distribution arrangements, that are not conducive to incorporating ETFs into existing retirement plan structures.
While ETFs offer a streamlined and transparent fee structure compared to mutual funds, they may struggle to compete in the 401(k) space where complex fee arrangements are common. Mutual funds typically have multiple share classes, each with different fees that are distributed among various parties involved in managing the fund. In contrast, ETFs have a single share class that does not allow for the bundling of distribution fees, leading to more transparent fee disclosures for investors. However, this transparency may result in investors perceiving ETFs as costlier due to the more explicit breakdown of fees, as opposed to the bundled fees of mutual funds.
Despite the regulatory and structural challenges facing ETFs in the 401(k) market, the potential for expansion into workplace retirement plans remains significant. As investors become more educated about the benefits of ETFs, including lower costs and greater transparency, there may be a shift towards incorporating these innovative investment vehicles into 401(k) offerings. With the continued growth of 401(k) assets and the desire for more investment options among plan participants, ETFs could play a more prominent role in shaping the future of retirement savings and investment strategies.
