By Stan Choe
Be the market. Minimize costs.
It sounds like a Zen saying, but it’s also an investing strategy. Every month, billions of dollars flow into mutual funds and exchange-traded funds that simply track a market index rather than try to beat it. Demand is so strong for the lower costs of index funds that it’s pushing the industry to alter its offerings. The latest shift: 401(k) plans built entirely around ETFs, rather than traditional mutual funds.
Charles Schwab has launched an all-ETF 401(k) offering and says it expects several employers to begin offering the program to their workers later this year.
For those who don’t have any investments outside their 401(k) accounts, it may seem like yet another impenetrable acronym to learn. But unlike CDOs, LBOs or EBITDA, ETFs are similar to something with which most investors are familiar: traditional mutual funds. Like them, an ETF offers an easy way to own a wide basket of stocks, bonds or commodities.
Owning a share of the SPDR S&P 500 ETF (SPY), for example, is like owning the entire Standard & Poor’s 500 index, from Abbott Laboratories to Zoetis. The Vanguard Total Bond Market ETF (BND) tracks an index that covers thousands of bonds from Treasurys to mortgage-backed securities.
Interest in ETFs has boomed in recent years. They had a total of $1.67 trillion in assets at the end of December — up elevenfold from a decade earlier, according to the Investment Company Institute. Just last year, their assets grew 25 percent, with a particularly strong surge for ETFs that hold U.S. stocks.
Traditional mutual funds still hold much more in assets — a total of $15 trillion at the end of 2013 — but ETFs represent a stronger growth opportunity for fund companies.
That meant it was only a matter of time before 401(k) providers began focusing on ETFs, says Steve Anderson, head of Schwab Retirement Plan Services. “Looking at the trends, I don’t know how we could afford to ignore them,” he said.
By offering ETFs, Anderson said some 401(k) plans could lower their expenses by more than 90 percent. They’re the ones that primarily use actively managed mutual funds, ones that try to beat their benchmark index and tend to charge higher expenses as a result.
“Active management has been dominant in the 401(k) space,” Anderson said. “The industry has done well over all, but we’re not as sure the participants have made out as well.”
Consider Schwab’s Multi-Cap Core ETF (SCHB), which tracks the performance of the Dow Jones U.S. Broad Stock Market index. It has an expense ratio of 0.04 percent, which means that $4 of every $10,000 invested in the fund goes to paying manager salaries and other operating costs in a year. Schwab’s ETF for stocks from emerging markets (SCHE) has an expense ratio of 0.15 percent.
Compare those figures with 0.92 percent, which was the average expense ratio for actively managed stock mutual funds in 2012, according to the Investment Company Institute’s most recent fact book.
Schwab is suggesting that 401(k) participants use some of those savings to pay for investing advice. In its new plans, Schwab will enroll participants in a service that suggests how much they should be saving and in what kind of ETFs depending on their age, income, account balance and savings rate. Participants can opt out of the advice service, which comes at a cost.
The drive toward ETFs has also accelerated as more investors get comfortable with merely matching a stock or bond index’s performance, rather than trying to beat it. Some actively managed mutual funds do top their benchmark index, but they’re rare.
Over the five years through June 2013, only 21 percent of large-cap U.S. stock mutual funds beat the S&P 500, according to the most recent data from S&P Dow Jones Indices. For global stock funds, only 37 percent beat the S&P Global 1200 index.
ETFs differ from traditional mutual funds in one key way: Investors can buy and sell ETFs whenever they want during the day. That’s in contrast to traditional mutual funds, whose shares trade only once per day after the market closes.
But experts say just because investors can buy and sell ETFs easily through the day doesn’t mean they should. Investors’ 401(k) accounts are supposed to be long-term investments.