| Differences Between ETFs and Mutual Funds | ||
|---|---|---|
| ETFs | Mutual Funds | |
| Investment Style | Mostly passive | Actively and passively managed |
| Cost | Low cost | Higher fees and costs |
| Trading Activity | Intraday | Only once per day |
| In 401(k)s | Newer and may have limited options | Dominant investment |
There are different types of ETFs from which investors can choose. These include:
- Bond ETFs: Track government (federal, municipal, local) and corporate bonds
- Commodity ETFs: Track various commodities like oil, grains, and precious metals, which are sold through futures contracts
- Currency ETFs: Track one or a basket of currencies
- Cryptocurrency ETFs: Newer ETF class that track the performance of virtual or digital currencies like Bitcoin and Ethereum
- Equity ETFs: Track different types of equity classes, such as large caps and blue chips
- Fixed Income ETFs: Track different types of fixed-income products, including bonds, T-bills, and securities
- Index ETFs: Track market indexes, such as the S&P 500 and Dow Jones Industrial Average (DJIA)
Cryptocurrency ETFs are fairly new to the market. The Securities and Exchange Commission (SEC) approved Bitcoin futures ETFs in 2021 and spot Bitcoin ETFs in January 2024. In May 2024, the commission approved the listing of eight spot Ether ETFs on the NYSE, Nasdaq, and CBOE BZX. Live trading will begin once the SEC announces final approval for these ETFs.
ETFs in 401(k)s
There are generally two types of ETFs: passively managed and actively managed funds. Many ETFs are passively managed because they track an index or benchmark, which keeps activity—and thus costs—from the fund managers to a minimum.
For example, the actively managed Vanguard U.S. Minimum Volatility ETF (VFMV) has a low expense ratio of 0.13%. VFMV doesn't track an index but is benchmarked against the Russell 3000 Index. The Vanguard Russell 3000 ETF (VTHR) is passively managed and has an expense ratio of 0.10%.
These low fees make a difference in the overall returns of the ETF to investors and are one of the primary reasons ETFs became available in 401(k)s. Another reason for their availability is that they have been gaining in popularity since they were first introduced, so there is a demand for them. Plan sponsors, therefore, designed plans with ETFs to give participants more choices in their retirement planning.
As many as 70 million people participated in 401(k) plans as of Dec. 31, 2023. There were about 710,000plans managed across the country with more than $7.4 trillion in assets.
Advantages and Disadvantages of ETFs in 401(k)s
Advantages
Among the popular arguments favoring ETF plans is that index ETFs are less expensive than actively managed mutual funds. This may be true, but many excellent low-cost 401(k) plans offer a mix of index funds and actively managed funds.
Passively managed exchange-traded funds offer tax advantages because there is less trading activity within the fund. Minimal activity means there are fewer capital gains events triggered, which directly affect the fund's profitability. The fewer taxable events there are in a fund, the lower the overall cost is to the investor.
The place where ETFs might work in a 401(k) plan is under their managed accounts. These might be offered instead of the target date funds that are the staple managed account offering. However, it would still be up to the plan sponsor to vet these accounts and ensure they are appropriate for their participants. They would also want to ensure they can be used as qualified default investment alternatives.
For retirement planners who prefer to have nothing but ETFs in their plans, some sponsors developed plans that accomplish this. For example, robo-advisor Betterment launched a 401(k) product using all the ETF portfolios offered in its core service as managed accounts for 401(k) participants. The company offers a variety of portfolio plans ranging in offerings (e.g., the Essential, the Pro, and the Flagship plan), and each plan has a monthly base fee along with a per-participant assessment charge.
Disadvantages
The use of ETFs makes the issue of cost disclosure that much tougher for plan sponsors due to the structure of many ETFs. One issue is the bid-ask spreads that can vary during the trading day. While not part of the ETF’s expense structure, this does represent a cost to the participants.
The issue of intraday trading could also be problematic. This could result in different end-of-day values for the same holding among participants. The reality is that participants do talk to each other, and any situation like this is bound to surface, as participants could view it as unfair.
Pros
Cheaper than actively managed mutual funds
Tax advantages
May work under managed account offerings
Cons
Cost disclosure is tougher for plan sponsors
Intraday trading could lead to different end-of-day values
Concerns about ETFs in 401(k)s
Some ETF advantages are irrelevant in a 401(k) setting. For example, the ability to trade ETFs during the day is unlikely to appeal to employers who don't want employees sitting at their computers watching or trading their holdings during work hours.
Additionally, the option to trade in real time may or may not be available to plan participants, as 401(k) providers are likely to aggregate trades at the end of the business day to alleviate intraday trading expenses and employer concerns. In any case, retirement plans are not designed for intraday trading. They are supposed to be long-term investments.
Many ETFs offer tax efficiency due to their structure, but this becomes irrelevant in a tax-deferred retirement plan such as a 401(k). It might be more tax-efficient to choose non-tax-deferrable investments to use in a 401(k) and keep ETFs in the investing portion of your portfolio.
How Do ETFs Differ From Mutual Funds in a 401(k) Context?
ETFs differ from mutual funds in several ways. ETFs trade on stock exchanges, which means you can buy and sell them throughout the trading day at market prices. Mutual funds are typically priced once a day after the market closes. ETFs also often have lower expense ratios than mutual funds and, in most cases, can provide more transparency into their holdings.
How Liquid Are ETFs, and Can I Trade Them Intraday?
ETFs are generally highly liquid because they are traded on stock exchanges. You can buy and sell ETFs throughout the trading day at market prices. Unfortunately, this benefit is usually lost among 401(k) investors, who are likelier not to want to trade securities often and throughout the day.
Are There Any Tax Considerations When Using ETFs in a 401(k)?
Tax considerations are generally less relevant in a 401(k) because contributions and earnings can grow tax-deferred if contributions are made pre-tax. For after-tax contributions, taxes are deferred until you withdraw funds from the account (i.e. when you retire).
What Asset Classes Can I Access Using ETFs in My 401(k?
You can access various asset classes through ETFs in your 401(k), including domestic and international stocks, bonds, real estate investment trusts (REITs), commodities, and more. There are thousands of ETFs, but what is available to you depends on your plan's offerings.
The Bottom Line
ETFs are investment vehicles that allow 401(k) participants to invest in a diversified portfolio of assets. However, ETFs lag behind mutual funds in 401(k) plans because their intraday trading features and tax benefits, while appealing to some investors, seem to appear less attractive to others.
