Morningstar: ETFs Should Be In Your 401(k)

If the rap on actively managed mutual funds is that they are expensive, inefficient and fail to keep up (mostly) with their benchmarks, what’s the natural solution?

For years, it has been index funds, but the industry is slowly coming around to the idea that exchange-traded funds (ETFs) can do the same job and, often, do it better. Morningstar, for instance, recently made the case that 401(k) savers should have more access to them.

In an Op-Ed, the mutual fund rating firm’s head of retirement research went so far as to say ETFs have three clear advantages: Price, freedom and investor engagement.

“We’ve reached a point where it’s possible to buy ETFs that track the same indexes as comparable mutual funds, but at a lower cost,” writes David Blanchett of Morningstar. “In other words, ETFs cost less to purchase, hold and sell than comparable ‘best-of-breed’ low-cost mutual funds that track the same portfolio.”

Cost is a huge factor. ETFs that track the broad market indexes now cost as low as a bottom-scraping 0.04%, with many in the area of between 0.05% and 0.07%. (One floating-rate bond ETF costs zero.) As Blanchett notes, this push downward has been the result of a price war between the major retirement brokerages.

Why so cheap? Because the big brokerages recognize that a huge number of people will exit 401(k) plans over the next few decades and that many of them will attempt to self-direct their investments. Low-cost ETFs are the ultimate loss-leader that creates new customers for them.

Blanchett goes on to expound on the positives of ETFs, such as the number of similar competing funds. He also brings up some caveats, the most important of which is that ETFs alone are no silver bullet. You still have to manage risk and invest prudently. You still have to be sure to own a reliable portfolio that will achieve your goals on your timetable.

Using ETFs in a portfolio

While many retirement investors are perfectly capable of doing so, many more will need help developing a reasonable portfolio of ETFs and help with rebalancing it in a timely, effective fashion. While the big brokerages are moving slowly toward providing that kind of support, they also are trying to find ways to make that help into a business model for themselves.

Somewhere in the middle is the self-directed investor who wants the power to make his or her own portfolio choices while not making the kinds of return-chasing mistakes that can seriously mar long-term performance. For those folks, the discipline to rebalance on time is an important piece of the retirement portfolio puzzle.

Will 401(k) plans eventually cede to the tremendous cost savings available through ETFs? Certainly the industry seems to think it’s the best choice for retiree investors, so it follows that working savers would benefit as well, assuming they bring enough pressure on employers to catch up on this important trend.