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ETFs' Low Cost Attracts Attention of 401(k)s

Exchange-traded funds, which have grown by leaps and bounds since their introduction in 1993, are now attracting attention from what is seemingly the unlikeliest of corners: 401(k) plans. While mutual funds have been the cornerstone of 401(k)s, it's ETFs' ultra-low cost and avoidance of internal capital gains that is providing them this new lure. Any slight boost to performance in an age of single-digit returns, financial planners say, is worth a close look.

Last year, ETF assets swelled to $222 billion, an increase of 47%, according to Morningstar of Chicago. In fact, ETFs took in $54.4 billion in net flows in 2004, accounting for a whopping 30% of the $180.3 billion in net flows to all types of equity funds, according to TrimTabs Investment Research of Santa Clara, Calif.

The space also added gold and China offerings, as a total of 35 new funds were launched, the largest number of ETF launches in five years and the second-busiest year for ETF funds in their history, bringing their total universe to 149 funds. Now, socially responsible and commodity-based ETFs appear to be on the horizon.

"[ETFs] are definitely taking market share away from the more traditional mutual funds," said Charles Biderman, TrimTabs president. "Pension and 401(k) plans are increasingly using ETFs, as well."

In line with this new trend, Banneker Capital Management has just launched one of the very first actively managed, ETF-exclusive 401(k) platforms. A minority-owned investment advisory firm specializing in small-cap growth, Owings Mills, Md.-based Banneker has joined with 401(k) service provider BenefitStreet of San Ramon, Calif., to launch the product. Banneker, a two-year-old firm with $10 million in assets, hopes to raise $20 million for the platform in its first year.

Banneker Co-President Kellie Thomas said the platform isn't wed to any particular name, like a Vanguard Viper or Barclay iShare. Instead, it will leverage a number of market indices, industry sectors, asset classes and fixed-income options. Plan sponsors can select from lifecycle and lifestyle options. In the former, Banneker will assemble an ETF array for investors geared toward a particular retirement date. In the lifestyle option, Banneker will create an ETF portfolio based on an investor's risk tolerance, which it will help them determine through a survey.

As to whether an all-ETF 401(k) platform can offer investors enough diversification and low enough risk, Deborah Fuhr an ETF strategist with Morgan Stanley's London office, recently said there's a wider variety of ETFs than index funds. Further, she believes ETFs and index funds based on large- and mid-cap indices do a better job of managing risk than actively managed funds.

Like other 401(k) plans comprised of ETFs, fees will be low. Banneker has said it will charge less than 1%, much like Invest n Retire of Portland, Ore., which also offers an ETF 401(k) platform costing between 80 basis points (BPS) and 1%, half the expense of some funds. Ameritrade of Omaha, Neb., which is planning to launch an ETF 401(k) platform this year, says the average ETF expense is 32 BPS, versus 75 BPS for an index fund, 152 BPS for a domestic equity fund and 189 BPS for an international equity fund.

While Thomas admits that high trading fees have long been perceived as a dilemma for ETFs in 401(k)s, Banneker solves that by using discount brokers and collecting trades through an omnibus account.

While it's a bit early to gauge investor response, Thomas said momentum is building as more and more people learn more about ETFs. "The first thing you have to do is go through an education process, but thanks to the folks at Barclays and State Street [who are] doing a wonderful marketing job, we're piggybacking on that," she said.

Gary Gastineau, managing director of ETF Consultants of Summit, N.J., and developer of the first ETFs to be traded on the American Stock Exchange, is curious why it has taken 401(k) and pension fund sponsors so long to embrace ETFs.

"Can it be done?" he asked, "Yes. Is it simple? Not really. It will cause some changes in fund administration. One way to do it is to use a large number of third-party administrators and the second way is to pool orders."

But Gastineau said education, not brokerage fees, is still the No. 1 stumbling block for offering ETFs in 401(k)s. "It's a lack of education that goes all the way up the line. Administrators just don't work ETFs correctly," he said.

And with the pending 4 p.m. hard close, Gastineau anticipates even greater interest in ETFs among 401(k) sponsors. It's expected that the new regulation will take hours out of the trading day for mutual funds. Some insiders think mutual fund orders will probably have to be placed by 1:30 p.m. to get that day's price. But since ETFs are currently priced, they can be traded right up to the 4 p.m. close.

"I've frankly been a little disappointed that [401(k)] investors haven't been angry at what has occurred to them in traditional funds. Now ETFs solve that problem. In the final analysis, the 401(k) investor should be protected, and [with the 4 p.m. close] that investor is being disadvantaged," Gastineau said.

But not everyone is convinced that ETFs are a logical choice for 401(k)s. Dave Haywood, director of alternative investment research at Financial Research Corp. of Boston is puzzled why a tax-sheltered plan with an eye toward the long-term would choose a tax-efficient fund with a "high-octane" reputation. In fact, ETF returns can be very volatile, especially those linked to foreign indexes.

"I don't understand what the benefit would be, [but] going forward, there are a lot of tools out there and managers are going to pick the best tool available," he said.

But in the end, Banneker believes it's ETFs' low cost that will win investors over. "They're undoubtedly the lowest-cost product out there that can contribute to a diversified portfolio," Thomas said.