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ETFs: Not Just a 401(k) Option, a Duty: Industry Insiders Tout Transparency, Cost

NEW YORK-Including exchange-traded funds in defined contribution platforms isn't just a good idea for plan sponsors, it's darn close to a fiduciary duty, said panelists at a recent ETF summit held here.

Citing low fees, an array of market exposures and passive structure, ETF enthusiasts discussed the challenges of getting into the 401(k) space, despite the vested interest of mutual fund companies to keep them off retirement platforms, during Financial Research Associates' "Exchange-Traded Products Summit" held here.

State Street Global Advisors Vice President Jill Iacono called on regulators to push for change, because mutual fund-linked plan providers, are unlikely to.

"Sixty-one million Americans have a 401(k), and it's really up to the Securities and Exchange Commission to see that [ETFs] work their way in [to plans]," she said. State Street was among the earliest to enter the ETF market, with the SPDRs line of ETFs that have managed to catch and keep a healthy share of the industry's $500 billion in assets.

Panelists offered many reasons for why ETFs might be attractive, ranging from their low cost to the value of tax efficiency, even in qualified tax-deferred plans. But chief among Iacono's arguments was the passive nature of these index-tracking products in a market where investors tend to favor actively managed funds, sometimes without realizing the costs involved.

"In the past 15 years, what percentage of truly active management beat the benchmark?" she posited. When it comes to core investments, the figure is a dismal 21%, she said.

"From a fiduciary standpoint, are the fees really commensurate with the alpha generated?" Iacono asked.

Getting onto retirement platforms is critical to ETFs' continued growth, speakers said. "The 401(k) is the golden goose of asset managers," said Michael Woods, chief executive of XTF, a New York-based company that designs all-ETF funds-of-funds and offers ETF performance and rating data.

But getting into the market has not been easy. Of the upwards of 500 ETFs, nearly a quarter are less than a year old, according to data from Lipper of New York. Plan sponsors generally seek longer performance records.

Another challenge is that in some ways, ETFs may be victims of their own success.

ETFs have earned a reputation for being tactical tools that splice broad indexes into very specific slices. Moreover, ETFs allow low-cost access to commodities that mutual finds simply cannot replicate. For example, the gold ETFs offered by State Street and Barclays have expenses around 40 basis points, compared to commodities mutual funds, where expenses hover around 160 basis points, Iacono said.

At the same time, some of the more recent, more esoteric ETF offerings, such as the ProShares QQQ Ultra-Short Bond Fund, can overwhelm investors. And then there is the danger of today's hot-sector fund burning retail investors later, warned Rick Genoni, product manager for ETFs at Malvern, Pa.-based Vanguard.

Such prospects make plan sponsors leery. The answer lies in striking a balance in what plan sponsors seek, said Richard Wolfe, a managing director at Saddle River Capital Management, an advisory firm in Saddle River, N.J., that helps sponsors develop plans.

His advice? "Broad ETFs only."

Sector-specific ETFs belong in SMAs and other tailored products, he said.

Like investors, it's important that sponsors understand plans. Saddle River, in partnership with Invest n' Retire of Portland, Ore., makes it simple by providing risk-adjusted funds-of-ETFs that essentially mimic the target-risk mutual funds that have gained popularity with investors, and seem to be gaining support from regulators as acceptable default options under the August 2006 Pension Protection Act.

BenefitsStreet, a company based in San Ramon, Calif., jumped on the bandwagon in May, announcing a partnership with Barclays to include its iShares in ETFs.

401(k) Retirement Solutions of New York also offers iShares, which the company describes as a suite of low-cost index funds, rather than explicitly using the term ETF.

"At the end of the day, the platform gives plans a smart and more effective product that is easy to understand," said Alvin Rapp, chief operating officer at 401(k) Retirement Solutions. His company charges a bundled fee that includes the costs of custody, trading and investment management.

For investors, such programs offer flexibility. For example, since ETFs trade like stocks, investors can purchase only whole shares. If an employee's $100 paycheck contribution can be applied toward only one $98 share, the platform allows a cash balance, which accumulates.

For plan sponsors, the option offers greater transparency, which means more comfort for compliance-conscious fiduciaries, Rapp said.

ETFs' tax efficiency makes them attractive even in tax-deferred retirement plans because, unlike mutual funds that may keep cash on hand for rebalancing purposes, the ability of ETFs to tax harvest means they stay more fully vested, said A. Seddick Meziani, a professor of finance at Montclair State University, in New Jersey.

Wider adoption of ETFs in retirement plans will mean education not only for individual investors, but of sponsors and regulators, Rapp said.

"The ETF industry should be working closely with the Department of Labor and Securities and Exchange Commission," he said. Between portfolio transparency and fee disclosure, ETFs become a logical choice for fiduciaries, he said. "Employers will feel the power of being put on the end of the shareholder," Rapp said.

The recordkeeping and technology challenges of getting ETFs onto retirement platforms can be overcome with time, panelists said.

"There is a place for a mutual fund, and a place for an ETF," Iacono said. Plan providers who introduce ETFs will have a competitive advantage, she said. "If one has access [to ETFs] and the competition does not, the one that is going to win is the one with the access," she said.

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