Coming Soon to Your 401(k): ETFs

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Exchange-traded funds are one of the fastest growing segments in the investment world today. With so many actively-managed funds falling down on the job during the last downturn, it's not surprising that so many investors are turning to lower-cost alternatives. Unfortunately, ETFs have been largely shut out of traditional 401(k) platforms, limiting access for millions of investors. Now, however, one major player is looking to change that.

The next frontier
Investment service provider Charles Schwab (NYSE: SCHW  ) recently announced that it plans to develop 401(k) platforms that focus exclusively on exchange-traded funds. Not only would Schwab offer these plans, but it would also let plan participants trade their ETFs free of charge. Clearly, Schwab is hoping that this move will allow it to steal market share from some of its larger rivals in the 401(k) space, such as Fidelity and Vanguard.

But whatever the business consequences for Schwab, making ETFs more available within employer-sponsored retirement plans could have a meaningful impact on how people invest for retirement. And while there are many benefits for investors, there are also some potential pitfalls.

Falling prices
First and foremost, making exchange-traded funds available to 401(k) investors should lower costs for a good number of individuals. Unfortunately, far too many 401(k) plans are riddled with poorly performing funds that charge excessive fees. Making ETFs available would free many investors from investing in high-cost, underperforming fund options. In addition, ETFs' lower price points might put further price pressure on actively-managed funds which would be competing for business in the retirement market.

As an example, look at how some ETFs stack up against similarly-managed index funds and popular actively-managed funds:

Fund Type


Annual Expenses

Actively-Managed American Funds Fundamental Investors (ANCFX)


Index Fund Vanguard 500 Index Inv (VFINX)


Exchange-Traded Fund Schwab Large-Cap ETF (NYSE: SCHX  )


  SPDR S&P 500 ETF (NYSE: SPY  )


Fund Type


Annual Expenses

Actively-Managed American Funds Europacific Growth (AEPGX)


Index Fund Vanguard Developed Markets Index (VDMIX)


Exchange-Traded Fund Schwab International Equity ETF (NYSE: SCHF  )


  Vanguard MSCI EAFE ETF (NYSE: VEA  )


Source: Morningstar.

Even with two very reasonably-priced active funds -- such as the two American Funds listed above -- ETFs can offer significant price savings. And considering that the average actively-managed large-cap blend domestic stock mutual fund charges 1.35%, investors stuck with pricier funds have a lot to gain if ETFs become available to them in their 401(k) plan.

Trading early and often
But I do see some potential problems with offering commission-free ETFs to 401(k) investors. The biggest stumbling block here would be that free trades would encourage a lot of folks to crank up the frequency of trading in their retirement accounts. Right now, mutual funds have at least a few points in their favor for discouraging frequent trades, including no intraday trading and short-term redemption fees, in many cases. There would be no such inducements not to trade with ETFs, and given the average investor's propensity to move into and out of the market at exactly the wrong times, some investors could end up hurting themselves more with such a strategy than if they had just stuck with slightly more expensive active funds for the long-run.

And many exchange-traded funds are not without risks themselves. If Schwab sticks to broad-based, well-diversified ETFs, investors should have a better chance of picking appropriate investments. However, if more narrow, sector-focused funds and leveraged or inverse funds are introduced, the opportunity for investors to make ill-advised investment selections increases dramatically. These funds are typically more expensive than their more diversified peers, more likely to veer from their stated benchmarks, and more prone to volatility. Time will tell whether or not ETFs will gain traction within retirement plans, but if they do, odds are other providers will jump into the game, offering higher-cost funds that investors probably don't need.

Ultimately, I think there's a decent chance the industry will see more platform providers make the move to include exchange-traded funds in 401(k) plans. So expect to see these options popping up in employer-sponsored retirement plans before long. However, the rules of ETF investing within your employer's retirement plan are the same as the rules for ETF investing anywhere else -- buy cheap, broad-market funds and invest for the long-run.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Motley Fool newsletter services have recommended buying shares of Charles Schwab. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. 

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