Recent trends have confirmed that scores of investors are ditching actively managed mutual funds in favor of cheaper passive investment vehicles like exchange-traded funds. While this move isn't completely surprising given active funds' generally disappointing performance in the wake of the financial crisis, it nonetheless marks an important change in investor preferences -- at least for now. But while ETFs are certainly gaining popularity and assets, there's one place you may not find them readily available: within your 401(k).
Limited access ahead
A recent Wall Street Journal article highlighted the fact that while some employer-sponsored retirement plans are making moves to include ETFs, many more are holding off. There are several reasons for employers' reluctance to embrace ETFs within their 401(k) plans, including the fact that ETFs trade throughout the day, unlike mutual funds, which only trade at the end of the day. This could lead to higher incurred commissions that would be passed on to plan participants. In addition, the institutional share classes of some actively managed funds used in 401(k) plans are actually cheaper than in a similar ETF, so there wouldn't be any cost savings for investors.
So while a small number of investors can expect to see exchange-traded funds sitting alongside actively managed funds as investment options in their retirement plan in the near future, most folks won't have that option. That means you've got to do some extra planning if you want ETFs to be a part of your portfolio.
First of all, even if you can't count on exchange-traded funds being available in your 401(k), you should still make the most of the funds that you do have access to. You may have a wide selection of excellent actively managed funds, or you may have a few merely tolerable ones that you probably wouldn't choose if you had more options.
Either way, make sure you're contributing at least enough to your plan to take advantage of any employer matching -- if you don't, you're leaving free money on the table. And if you do have a wide selection of funds, stick to those that have long-tenured managers or management teams, low expenses, a consistent history of using the same investment process over time, and solid performance in both and good and bad market environments. Many investors will end up relying on the money they have saved in their 401(k) as their primary source of funding in retirement, so it's important to make sure you've got your bases covered here.
And if you're one of the lucky ones who does have ETFs in your 401(k), there are a few things to keep in mind. Most important, don't be lured by these funds' trading flexibility. If you do have the option of intraday trading in your retirement plan, don't use that as an excuse to engage in frequent buying and selling. You will incur commissions with each transaction, and attempting to time the market will likely backfire on you over time. ETFs should be used as long-term investment vehicles, no differently than actively managed funds.
Care and handling of ETFs
If you've really got the ETF itch and don't have access to these funds within your employer-sponsored retirement plan, you may need to look at opening a separate brokerage account to get the job done. Just remember that if you open a non-tax-favored account, you'll be responsible for paying taxes on any fund distributions and capital gains (in tax-deferred accounts like 401(k)s, you don't pay taxes until you withdraw your money).
Once you are able to have your pick of exchange-traded funds, don't be dazzled by the sheer number of these investments, which are now available in hundreds of variations and permutations. Stick to the tried and true, and avoid trendy new leveraged or inverse leveraged products. For broad stock market coverage, consider SPDR S&P 500 ETF (NYSE: SPY ) or Schwab U.S. Broad Market ETF (NYSE: SCHB ) , which offer cheap exposure to U.S. stocks. Foreign investors might want to look at iShares MSCI EAFE Index (NYSE: EFA ) for developed markets coverage or Vanguard MSCI Emerging Markets ETF (NYSE: VWO ) for riskier and potentially more rewarding emerging markets exposure. Bond investors would do well to invest in a wide-ranging bond fund such as Vanguard Total Bond Market ETF (NYSE: BND ) , which offers access to multiple bond sectors at a low 0.11% price of admission.
While exchange-traded funds are likely to remain a favorite for some time to come, investors may have to do some wrangling to get these investments into their retirement portfolio. As long as ETFs are used cautiously -- by focusing on well-diversified, inexpensive funds that are held for the long run -- these funds can play an important part in creating a well-funded retirement.
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