One of the most common ways people save for retirement is by using their 401(k) plans at work. For decades, most employers have gravitated toward providing mutual fund investment options to their workers, but with the advent of exchange-traded funds, some of the financial providers that help employers set up their 401(k) plans have allowed ETFs to enter into the mix.
That still leaves a key question for participants: Should you prefer ETFs to their mutual fund counterparts in your 401(k)? Let's take a look at the some of the reasons ETFs got into 401(k)s in the first place and then turn to the pros and cons of ETFs in your retirement plan.
Exchange-traded funds have become a hugely popular investment option outside the 401(k) context. By combining the instant diversification of a mutual fund with the all-day tradability of a stock, ETFs catered to long-term investors and short-term traders alike. The market has grown quickly, with ETFs passing the $2 trillion mark in assets under management over the past year.
Yet for a long time, ETFs found resistance in the 401(k) market. Retirement-plan administrators tend to be conservative, sticking with tried-and-true investment options that they know will pass regulatory scrutiny, and so innovation takes a while to catch on.
What finally got things moving forward were the financial companies that helped employers administer their 401(k) plans. Many major brokerage companies have embraced ETFs, either by starting their own proprietary funds or by bringing on outside ETF providers as partners. In order to build assets and trading volume, these brokerage companies saw the retirement-plan market as a huge untapped resource. By offering first isolated ETF options within a mutual fund-dominated investment menu and then offering ETF-only 401(k) plans, these companies were able to build interest in their ETFs and give 401(k) participants the broader range of investment options they wanted.
Does an ETF make sense in your 401(k)?
Just because you have ETFs available in your 401(k) plan doesn't necessarily mean that they're good investment options. As with any investment, there are good ETFs and bad ETFs, and the exchange-traded funds in your plan might be a good choice for you but a less-than-ideal option for someone else.
The biggest advantage of ETFs is that many of them have rock-bottom costs. You can find several ETFs that will charge less than $1 per year for every $1,000 you have invested in your 401(k). Given that many actively managed mutual funds can charge $10 or more in annual fees for that same $1,000, the savings adds up over time, especially as your account balance grows.
Moreover, ETFs often track popular benchmark indexes that you're familiar with, making them more transparent than a typical mutual fund. ETFs tracking the S&P 500 (SNPINDEX:^GSPC) are among the most popular, and since you can look up how the S&P 500 is doing at any time, you'll always know how an S&P-tracking ETF has performed just by looking at the stock market's daily results.
Things to think twice about with ETFs in your 401(k)
By contrast, though, not all ETFs are necessarily geared toward a conservative retirement investor's needs. Niche ETFs often track the performance of a given sector of the market, focusing on a particular industry or type of stock, and expenses for those ETFs can be much higher than those for a fund that tracks a broad index, approaching what you'd pay for an actively managed mutual fund. More concentrated ETFs can also be more volatile, offering higher return potential but with higher risk.
It's also important to look at how your employer and the financial company that stands behind the 401(k) deal with ETFs. Some brokers offer commission-free ETF trading, which is vital in order to avoid a huge potential added cost involved with buying and selling ETFs in your 401(k). Even so, though, more popular ETFs are generally preferable to less popular ones in that some of the costs involved in dealing with illiquid funds are higher than those for funds with more activity.
Finally, just because you can trade ETFs at any time of day doesn't mean that you should start day trading your retirement account. A 401(k) is meant to be a stable, reliable portion of your financial plan, and taking too much advantage of trading capabilities can get you in trouble.
Overall, though, ETFs are a great addition to the 401(k) investment menu. If you have a low-cost ETF option covering a major asset class in your 401(k), it makes sense to look closely at it and consider making it part of your retirement portfolio.
Dan Caplinger and The Motley Fool have no position in any of the stocks mentioned. 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.