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ETFs making headway in 401(k)

Employees tired of carrying expense-heavy mutual funds in their 401(k) plans might find there's an alternative that will allow them to build a well-diversified retirement portfolio at less cost.

A growing number of employees, particularly people who work for smaller companies, may find that they have the option of investing in exchange-traded funds, or ETFs, in their 401(k) plans. Until recently, ETFs have been shunned by defined contribution plans, in part because a commission is charged for every trade and because they can be traded on the exchanges throughout the day like stocks. Daily trading would be considered excessive by many retirement plans. But some providers of 401(k) plans are finding ways around those drawbacks.

Essentially, ETFs track market indexes, such as the S&P 500 or small cap growth stocks, health care, technology, utilities, etc. ETFs usually have lower costs associated with owning them, since most simply track an index and don't require active management.

Added benefit
Another benefit is that, unlike a mutual fund, on any given day you can find an up-to-date list of every stock that makes up a particular ETF. Most mutual funds, because they're actively managed and competing against other mutual funds, list only their 10 largest stock holdings every quarter, and that information might be outdated by the time you get it.

"We're definitely seeing increased use of ETFs because of transparency, low cost and the ability to access markets very broadly," says Lance Berg, spokesman for Barclay's Global Investments, a San Francisco-based asset management company that's one of the largest managers of ETFs with its iShares.

"We feel that as investors become savvier about ETFs it's inevitable that ETFs will be in 401(k) plans."

No one's expecting ETFs to dislodge mutual funds as the main investment option anytime soon, but small companies that get stuck with expensive 401(k)s could be the first in line to explore the opportunity.

"Small companies that don't have a high dollar amount in contributions almost by definition face the highest costs when setting up a 401(k)," says Rick Meigs, president of 401khelpcenter.com in Portland, Ore.

"If you can't get a handle on costs then you might want to look at ETFs. Every plan needs to re-evaluate because there are plenty of people paying way too much in their plans. Every fiduciary in these plans should be looking at fees. No one should be paying a 200-basis-points expense ratio. Anything over 150 basis points, unless it's a really rinky-dink startup plan, should raise a red flag."

Getting around the roadblocks
Darwin Abrahamson, CEO and founder of Invest n Retire, a Portland, Ore., company that designs asset allocation software utilizing index funds and ETFs, says he's devised a way around the cost, record keeping and other roadblocks that keep so many plans from including ETFs as options. For example, he keeps commissions down by allowing participants one trade per day, which the company aggregates to make large trades at the end of the day.

"We traded $297,000 worth of ETFs, and the total trading cost to all 200 participants was $43.22. That's far less than the trading costs inside mutual funds. ETFs are the best way to build asset allocation models -- lower risk and higher return than models using any other investment option. Seventy (percent) to 90 percent of the cost of a 401(k) plan is in the investment options.

-- Posted: Nov. 1, 2006
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