ETFs giving mutual funds a run for their money

NEW YORK -- While mutual funds are a staple of many 401(k) and other retirement plans, ETFs are likely to become serious competitors in the coming years.

An ETF -- that's short for exchange-traded fund -- is a security that tracks an underlying benchmark much like an index mutual fund but that trades like a stock on an exchange. Because they are linked to indexes, ETFs are known for having low costs -- something that can benefit investors with 401(k) plans, where assets accumulate over long periods of time and where low fees can help boost returns.

That advantage is expected to help ETFs become an integral part of more 401(k) accounts.

"Over the next 24 months, the growth is going to be huge," said Darwin Abrahamson, chief executive of Invest n Retire LLC, which has designed a system that allows funds like 401(k) plans to offer ETFs.

He said ETFs' low expenses have attracted interest from boards overseeing retirement plans.

"They're really creating a huge, huge awareness with fiduciaries and plan sponsors that they had better be aware of what the fees are in their investment options," he said of grumbling among some investors concerned that fees for their retirement plans take an unreasonable bite out of returns. In addition, litigation and legislation are prying open more information about fund expenses, he said.

But there may be some resistance to ETFs from the companies that operate mutual funds. The more traditional funds can bring in more money for fund companies because many have managers who try to outrun a simple index; investors often have to pay for that kind of stewardship through higher expenses.

"A lot of providers do not want ETFs in 401(k) plans because they're trying to gather their own assets under management in their own funds," Abrahamson said.

But beyond the motivations of mutual fund companies, many of which offer ETFs as well, there are logistical hurdles.

Unlike mutual funds, ETFs can be bought and sold during the trading day, rather than once a day as with mutual funds. While that could be appealing for some investors, it makes it harder for 401(k) overseers. Imagine the difficulty faced by a company with thousands of employees who might want to place trades at varying times during the day.

"The problem with the 401(k) providers out there is that they don't have the software where they can offer ETFs. All of the record-keeping systems out there were built to trade mutual funds," Abrahamson said.

But the potential benefits of having an ETF as an option in a 401(k) plan mean it is likely these funds will at some point become available for retirement accounts, observers say.

"I think ETFs can be a benefit in the 401(k) space like index funds have been beneficial. It's a good, inexpensive way to get exposure to different markets at very low cost," said John Thompson, portfolio manager at Ibbotson Associates, a division of Morningstar Inc. that provides financial advice for 401(k) investors.

Thompson said investors could move into more unique parts of the market "if they are looking for something a little more unique like Eastern European stocks without having all the extra fees that generally comes with active management."

And there can be tax advantages with ETFs, which generally don't make big capital gains distributions the way some mutual funds often have to.

But there are other obstacles for ETFs to overcome. Thompson notes that because ETFs are less familiar to many investors than mutual funds, there may be new questions about how to best employ them. Employers with workers who are savvy investors could be among the first to adopt use of ETFs.

He believes interest in ETFs will spread.

"I think the investment ideas are pretty simple behind the ETF and people will embrace that. It may be the mechanics that take a little work at first," he said. "I see ETFs still growing and becoming more and more popular with investors and they may start demanding them for their 401(k) plans."