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ETFs are Finding Their Way into 401(k) Plans

In a recent blog post we discussed how mutual fund fees can drastically reduce funds available for retirement (see "401(k) Fees Can Drastically Reduce Nest Egg"). We cited a paper from the Center for Retirement Research that studied a typical 401(k) plan's investment costs, which including advertising fees, administration fees, asset management fees, and trading costs total 1-2% of assets annually. The paper proposed boosting the returns of 401(k) plans by investing in passively managed and lower cost ETFs instead of actively managed and higher cost mutual funds. In another of our blog posts we commented on an S&P performance report that found that most actively managed mutual funds exhibit lower returns than their analogous passive benchmark indices (see "SPIVA Scorecard Year-End 2011"). Nevertheless, most 401(k) savings plans consist of a set of mutual funds and do not allow investing in ETFs. This reality may soon change.

SEC exemptions have made it possible for mutual fund companies to invest in ETFs. Historically, the Investment Company Act of 1940 limited mutual funds and other investment companies from:

(i) Acquiring more than 3% of the total outstanding voting stock of another investment company (or ETF);
(ii) Investing more than 5% of their assets in a single investment company; and
(iii) Investing more than 10% of their assets in other investment companies (see Section 12(d)(1)(A)).

Recently, many ETFs have received SEC exemptions allowing other investment companies (including mutual funds) to invest in them above the 3%, 5%, and 10% limitations. JPMorgan SmartRetirement Blend Funds are a new family of funds that invests both in other JPMorgan mutual funds and in ETFs that have received the SEC exemption (see prospectus). The advantage of this new type of fund is that their investment in passively managed ETFs may reduce the costs of 401(k)s without compromising returns.

So far the average 401(k) investor cannot typically trade directly into an ETF. In a Bloomberg interview, Neil Plein, vice president of Invest n Retire LLC, posits that technological reasons may be the biggest issue preventing 401(k) plans to invest directly in ETFs. He states that the 401(k) systems "were designed for mutual funds with end-of-day pricing [...] When you have an ETF, you have an investment vehicle that trades intra-day, not end-of-day" (see full interview). Another often heard critique of 401(k) plans offering ETFs directly is that the ability to trade intraday may result in higher trading costs for investors chasing performance.

Even though most investors cannot invest in ETFs directly through their 401(k) plans, they may soon be able to invest in mutual funds that invest in ETFs. The JPMorgan Funds may lead the way to more 401(k) assets shifting from traditional mutual funds to ETFs.