Make Way, Mutual Funds!

The ETF Advantage?
IndexUniverse carries an article (originally from the paywalled site ETF Report) entitled “Has Schwab Cracked [the] 401k Code For ETFs?” It's an intriguing question. Exchange-traded funds have thus far barely appeared in 401(k) plans. ETFs can't be offered to 401(k)s without being connected to a record-keeper, and they weren't built to be sold in fractional shares, which are necessary to accommodate varying employee balances. Obviously, though, ETFs are very much a force to be reckoned with. They've socked conventional mutual funds in the mouth in the retail marketplace, and they might well do so with 401(k) plans, too.

That's what Schwab(1) claims. There's a certain logic to Schwab teaming up with ETFs, as Schwab is also a low-cost, retail powerhouse that is not a 401(k) market leader. However, I can't say that I'm terribly convinced by the company's argument. Assuming that the operational challenge of fractional shares is resolved--which Schwab claims is the case--then ETFs are no worse than similarly priced mutual funds. But neither are they better.

Consider the three advantages ETFs have over mutual funds: liquidity, transparency, and (arguably) taxes. Liquidity means nothing here: Who day-trades 401(k) plans? Transparency is also beside the point. Most 401(k) participants don't know what funds they own. (Some are not even sure that they own any funds at all.) That they can see their portfolios' holdings on a real-time basis matters not-- particularly when the fund is likely an index that carries no surprises. Finally, there are no tax benefits for ETFs in 401(k) plans.

Cost is not an advantage because while ETFs tend to carry low expense ratios, they're not necessarily cheaper than index mutual funds and/or institutional share classes. Indeed, they're costlier than the very cheapest 401(k) option: separate accounts for the giant companies. (The S&P 500 Index fund for Boeing's 401(k) plan has an expense ratio of 0.01% annually, or 1 basis point.) It's true that even a relatively costly ETF looks attractively priced when compared with the expensive mutual funds that populate some small 401(k) plans, but even in those cases, switching to ETFs might not lower an employee's fees. The 401(k) provider needs to collect revenue somewhere. If not from fund expenses, then the revenue may perhaps come through plan or advice fees.

Call me neutral. I'm certainly not against the invasion of ETFs, but I don't see it as meaningfully affecting the 401(k) marketplace.

(1) Morningstar Associates LLC, a subsidiary of Morningstar Inc., recently signed a deal to be one of Schwab's advice providers for the 401(k) market.

You Don't Get What You Pay For
The Maryland Public Policy Institute and Maryland Tax Education foundation has released a study of state pension funds that examines the relationship between the amount of fees paid by the states and their investment performance. The time period is the five years from July 2007 through June 2012. So far, I've just had a quick glance.

The big and unsurprising finding is the negative correlation between costs and performance: More cost meant less performance. The 10 states that paid the most in fees had a median annualized total return of 1.34% annually, while those that paid the least had 2.38%.

Neatly, the states at the two extremes had almost identical results before expenses. Maryland gained 3.0% in gross return. After paying its modest 0.09% expense ratio, the state netted 2.9%. Meanwhile, South Carolina fared almost as well at 2.8% gross. However, a whopping 1.3% in annual fees cut its net performance almost in half, to 1.5%.

The time period could be longer, and there are always cross-currents to consider. For example, did the high-expense states have a different asset mix from the lower-cost states? I'll need to read the full study before drawing a final conclusion. However, 50 is a pretty good sample size--and it's not as if higher costs in other studies have led to higher performance (either pre- or post-expense). I suspect these results will stand.

The Doublecoin Twins
Here's an early entrant for "The Dumbest Funds of the 2010s" article that Dan Culloton and I will coauthor in early 2020. Would you buy bitcoins from these guys? I wouldn't. Nor from these fellas, either.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.