Exchange-traded funds, long known as a low-cost method of investing for individual investors, are receiving increasing media exposure as a potential solution to reduce 401(k) plan fees. In fact, ETFs have been touted by at least one firm as the low-cost solution for 401(k)s. The reason for the increased media exposure for ETFs is relatively straightforward: On average, ETFs cost less (i.e. have lower expense ratios) than actively managed mutual funds. However, comparing passively managed ETFs with actively managed mutual funds ignores the fact that there are already passive index mutual funds that are being used in retirement plans today.

Similar to ETFs, index mutual funds are less expensive than actively managed mutual funds. Therefore, the real debate regarding the potential benefits of ETFs in 401(k)s is not whether ETFs create cost savings versus actively managed mutual funds, but whether ETFs create additional cost savings when compared with traditional index mutual funds.

Unlike traditional mutual funds, though, ETFs are not 401(k)-ready, and a variety of costs must be incurred (both explicit and implicit) in order to make ETFs available in a 401(k) plan. This paper will explore the benefits and costs associated with using ETFs in 401(k)s and will provide guidance on whether ETFs represent a better indexing option than traditional index mutual funds.

An Overview Of ETFs

While ETFs were first introduced in the 1990s, the ability to trade a whole stock basket in a single transaction dates further back. Major U.S. brokerage firms provided such program trading facilities as early as the late 1970s, particularly for the S&P 500 Index. With the introduction of index futures contracts, program trading became more popular. As such, the interest in developing a suitable instrument that would allow index components to be negotiated in a single trade increased. This led to the introduction of the exchange-traded fund. The first ETF introduced was the Toronto Index Participation (TIPS) in Canada, which was followed three years later by the Standard & Poor’s 500 Depositary Receipts (SPDRs) in the U.S. [Deville 2006].

The ETF marketplace experienced its first effective boom in March 1999, with the launch of the NASDAQ-100 Index Tracking Stock, popularly known as Cubes or Qubes (in reference to its initial ticker, QQQ [which has since changed to QQQQ]). In its second year of trading, QQQ had an average daily volume of 70 million shares, which was approximately 4 percent of the trading volume of the NASDAQ at the time. Since then, ETF growth in the U.S. has been considerable: Assets under management rose 27 percent in 2001, 23 percent in 2002, 48 percent in 2003, 50 percent in 2004 and 31 percent in 2005 (source: Investment Company Institute). Growth in 2006 hit 35.8 percent, according to Morgan Stanley, and 42.7 percent in 2007.

One reason for the rising popularity of ETFs among individual investors is the increased tax efficiency of ETFs relative to traditional index funds. The ability of ETFs to utilize in-kind redemptions enables an ETF to transfer its underlying holdings with the biggest unrealized gains, thereby limiting the ETF’s potential for capital gains distributions. However, tax considerations are not pertinent to qualified retirement plans (e.g. a 401(k) plan), since they are tax-deferred savings vehicles [Deville 2006].

www.etfguide.com/exchangetradedfunds.htm ):

1. Open-end index fund: This type of ETF structure reinvests dividends the date of receipt and pays them out via a quarterly cash distribution. This ETF design is also permitted to use derivatives, loan securities and is registered under the Investment Company Act of 1940. ETFs that utilize this legal structure include iShares and the Select Sector SPDRs.

2. Unit Investment Trust: This type of ETF structure does not reinvest dividends in the fund and pays them out via a quarterly cash distribution. In order to comply with diversification rules, this ETF design will sometimes deviate from the exact composition of a benchmark index. This type of fund is registered under the Investment Company Act of 1940. The Diamonds, Cubes and SPDR follow this format.

3. Grantor Trust: This type of ETF structure distributes dividends directly to shareholders and allows investors to retain their voting rights on the underlying securities within the fund. The original fund components of the index remain fixed and this legal structure is not registered under the Investment Company Act of 1940. Merrill Lynch’s HOLDRs follow this format.

Although the SEC states that an ETF is a type of investment company whose investment objective is to achieve the same return as a particular market index,www.sec.gov/rules/concept/ic-25258.htm#seciii ). Indeed, some active ETFs with transparent portfolios have already launched. However, there are a number of obstacles, such as arbitrage and transparency, that will need to be addressed before actively managed ETFs become widespread.

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