ETFsbetterthanmutualfunds

Let’s say I’m a water salesperson, and my job is to sell water to people in homes and offices everywhere.

I may know that the best option would be to drink regular tap water; many objective experts say it’s just as good as bottled water, the lack of packaging is better for the environment, the fluoride makes it better for my customers’ teeth, and—perhaps most importantly—it’s more affordable.

But, I make a commission off of bottled water, so I sell bottled water. Even though it’s easy for us to see from the outside that the most sensible choice for the customer is to drink tap water, everything about the system is designed to promote consumption of bottled water.

This isn’t far off from how 401(k)s work. In the 401(k) world:

  1. The water salesperson is a third-party service provider (as defined by the Department of Labor).
  2. The water buyer is a plan sponsor (i.e., the employer purchasing the 401(k) plan).
  3. The bottled water is a mutual fund.
  4. The tap water is an exchange-traded fund (ETF).

Service providers—you could also consider them brokers or investment advisors—may try to sell a mutual fund because they get a cut of the fees, even though the ETF might be cheaper and better for the plan participant.

Not only that, but the fact that this is happening, and the amount the service provider is getting paid, are often buried in the fine print. To be clear, not all service providers are compensated in this way.

There are other costs of owning mutual funds that are even more opaque. This makes it hard for plan sponsors (employers) to evaluate the best plan for participants (employees), and even harder for participants to see where their money is going.

One way to avoid these issues is to use ETFs in 401(k) plan portfolios, which are usually more cost-effective than mutual funds.

ETFs are better choices for 401(k)s because they’re far more likely to be passive, which usually correlates with lower cost. And the incentive structure behind them is completely transparent, making them less likely to have conflicts of interest that lead to hidden fees.

With Mutual Funds, Costs Can Be Buried

Administering a 401(k) plan involves many moving parts carried out by a variety of parties.

Regardless of whether a single party performs one or or multiple functions, each function is associated with a cost that is embedded into the plan. Below are examples of all the roles that can make up a plan’s administration:

Key Players in the Traditional 401(k) Space

Player Function
Mutual Fund Company Company that manages investment funds
Custodian Holds assets in trust and processes transactions
Recordkeeper Tracks each individual participant’s assets
Third-Party Administrator Performs compliance testing, assists with government reporting
Investment Advisor Advises plan sponsor on investment selection for the plan
Accounting Firm Performs annual audit for larger plans (with 100+ participants or certain assets)

Mutual fund providers generate revenues from both stated management fees, as well as less direct forms of compensation. Of course the mutual fund provider keeps some revenues for itself, but it also shares revenues with the variety of other providers that are typically involved with a 401(k) plan.

It’s important for plan sponsors to understand a plan’s true costs and compensation incentives so they can make the best decisions for their participants.

Fees and Commissions

Providers of 401(k) plans are often compensated through revenue sharing arrangements with those mutual fund companies selected by plan sponsors (with an investment advisor’s help).

Common revenue-sharing arrangements, include:

  • 12(b)-1 fees, which are disclosed in a fund’s expense ratios, and are an annual distribution or marketing fees (i.e., the salesperson’s cut), and,
  • Sub Transfer Agent (Sub-TA) fees, for maintaining records of a mutual fund’s shareholders.

Internal Fund Trading Expenses

The buying and selling of internal, underlying assets in a mutual fund are another cost to investors—one that is rarely discussed, and far less understood than the fund’s stated expense ratios.

Each day, a mutual fund manager buys and sells shares of stocks and bonds that make up a fund’s portfolio. This trading activity entails a cost in the form of commissions paid to a broker-dealer, and the bid-ask spread in the market, the latter of which is the difference between highest price a buyer is willing to pay for an asset, and the lowest price for which a seller is willing to sell it.

It’s worth noting that these brokerage expenses are incurred by the mutual fund’s investors, not by the mutual fund manager. However, unlike the conspicuous fees in a fund’s expense ratio, these brokerage expenses are not disclosed and actual amounts may never be known. Instead, the costs of trading underlying shares are simply paid out of the mutual fund’s assets, which results in overall lower returns for investors.

Other commission schemes known as soft-dollar arrangements, sometimes called excess commissions, exacerbate the problem of hidden brokerage expenses.

In a soft-dollar arrangement, the mutual fund manager engages a broker-dealer to do more than just execute trades for the fund.

The broker-dealer manages a fund with bundled value-added services that drive up brokerage costs. These services have been reported to include wide ranging expenses, such as securities research, data, hardware, software, or even an accounting firm’s conference hotel costs.

Of course, bundled costs are more expensive, so while these added services may be essential to running the mutual fund management’s business, it’s investors who unknowingly foot the bill rather than the fund manager reaching into its own pocket to pick up the tab.

Because of the opacity of brokerage expenses, estimates of their magnitude vary widely. A 2009 study of U.S.-stock funds placed the average trading costs of U.S. stock funds at 1.44% of total assets.1

To recap, brokerage expenses are a hidden cost of mutual fund ownership, for which investors and plan sponsors usually don’t anticipate. Soft-dollar arrangements exist between fund managers and their broker-dealers as a potentially deceptive strategy to charge their expenses to investors, rather than paying for them themselves. This results in increased profits at the investors’ expense.

ETFs are Different

ETFs do not have the same revenue-sharing or brokerage relationships that mutual funds have.

This means that with ETFs, the 401(k) players aren’t being compensated behind closed doors, so they have to charge clear and explicit fees for their services, making it easier for plan sponsors to evaluate, compare, and understand true costs of administration. And it allows participants to see where their money is going.

The Conflicts of Interest with Mutual Funds

The 401(k) market is largely dominated by players who are incentivized to offer certain funds: There are the service providers that are, at their core, mutual fund companies.2 And there are the investment advisors, who sometimes get a cut of the sale and are therefore incentivized to push certain funds.

This means that both fund families providing 401(k) services and the advisors who sell the plans may have a conflict of interest.

Dual Role, Biased Advice

Mutual fund companies play a dual role in the world of 401(k)s: (1) They work with plan sponsors and their advisors to select from a menu of investment options for their employees, and (2) they create and manage their own products that they want to sell.

As noted in a report by the Center for Retirement Research (CRC), 76% of plans had trustees affiliated with mutual fund management companies, which creates a conflict of interest. The report states:

On the one hand, fund companies are hired by plan sponsors to create menus that serve the interests of plan participants. On the other hand, they also have an incentive to include their own proprietary funds on the menu, even when more suitable options are available from other fund families.

The Salesman’s Cut

But the conflict of interest doesn’t stop with the mutual fund managers. Investment advisors who are compensated by the soft dollars previously mentioned are incentivized to distribute funds that are going to result in such a commission. That means that some (not all) investment advisors could be acting with their own interest in mind.

This rarely happens with ETFs. Because ETFs are traded on an open market, there’s no way for a fund company to track shareholders. If there’s no way to track shareholders, there’s no way to give compensation for sales, or know who should be compensated with a 12(b)-1 fee.

Additionally, advisors are not compensated by the fund managers for selling ETFs (again, because there’s no way to track who’s buying and selling them). So with ETFs, advisors can provide unbiased advice to plan sponsors and participants about what funds are truly best for them.

ETFs Are Passive and Generally Lower Cost

These costs and conflicts of interest aside, most ETFs have expense ratios that are as low as, if not lower than, those of the retail class of mutual funds (minimum investment of $10,000 or less), and their cost savings are apparent. According to Morningstar, with the exception of long government bonds, the equal-weighted expense ratio of ETFs was cheaper in every single category.

Another key difference is that most ETFs are index-tracking, meaning that they try to match the returns and price movements of an index, such as the S&P 500, by assembling a portfolio that matches the index constituents as closely as possible. While mutual funds sometimes track index funds, most are actively managed. In that instance, the fund managers pick holdings to try to beat the index.

That can get expensive. Actively managed funds must spend money on analysts, economic and industry research, and company visits, among other things. That typically makes mutual funds more expensive to run—and for investors to own—than ETFs. Not to mention, they don’t perform as well. While active managers claim to outperform popular benchmarks, such as the S&P 500, research conclusively shows that they rarely succeed in doing so.

Why It’s Rare to See ETFs in 401(k)s

Mutual funds continue to make up the majority of assets in 401(k) plans for various reasons, not despite these hidden fees and conflicts of interest, but because of them.

As the industry saying goes, 401(k) plans are sold, not bought. Plans are often sold through distribution partners, which can include brokers, advisors, recordkeepers or third-party administrators. It’s difficult for these partners to market ETFs for 401(k)s if their traditional financial incentives are based on revenue-sharing associated with mutual funds.

Another reason why it’s rare to see ETFs in a 401(k) is the existing technology limitations. Most 401(k) recordkeeping systems were built decades ago and designed to handle once-per-day trading, not intraday trading (the way ETFs are traded)—so these systems can’t handle ETFs on the platform at all. In fact, those that do allow ETFs oftentimes repackage the security so that, from a trading perspective, it behaves like a mutual fund.

So while ETFs have gained traction in the general marketplace, where people are more likely to independently research their funds, ETFs haven’t caught on in 401(k)s.

The 401(k) Landscape Is Changing

As the average plan participant and sponsor become more aware of hidden fees inside 401(k)s, an all-ETF 401(k) becomes more attractive.

While a mutual fund-only 401(k) can have some conflicts of interests, a managed ETF portfolio offers benefits similar to those offered by mutual funds, with fewer participant risks.

1Pg. 2: http://gsm.ucdavis.edu/sites/main/files/file-attachments/edelen_sheddinglighttradingcosts.pdf
2Pg. 1: https://www.ici.org/policy/retirement/plan/401k/faqs_401k

A version of this article originally appeared on ETF.com.