ETFs and managed portfolios as options in your 401(k) Plan

At Betterment, we use exchange-traded funds (ETFs) to build our managed portfolios. Learn about the different types of investment vehicles and how Betterment crafts our investment solutions.

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Mutual funds have historically dominated the retirement investment landscape. Over time, exchange-traded funds (ETFs) have received more attention due to their cost-effectiveness and flexibility. Here at Betterment, we use them to build our diversified managed ETF portfolios. Learn about the differences between the investment vehicles and the ways investments can be managed.

What is active vs. passive (Indexing) investing?

People often associate active or passive investing with certain investment vehicles (e.g. ETFs or mutual funds). However, active and passive are really two different management strategies.

Characteristics

Active 

Passive (indexing approach)

Portfolio managers/team use their investment expertise in an attempt to outperform their benchmark or specified market index. 

x

 

Portfolio managers/team seeks to match the performance of their benchmark, usually a market index such as the S&P 500. 

 

x

Usually has relatively high turnover (meaning they will buy/sell securities more frequently)

x

 

Usually has low turnover

 

x

Tends to have higher management fees

x

 

Tends to have lower management fees

 

x

Higher tracking error (Greater volatility in returns as they deviate from the index to drive outperformance)

x

 

Lower tracking error (Lower volatility in returns as they try to replicate the index they are tracking and invest in the same securities)

 

x

Exchange-traded funds are:

x

x

Mutual funds are:

x

x

From the table above, notice how both ETFs AND mutual funds can be actively or passively managed. 

What’s the difference between mutual funds and ETFs?

ETFs and mutual funds do have qualities in common. Both consist of a mix of many different assets, which helps investors easily diversify their portfolios. However, they have a few key differences:

Mutual Funds

ETFs

Both

  • Most are actively managed
  • Tend to have higher fees, sales charges
  • Less transparent, holdings typically disclosed monthly or quarterly
  • Trades once per day, bought and sold directly with the mutual fund provider
  • Mutual funds still remain the dominant investments in 401(k) plans
  • Most are passively managed, but can be active
  • Relatively lower fees
  • Have clear goals and mandates
  • Transparent
  • Liquid, trades throughout the day (like a stock)
  • ETFs are growing quickly
  • Unique product structure with creation/redemption mechanism
  • Easy diversification
  • Easily access a variety of exposures, eg. stocks, bonds, commodities, alternatives, themes, etc. 
  • Costs have reduced over time
  • Mutual funds are traditionally known for their active approach. It is a key reason why mutual funds tend to have higher fees and higher expense ratios than ETFs. Costs are also higher in instances where smaller retirement plans do not have access to institutional share classes. However, Index mutual funds, which are passively managed and lower in costs, have continued to become more popular. 
  • ETFs, on the other hand, are usually passively managed. More differentiated ETFs however, that are actively managed or use other fundamentals like factors (smart beta), have emerged over the years.
  • Most ETFs are transparent, meaning you can see the underlying holdings daily. Mutual funds either report their holdings monthly or quarterly.
  • ETFs can be traded like stocks whereas mutual funds may only be purchased at the end of each trading day based on a calculated price.

ETFs have a unique share creation and redemption mechanism, which provides efficiencies such as reducing trade costs incurred by the fund, allowing tighter tracking to the index.

Differences in costs between mutual funds and ETFs

Another difference to highlight is costs. Both mutual funds and ETFs have some form of implicit and explicit costs. Here’s a breakdown of the different types:

Types of Costs

Mutual Funds

ETFs

Management fee

Both include a stated management fee 

Trading costs

N/A

May trade at a price slightly more or less than NAV

Transaction costs 

May include sales loads, redemption fees 

Similar to stocks, may be subject to brokerage commissions 


Revenue sharing agreements

Agreements among 401(k) plan providers and mutual fund companies include:

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

Revenue sharing agreements often appear as conflicts of interests.

 

Soft-dollar arrangements

These commission arrangements, sometimes called excess commissions, exacerbate the problem of hidden expenses because the mutual fund manager engages a broker-dealer to do more than just execute trades for the fund. These services could include nearly anything—securities research, hardware, or even an accounting firm’s conference hotel costs.

 

These are the different types of costs that can ultimately drive the “all-in” mutual funds fees experience to be different from ETFs.

What else didn’t I realize about mutual funds?

Conflicts of interest

Often, there are conflicts of interest with mutual funds. Some service providers are, at their core, mutual fund companies. And therefore, some investment advisors are incentivized to promote certain funds. This means that the fund family providing 401(k) services and the advisor who sells the plans may have a conflict of interest.

Some mutual funds invest in a portfolio of ETFs

Target-date funds have evolved to now include ETFs, so it is important to understand the way your TDFs are constructed and that ETFs are also being considered for a traditional mutual fund product like TDFs.

Why is it unusual to see ETFs in 401(k)s?

The 401(k) market is largely dominated by players who are incentivized to offer certain mutual funds. Plans are often sold through distribution partners, which can include brokers, advisors, recordkeepers or third-party administrators. The fees embedded in mutual funds help offset expenses and facilitate payment of every party involved in the sale. However, it’s challenging for employers and employees because the fees aren’t easy to understand even with the mandated disclosure requirements.

Existing technology limitations prevent traditional recordkeeping systems from supporting ETFs. Most 401(k) recordkeeping systems were built decades ago and designed to handle once-per-day trading, not intra-day trading (the way ETFs are traded)—so these systems can’t handle ETFs on the platform (at all).

How Betterment manages your investments

Betterment combines managed ETF portfolios with personalized, unbiased advice to create an easy solution for today’s retirement savers.

At Betterment, we use ETFs as the building blocks for our managed portfolios where you have the ability to choose from a menu of portfolio strategies that are managed over time. To select the ETFs that we use to construct our portfolios, we use our proprietary unbiased investment selection methodology that is based on qualitative and quantitative factors, always serving your employees’ best interest.

Many retirement plans use target-date funds because they are often viewed as a one-stop solution. While having  specific retirement date funds (2045 Fund, 2050 Fund, etc.) may satisfy most investors, it is important to consider options for those whose circumstances have changed (if someone decides to retire early, for example) and require flexibility. Betterment can tailor our advice to the exact year your employees want to retire. Our retirement advice adapts to your employees’ desired retirement timeline and can be customized for their risk appetite if they want to be more conservative or aggressive.

Betterment can also tell your employees if they‘re on or off track, factoring in all of their retirement savings, Social Security, pensions, and more. Employees can also link outside investments, savings accounts, IRAs—even spousal/partner assets—to create a real-time holistic snapshot of their finances. It can make saving for retirement (and any other short- or long-term goals) even easier.

At Betterment, we believe in providing investment options and retirement advice that allows for customization and flexibility in a cost-effective way.

Interested in bringing a Betterment 401(k) to your organization? Get in touch today at 401k@betterment.com.