Exchange-traded funds grow in popularity for some investors
Few 401(k) plans include pooled investment securitySeptember 22nd, 2022
Exchange-traded funds are growing in popularity as a part of some retirement strategies, despite a general lack of ETFs in 401(k) plans, some financial advisers here say.
Dustin Allbery, vice president of operations at Northwest Planning Inc., says ETFs are “like mutual funds in a lot of ways, where they can be diversified in a bunch of different things, but they trade daily like a stock,” Allbery says.
Created in the early 1990s, ETFs are a type of pooled investment vehicle in which investors can buy and sell shares throughout the trading day at market price on a stock exchange.
ETFs comprised $7.2 trillion of the total $34.6 trillion in total net assets of U.S.-registered investment companies in 2021, according to trade group Investment Company Institute.
“They can track an index. They can track an industry. They can track a commodity. They can track a different sector—like technology or industrial or energy,” Allbery says. “You can’t just go out and invest in the S&P 500, but you can buy an ETF that tracks the same price.”
The first ETF to catch on debuted in 1993. Now called SPY, the fund tracks the Standard & Poor’s 500 index, which is comprised of 500 of the largest-cap stocks. At the close of the market on Sept. 13, SPY was trading at $393.10 per share, down from a year-to-date high of $477.71 on Jan. 3, but up from a low of $366.65 on June 16.
Some ETFs base profits on the performance of an index or leverage debt.
“There’s inverse ETFs, where you make money when the markets go down,” he says. “There’s ultra-ETFs, which leverage funds. There’s actively managed ETFs, which are intended to beat a benchmark—oftentimes, they might not.”
Paul Viren, owner of Spokane-based independent financial planning company Viren & Associates, says ETFs can be a good choice for some investors thinking about retirement. However, Viren says his company rarely sees ETFs in 401(k) portfolios.
“We manage a lot of 401(k) plans in our practice, and on only a handful of occasions do we have ETFs that are allowed to be in the 401(k) world,” Viren says.
Most retirement advisers prefer the relative stability of mutual funds, Viren says, over the intraday trading of ETFs.
Allbery says that mutual funds typically take three days to trade and settle, whereas ETFs take one to two days.
“Retirees usually aren’t day trading, so it’s not a huge incentive, but turnaround time can be a benefit,” he says.
Viren notes that’s beginning to change.
“Some vendors in the 401(k) world are what they call open architecture design, where they allow really low-cost funds and/or ETFs to be in those plans. That gives it a little more viability,” Viren says. “But sometimes the service is a little rocky and not quite the same as you’d have with a larger, more established 401(k) vendor.”
Viren says many investors are drawn to ETFs by their lower fees.
“ETFs predominantly do not have a sales charge or a commission,” Viren says. “That’s one of the attractive benefits of an ETF. You can trade many of the ETFs without a transaction cost or commissions to the broker. There are very low fees.”
According to a study by the asset management team at Charles Schwab Corp., ETFs now make up 33% of portfolios, a 6% increase from 2017. Millennials are the most likely to embrace ETFs.
The average millennial investor has 41% of their portfolio in ETFs. Generation X has 33% of its collective portfolio in ETFs, while baby boomers have low engagement with the security option, with 19% of their portfolio invested in ETFs.
“I don’t think retirees should shy away from them at all,” Allbery says. “I like them a lot, but you have to know how to structure them, because there’s no one thing that works.”
Those in or nearing retirement should be especially picky about their ETF choices, he says
“The ones you come across the most, especially for retirees, are low-cost, big index benchmarks,” he says. “We want to get some of that exposure, but don’t hang your whole portfolio on one or two indexes. There are certain ETFs that you may want to avoid or have limited exposure to.”
Like with any other portfolio, Allbery advises that investors in ETFs diversify.
“They all have their own risks,” Allbery says. “There’s no one ETF you should be in. You should be diversified, like everything else, especially when retirement is in consideration.”
Diversification should include different sizes of ETFs, Allbery says. He notes that some of the larger ETF indexes, such as SPY and QQQ, exclude companies with small and midsize market capitalization.
“Those companies that are smaller in nature now, that could be mega companies later, often get overlooked,” Allbery says. “I can’t say that retirees should have a lion’s share of small- and mid-cap, but it always makes sense to have a small portion, because historically they have a higher risk-adjusted return than the larger companies. You’d want to put some of those in your portfolio as well.”
Viren cautions that smaller ETFs can pose a riskier investment.
“The risk is that those ETFs won’t have enough capacity to survive a volatile environment,” Viren says. “Some ETFs don’t have enough critical mass to provide for that.”