There are three ways to invest: buy stock, purchase a mutual fund or invest in an index fund. Purchasing individual stock has its risks and rewards. Often, retail investors think about the successes of Google and Apple, or happily recall the 80s and 90s victories of Coke and others. Unfortunately, it’s easy to forget about stock blowups like Enron, GM and BP, which are examples of company risk. Since the 1980s, mutual funds have served as a great diversifier for individual investors by giving them access to professional money management. However, over the last decade, many of the best fund managers have left the mutual fund business to work in the less regulated hedge fund world. The loss of talent, volatile investment climate, under performance and ethical missteps have brought a lot of unsavory attention to mutual funds recently, putting more focus on a third investment option, indexing.
Indexing visionary John Bogle, founder of Vanguard, brought the first index mutual fund to market. The concept is that over the long term, an active portfolio manager’s rate of return moves back to the average (the index; S&P500). We see this in a University of Maryland study that shows that only .06% of managers beat their assigned index from 1975 – 2007 after fees. Over shorter periods of time, active management improves its record with 33% beating the assigned index, according to Morningstar. This is the same concept that compelled the great investor Warren Buffet to bet hedge fund managers $1 million that they could not beat the S&P 500 over a ten year period. He had also offered investment advice to individuals, stating that most individual investors should consider index funds for long term investments.
The concept behind indexing is to purchase everything within an asset class. For example, if you want to hold domestic large cap stock, you can purchase a Vanguard S&P 500 index fund that holds all 500 S&P companies. This works in opposition to a mutual fund manager selecting 30 to 100 funds and having 100% turnover in annual portfolio holdings. The same system applies to the S&P 600, 400 and International indexes. The indexing approach virtually eliminates company risk, as well as active management risk.
In 1993, the first Exchange Traded Fund, named the Spyder, was created. Today, it still represents the S&P 500. An ETF is very similar to an index mutual fund, but with added benefits. An ETF trades similarly to a stock in that you can trade during market hours rather than waiting for the close of business like a mutual fund. The structure of an ETF allows the fund administrator to rebalance the fund without passing through any capital gains to investors. Because there is no active management involved, the cost of ownership is very inexpensive. The S&P 500 ETF costs 0.09% a year in fees. This is much less than the average 2.2% that a mutual fund costs. An ETF is also very transparent, allowing investors to see the fund’s holdings in real time versus just quarterly with mutual funds. There are currently over 900 ETFs on the market with over $1 trillion in assets. In the last three years, more money has flowed into ETFs than mutual funds. TD Ameritrade says that 80% of portfolio managers, active and passive, use ETFs in some fashion. Charles Schwab says that 15% of retail investors are using this relatively young product. We also see innovative companies such as Fed Ex and Apple now building 401k portfolios entirely with index funds and in Apple’s case, ETFs.
A plan sponsor has the fiduciary responsibility to act solely in the interest of plan participants and their beneficiaries with the exclusive purpose of providing benefits to them. This means carrying out their duties prudently, following the plan documents (unless inconsistent with ERISA), diversifying plan investments and paying only reasonable plan expenses. Adding Exchange Traded Funds to a brokerage link allows the participant to diversify away from active management risk and specific company risk. The ETFs will bring substantially lower investing fees to the plan versus what is currently being offered. Fiduciary duty demands that ETFs and/or index mutual funds be considered in any 401k plan.
The graph below compares the cost of a moderate risk portfolio using the current JP Morgan 401k plan options versus a moderate risk ETF portfolio that could be held within the brokerage link. The difference is 0.61% a year, which would add 11% to a participant’s 401k balance assuming he or she is adding $8K a year to the plan for 30 years. That provides an additional $59K in value to the participant. The two portfolios had essentially the same performance over similar time periods. Low Cost was the contributing factor to the increased rate of return.
Many ask why it is a good idea to choose ETFs over Index Mutual Funds. Inside a 401K, it is difficult to compete with Vanguard Index Mutual Funds as a built-in investment option. We would think this is one reason why Fed Ex and other large companies have chosen Vanguard as their 401k custodian and administrator. Otherwise, ETFs inside a brokerage link are a great option compared to expensive plan mutual funds. Essentially, the creation of Index Mutual Funds was the stepping stone to ETFs. ETFs provide low cost index access to areas that many 401k mutual funds do not cover, such as small cap developed international, frontier markets, commodities, emerging markets, Treasury Inflation Protected Bonds, Emerging Market Bonds and various durations of treasury and corporate bonds. ETFs also cover all traditional asset classes much less expensively than traditional index mutual funds and 401k plan options.
Wiser Wealth Management is a leader in the usage of ETFs, as well as developing and disseminating ETF education worldwide. We have spoken in Europe, Asia and the United States about the benefits of using ETFs within portfolios. However, some ETFs are not for retail investors. The Pro Shares product line of inverse funds are for day trading only and in our opinion should never be an option for a plan participant. Other ETFs should be limited based on their low trading volume and low assets under management. We would also recommend that the plan sponsor request a best execution strategy for trading stock and ETFs within the brokerage link to prevent JPM from marking up trades. Additionally, we would recommend that education be provided to all plan participants about the benefits of a brokerage link, as well as the risk (in plain language) just as ALPA is doing with its pilots.
In “A Father’s Book of Wisdom,” H. Jackson Brown wrote “ignorance is to reject something that you know nothing about.” Financial advisors, individuals, the media and professors are all still learning about the benefits of Exchange Traded Funds. Undoubtedly, ETFs have shaken the investment world by empowering investors at all levels with quick access to low cost diversification. Adding ETFs to the Atlantic Southeast 401k brokerage link will allow investors low cost access to global asset classes. If used properly, ETFs can increase the standard of living of the Atlantic Southeast retirees and allow for current reduced company risk, active management risk and portfolio liquidity. ETFs will allow plan participants to purchase the indexes that the active managers cannot seem to beat over long periods of time.
Casey T Smith
Wiser Wealth Management, Inc
ASA ALPA 401k Specialist