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RETIREMENT - The Indexers' Sanctuary

Exchange-traded funds: poised for growth in the 401(k) market?

When it comes to defined contribution retirement accounts, purveyors of exchange-traded funds have a simple message for the mutual fund business: Move over. Advocates of ETFs, depositary receipts linked to specific indexes or baskets of stocks, see enormous potential for their use in 401(k) plans.

"We have a lot of confidence that market demand is there," says Michael Latham, who heads the North America individual investor and exchange-traded funds businesses at San Francisco­based Barclays Global Investors, which has about $250 billion in ETF assets and dominates a market that was worth about $400 billion at the end of 2006.

The amount of ETF assets held in retirement accounts is still paltry -- only about 0.25 percent of total 401(k) assets. Nonetheless, Latham and his competitors figure that the percentage is poised to rise quickly. Because large plan sponsors can buy other index products at a lower cost than ETFs, the potential takers are small to midsize plans with less than $20 million, experts say.

A few plans are already using ETFs in their 401(k)s. Chip Stein, vice president of Albany, New York­based Stein Fibers, a manufacturer and distributor of polyester fibers, says about three quarters of his company's profit-sharing and retirement accounts, which have more than $3 million in assets, are invested in ETFs.

The vehicles have proved to be a money-saving option. The average fee for ETFs charged by 401K Retirement Solutions, Stein Fiber's recordkeeper, is about 160 basis points, which comprises 20 basis points for the ETFs' internal expenses, 40 for custody and 100 for recordkeeping and administration. For comparable-size plans composed of mutual funds, the average fee is about 350 basis points.

The obstacles that have kept most defined-contribution-plan investors out of stocks have also impeded use of ETFs. But that is changing with shifts in the 401(k) market.

Take fees. ETF sales have been slow in part because they do not have loads and commissions, the fees that have financed the distribution of mutual funds through institutional brokerages and other intermediaries that administer retirement plans. But a solution is in the offing: fee-based advice. As this approach takes hold among retirement plans, the lack of loads and commissions will become less consequential, experts say.

Another impediment is the fact that defined contribution recordkeeping systems are geared to the trading patterns of mutual funds, which settle once a day, not intraday as ETFs do. Although some retirement plan investors can buy ETFs like any other stock or bond through what is known as a self-directed brokerage window, which permits daily trading of individual securities, only about 6 percent of investors who have the option use it, says Gregory Kasten, CEO of Unified Trust Co. of Lexington, Kentucky, a trust company that offers fee-based advisory services to defined contribution retirement plans.

The solution: Wrap one or more ETFs in a collective trust, a pooled vehicle for institutional investors that is priced once a day. This simple move solves the recordkeeping headaches for defined-contribution-plan administrators.

Proponents of using ETFs in 401(k) plans see other advantages. Gary Gastineau, who launched trading of the vehicles on the American Stock Exchange in the 1990s, says their low transaction costs are a big benefit compared with those of mutual funds, which must maintain cash for redemptions and purchases. "ETFs are simply more cost-efficient, particularly for 401(k) investors who are in for the long haul and should be concerned about purchase and sales costs being allocated fairly," says Gastineau, co-founder of Summit, New Jersey­based ETF Consultants.

Gastineau sees another big advantage to using ETFs in tax-deferred retirement accounts: It removes the disadvantage that some mutual fund managers inflict on nontaxable investors by choosing to avoid taxes by not locking in capital gains.

"With ETFs, the conflict of interest between taxable and tax-exempt investors disappears," says Gastineau. "You simply don't have portfolio managers looking over their shoulders to figure out which class of shareholders they need to serve."

Over the past decade the sale of ETFs to retail investors has been nothing short of explosive. As these vehicles migrate to the 401(k) market, retirement plan investors -- widely recognized as a passive lot -- are likely to benefit from more low-cost index options. As Stein Fiber's Stein puts it, "You don't have to be a genius or even be well versed in the stock market to do well with ETFs."