Impact of ETF Growth on The DC Market
A comprehensive study by PwC
projects that ETFs are on track to double to $5 trillion by 2020. A view of what is driving much of this growth helps to shed light on what may lie ahead for the DC market.
The Role of ETFs in Retirement Plans
According to the PwC report, the growth of ETF assets is being “spurred on partly by a widespread move away from commissions toward asset-based compensation; advisors are increasingly focused on asset allocation rather than security selection." What seems most relevant in this study for the DC market is the shift in focus from individual security selection to asset allocation.
As is evident from the upsurge in asset allocation programs (particularly target date funds), this shift away from individual security selection is equally as strong in the DC space as in the retail market. Nonetheless, the same cannot be said for ETFs versus mutual funds, which are still the dominant vehicle either as direct investments or as underlying investments in target date constructs.
The PwC report acknowledges that, as it relates to ETFs in the retirement market, it has been “slow going.” The report cites a number of reasons for this slow rate of adoption:
- Mutual funds already have share classes “designed for retirement plans” that are cost competitive with ETFs
- Recordkeeping systems are “geared toward mutual funds”
- Tax efficiency is not an advantage in retirement plans
The report, however, goes on to state that:
It would nevertheless be a mistake to write off the retirement market as unsuitable for ETFs. Uptake may be slower than other segments, but retirement plans could eventually become an important market for both broad-based and specialist ETF providers. A variety of actively managed target date and target risk funds are already being rolled out to defined contribution plans in the US.
Beyond this one comment, the report says little else about the prospects for ETFs in the DC market.
Prospects for the DC Market
There are trends in the report (not necessary tied to the DC market) that provide some clues as to how the ETF growth trajectory could affect the adoption of ETFs in DC plans:
- The shift from commission-based advisors to fee-based advisors and the fact that the latter are increasingly utilizing ETFs.
- ETFs are viewed as “an excellent tool for [fee-based] advisors assuming the role of portfolio manager and needing to dynamically manage exposure and risks.”
- Many advisors are “riding the wave of demand for alternative investments of all types that have swept the industry for years.”
- ETF strategists represent one of the fastest growing parts of the managed account business.
Taking these factors into consideration, some theories can be constructed as to what the DC trajectory of ETF adoption may look like in the coming years.
The Rise of the Fee-based DC Advisor
In addition to the overall shift from commission-based to fee-based advice, in the DC space there is the extra tailwind of the increased push for advisors to act as named fiduciaries, which, of course, favors the fee-based model. Given that fee-based advisors are behind the push for increased ETF adoption, it only stands to reason that many will want to extend the same programs to DC plans. Furthermore, as advisors continue to view ETFs as a “convenient, cost effective means of constructing customized client solutions,” this market dynamic will likely coalesce with the trend in DC plans to focus on creating effective asset allocation solutions — solutions that are increasingly being constructed from low-cost beta building blocks.
The second and third points are interconnected in that the need to “dynamically manage exposure and risks” is tied to the “demand for alternative investments of all types.” Markets are becoming increasingly global, interconnected and complex. Volatility has been increasing with “volatility bursts occurring approximately every two or three months
.” Of course, with market valuations at 10-year highs, there is always the concern of when the other shoe is going to fall — when will the next “black swan” rear its ugly head? Which is to say that asset allocation will become progressively more tactical verses strategic. ETFs represent, for various reasons, good trading vehicles to shift exposure across a wide dispersion of asset classes. ETFs also offer a broad range of alternatives, which play an integral role when constructing and managing defensive portfolios.
Though most target date strategies dodged a bullet in the 2007-2009 Great Recession, primarily due to quick action on the part of the Fed, this same Fed may be short on ammo the next time around. In short, there is a growing awareness of the need to be defensive given the many uncertainties that lie ahead.
The Rise of the ETF Strategist
Though ETF portfolios with tactical components are likely to become increasingly in demand by DC fee-based advisors with ETF-based practices, the fact is that managing these overlays requires a deep bench of portfolio management talent, extensive research capabilities and ETF-focused trading platforms. To provide these portfolios to DC investors, plan advisors will become increasingly dependent on ETF strategists who have the platforms to deliver them. In these types of strategic alliances, the fees for asset allocation will often be shared between the DC advisor who has the relationship with the plan sponsor and the ETF strategist who is acting as the portfolio manager.
Other Supporting Trends
There are other trends that could serve as accelerators of ETF adoption in the DC market:
The Rise of Collective Investment Trusts (CITs)
CITs have always made a great deal of sense for 401(k) plans given the fact that they are designed specifically for the qualified plan (i.e., institutional) market and, thus, carry significant benefits over retail mutual funds:
- Retail and institutional money are not commingled, which is in the best interest of the latter given the fact thatinstitutional money tends to be more stable.
- Though many CIT providers speak of having different share classes, the fact is that there is no reason that CITs cannot have floating unit values and, thus, implement across-the-board fee flexibility based on an infinite number of cost allocation formulas.
- CITs have no explicit need to build in any costs except what is needed for fund administration and money management expenses, thus creating a clear starting point for any added additional cost — making CITs easier to understand from a pricing perspective.
- Due to the minimal disclosure requirements, DC investors can be provided with simple fund overviews without the deluge of mutual fund data that no one reads and only clutters up the communication process.
There is no natural connection between CITs and ETFs. However, for ETF strategists to deploy asset allocation portfolios, given the low regulatory bar (e.g., no SEC registration, no fund boards, no prospectus), it is much easier to do so in a CIT than in a mutual fund.
One of the advantages that many mutual funds have over CITs is their sheer size. The most popular mutual funds found in DC plans are often over $10 billion in size, with many over $50 billion. This creates enormous scale and, thus, many retail mutual funds have lower fees than do comparable CIT funds. To state that CITs have lower costs across the board is not an accurate statement. To say that, all things being equal, CITs should cost less than mutual funds is an accurate statement. However, all things are not equal when it comes to comparing very large mutual funds with, typically, much smaller CITs.
One of the major challenges of utilizing ETFs in 401(k) plans is that, with the exception of a smattering of independent record keepers and at least one large 401(k) record keeper selling proprietary ETFs, most firms will not record keep ETFs on their platforms. However, if the ETFs are imbedded in a CIT and, therefore, trade like a mutual fund, then any record keeping platform can accommodate ETFs. Hence, for the ETF providers, advisors and strategists, the way into the DC market is through the use of CITs.
ETFs being made available as core investment vehicles across the board is not likely to come about any time soon. However, it should be noted that for any plan sponsor who wants to offer ETFs as a core investment option, there are reputable firms fully capable of doing so.
This issue of size becomes less of a factor when using ETFs as beta building blocks since the expense advantage is less of a factor than it is when using an active manager. However, portfolio managers utilizing low-cost institutional indices can still significantly undercut ETF pricing, especially when the plan is sufficiently large enough to qualify for the special pricing.
Without delving into all the reasons why institutional managers are increasingly using ETFs as funding vehicles over traditional index funds, the fact is, in spite of having access to institutionally priced index funds, institutional managers, year after year, are choosing to utilize ETFs:
Usage is significantly higher among certain types of institutions, especially among the largest and most innovative institutional investors. For example, 47% of U.S. endowments use ETFs, as do nearly a quarter of corporate and public pension funds with more than $5 billion in assets under management. — 2013 GREENWICH ASSOCIATES
The short answer may be that trading efficiencies and broader sector exposure are possibly at the heart of increased institutional usage. As DC portfolios become increasingly tactical and defensive in nature, perhaps the benefits of ETFs as trading vehicles will begin to outweigh the benefits of super cheap beta funds.
A study conducted by Neil Plein in 2012, “Study of Indexing in DC Plans
,” does make the claim that, “for plans with less than $200 million in assets, ETFs should be used for index investing rather than mutual funds.” In reviewing the study it appears that this claim is based on what plans are paying versus what they could be paying. However, in all fairness, the fact that plans are paying these prices for access to beta can be related to the higher cost of marketing and servicing plans in the low end of the market. So perhaps the true picture is somewhere in the middle. Even Vanguard, in a report titled, “Should You Offer ETFs in Your DC Plan?”, takes the position “that the one major exception to this trend [use of index funds in DC plans] may be the smallest plans, which often can't make the minimum account requirements to access lower-cost indexing options.”
For now, it seems that the road forward for ETF-based CIT funds will be in the small to mid market. There is less price competition on the lower end of the market as the fee-based plan advisors are a much more significant part of the sales and service process. These advisors often have a preference for ETF portfolio strategies they are deploying on the wealth management side of their business. It is also an economical reality that smaller plans pay more due to the higher cost of marketing and servicing smaller plans. This is why it is rare to find institutional shares of index funds with rock-bottom pricing in small and even in mid-size plans. Time will tell how much headway ETF-based asset allocation portfolios will make in the large and jumbo DC market.
The Rise of Custom TDFs
Much has been written about the need for custom target date funds as well as the increased adoption rate, especially on the larger end of the DC market. The primary reason that custom target date solutions have not experienced anywhere near the adoption rate in small/mid-size plans is the extra costs associated with creating custom arrangements. As noted above, CITs are much less costly to create and, thus, offer an advantage, especially down market, as it relates to implementing customized strategies across companies with varying demographics.
Given the efficient combination of CITs, ETFs and asset allocation strategies, creating custom target-date arrangements is an open opportunity for advisors preferring the ETF approach. Of course, creating custom target-date arrangements calls for a sophisticated analysis, a service that the ETF strategist would be the most likely candidate to provide.
The Rise of the Cash Balance Plan
Although the PwC report on ETFs does not specifically breakout cash balance plans, it does point out that, “ETFs are also being used opportunistically by defined benefit plans, with such use growing by more than 25% between 2009 and 2013.” It seems reasonable to conjecture that defined benefit plan managers — be they cash balance or traditional — are being equally drawn to using ETFs as underlying investment vehicles. The fact that cash balance plans (which, as noted above, are growing at a faster new plan adoption rate than 401(k) plans) and 401(k) plans are often sold and serviced by the same providers, creates another potential entry point for the fee-based advisor and ETF strategist.
In the past, some firms have seen the ETF entry into the DC market as a magic bullet to bring low-cost solutions to the DC market. However, after a major push by a number of firms, this big shift has yet to occur. The market has been pushed back both for expense as well as other practical considerations such as communication and record keeping.
The way forward for ETF providers, advisors and strategists appears to be to enter the market in the lower stratum and push up market as opportunities emerge. The drive for more actively managed asset allocation and custom target-date strategies should provide some impetus to the growth of ETF target date portfolios, especially for those firms with an existing track record. The continued expansion of the CIT funds (as a replacement for traditional mutual funds) fits well with creating customized portfolios and allows relative easy entry for ETF strategists seeking to package their portfolios for the DC market. Finally, the cash balance opportunity is a growing market that fits well with ETF strategists with LDI capabilities.
The subtitle of the PwC report on ETFs, “Why Every Asset Manager needs an ETF Strategy,” could be said for plan advisors as well — even if that strategy is simply to “wait and see” how ETFs expand into the DC space.
The relative brief history of ETFs and their rapid emergence across so many sectors of the investment industry would indicate that these vehicles will ultimately make significant inroads into the DC space. As discussed above, there are some trends that favor the use of ETF portfolios and market niches that can serve as entry points. It will be interesting to see if any of these turn out to serve as thin wedges, opening up larger ETF opportunities in the DC space.