Saving for Retirement: 401k ETF Investment

Exchange-traded funds, or ETFs, are investment funds that are traded like stocks and can be useful tool in a 401(k) account. ETFs are similar to mutual funds because they both represent a particular set of assets. However, the two fund types behave differently. An investor should consider some very important distinctions between ETFs and mutual funds before making any investment decisions.

Management Fees and Taxes

Mutual funds are actively managed and require that a fee be paid to the fund manager. On the other hand, ETFs mirror an index and have no management fees to pay. Additionally, ETFs trade on their respective exchanges so shares are traded among investors instead of with the fund. ETFs do not typically distribute capital gains because no assets must be sold to pay out any redeemed shares. As a result, tax implication are deferred with ETFs better than a mutual funds. Within a 401(k) plan, though, investors do not pay taxes on capital gains and thus ETFs have no significant tax advantage when they are held in a 401(k) account.

Intraday Trading

Investors must wait until trading closes for mutual fund transactions to execute since a mutual fund’s NAV is only calculated once per day. ETFs can be traded at any time during trading hours and have the benefit of setting stop and limit orders. Investors can therefore take advantage of brief market swings within a 401(k) account. This advantage is not typically possible because stock trades are not permitted in a 401(k). Irrespective of intraday trades, mutual funds typically list in their prospectus that they charge a fee for selling shares purchased within 30, 60, or 90 days. This flexibility is only necessary for investors who are looking for short-term trading.

Commissions

While ETFs are considered to be low-cost alternatives to mutual funds, there is a brokerage fee associated with each executed trade. There is usually a comparable index mutual fund offered for each index ETF at a similar cost. If the investor participates in frequent trades, the commission costs for ETFs could heavily outweigh the costs of trading mutual funds since most 401(k) plans offer a list of commission-free mutual funds. Some investment managers, such as Vanguard, offer commission-free ETFs as well. However, not all ETFs are available.

Diversity

There are presently over 800 ETFs listed on stock exchanges and all the major indexes like the S&P 500, Nasdaq 100, and Dow Jones Industrial Average. There are also ETFs for industries like the US Basic Materials Index and even international ETFs that track country economies like South Kora, Spain and Italy. With hundreds of funds to choose from, ETFs can be as broad, or specific, as an investor requires. There is also no exposure to the risk of a fund manager choosing the wrong securities to hold since the ETF mirrors a well-defined index with no surprises. Finding the right mutual fund in a 401(k) plan is a major headache that can be avoided altogether with ETFs.

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