Plan Sponsor Series 2: Six Reasons to Use Index Funds and ETFs Exclusively

We have discussed index funds and exchange-traded funds (ETFs) several times in the past in conjunction with expert articles from others. We have also mentioned the ongoing industry discourse about the relative pros and cons of passive fund management vs. active management. Since plan sponsors for 401(k)s continue to move away from actively-managed funds, now is a good time to acknowledge this change and discuss some of the reasons why exclusive use of index funds and ETF's in 401(k) plans makes sense.

First, let's review their respective definitions from Investopedia:

Index Fund: "A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover."

Exchange-traded fund (ETF): "An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors."

These definitions contain the inherent characteristics that provide the reasons why the exclusive use of index funds and ETFs in 401(k) plans could be beneficial to plan participants and sponsors. The six most important reasons to exclusively offer index funds and ETFs in 401(k) plans are as follows:

• Lower overall total plan costs - Index funds and ETFs have lower portfolio turnover, less marketing distribution expense, less indeterminable trading costs, and less spread than actively-managed funds. All of these detract from investment performance. The principal proponent of index funds is the founder of Vanguard, John Bogle, who details the more subtle expenses in actively-managed funds.
  
• Greater fiduciary compliance - The lower cost nature of these funds make them more compliant with DOL guidelines as being reasonable for the services rendered. And because they do not have as many of the payment streams between providers, such as revenue-sharing, there is less chance of prohibited transactions occurring, thus decreasing litigation risk.
  
• Less worry about poorly performing individual funds - Since index funds/ETFs mirror the market averages very closely, the chances of one of these funds not meeting their respective benchmarks is very small considering that they are images of the benchmarks.
  
• Less need for constant fund review and changes - As mirrors of benchmarks there should be less need to replace poorly performing funds. This can decrease overall administration expenses.
  
• Greater plan simplicity - Since index funds/ETFs have far fewer share classes and performance contingencies in some contracts, fund lineups and share classes are simpler and easier to understand.
  
• Greater overall plan transparency - Given their simpler nature and construction, index funds and ETFs are easier to understand and monitor than actively-managed funds.

Taken together and summed, the overriding reason for exclusive use of index funds and ETFs in 401(k) plans is that they can achieve better returns over time. Therefore, better retirement outcomes for plan participants could be achieved than those from actively-managed funds. Plan sponsors/trustees also benefit from lower fiduciary risk and less plan administration. So...why not?