A reader recently asked if I was “for or against” ETFs in 401(k) plans. I’ve spoken on this issue for several years at various national conferences. I’ve reported on the topic from still other conferences. But, rather than merely repeat pre-existing public record, I decided to dip further back into a piece of my writing portfolio that has yet to find its way into the digital world. My response: “A better question might be whether I was for or against mutual funds in 401(k) plans.”

My 1999 book "Due Diligence: The Individual Trustee’s Guide to Selecting and Monitoring a Professional Investment Adviser" spoke of a scenario whereby a 401(k) fiduciary needed to select investment options. Using an example with only a growth fund and a value fund, I wrote

“Though consistently sticking to either ‘growth’ or ‘value’ over the long haul can provide adequate returns, unsophisticated investors attempting to time between either can lead to disastrous results. As a fiduciary, you prefer to create a structure that helps the beneficiaries avoid making this mistake.”

Given the demand for unitized portfolios, there was a shift away from managing individual portfolios in 401(k) plans towards the use of mutual funds. As a result of these conflicting realities, I recommended

“because you want to encourage employees to have a long term approach and you want to help them avoid doing anything close to market timing, you limit their ability to switch between investment options to semi-annually.”

Remember, retirement investing is for the long haul and you just want to point the ship in the right direction, you don’t want to run out of fuel by zigging and zagging all the way to your ultimate destination.

Ironically, that same unitized accounting structure has hampered the use of ETFs in 401k plans. Administration is perhaps the most significant impediment identified in 5 reasons why a 401k plan fiduciary should reconsider using ETFs. As more recordkeepers have restructured their systems to solve this unitization issue, other trading issues have become apparent. Unlike mutual funds, for example, ETFs cannot trade fractional shares, making the often smaller trade amounts of many 401(k) plan participants difficult to administer.

Worse, unlike the set price of mutual funds, ETFs, like their closed-end fund cousins, can often experience liquidity problems. These produce large bid-ask spreads, a hidden and hard-to-document cost to using even “commission free” ETFs.

The challenge of trading ETFs can confound professional advisers, too. At a recent conference, a group of these experts listed the top 10 reasons 401k professionals fear ETFs are not ready for primetime. Most ETFs are index funds. As a result, whereas professionals usually use ETFs to fill specific voids in managed portfolios, they suspect it might be more difficult for 401(k) plan participants to exhibit the sophistication to employ ETFs in this manner. Similarly, to avoid the downside of a potential liquidity squeeze, a professional almost always enters an ETF trade as a limit order, not as a market order. Will 401(k) plan participants be able to place limit orders?

Like the Wild West, the ETF world sees innovation and peril around every corner. In the end, when considering whether ETF innovations are good or bad for ERISA plan sponsors, it comes down to the specific use. As an option for professional portfolio managers, ETFs can often supplement existing positions in a traditional pension or profit sharing managed portfolio. This assumes the adviser has experience trading in both illiquid securities and the type of underlying assets making up the particular ETFs they choose to invest in.

With 401(k) plans, ETFs may not be a perfect fit right now. Since most 401(k) assets are invested in actively managed funds, there aren’t many comparable ETFs with adequate track records. That leaves ETFs for the index portion of the 401(k) plan – and it’s not clear ETFs can effectively compete with the lowest cost index funds.

But all this fails to address the issue addressed in my 1999 book: Are plan participants better served by higher frequency trading? Mutual funds allow participants to trade every day. ETFs can allow participants to trade every minute. Does the encouragement of day-trading reflect the best interests of unsophisticated employees? Is it in the best interests of their employer? And who’s going to fund the employee’s retirement when they inevitably crap out in the day trading casino?

If, ultimately, we move away from the unitized world of the mutual fund, then perhaps everyone is best served by returning to managed portfolios as default options in 401(k) plans. Without the regulatory burden of commingled products and without the trading risks of ETFs, plan sponsors can rely on tried-and-true pension/profit sharing procedures to perform their fiduciary duties.