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A Potential Flood Of Money Into ETF’s?

April 9th, 2009

money21You may wonder why there are very few, if any, ETFs to choose from in corporate-sponsored 401(k) plans. It’s a simple answer: Just like when you buy a stock, every time you buy shares of an ETF, you pay a transaction fee. With open-end mutual funds in 401(k) plans, the contributing employee pays no transaction fee. Even an $8 fee would be a material performance drag against an investor that is contributing a few hundred dollars every other week.

ETF providers would love to break down this barrier given that the majority of the $2.5 trillion parked in 401(k) plans is invested in open-end mutual funds. We don’t see an easy solution to this issue, but it may be irrelevant. We predict that over the next few months, 401(k) money will be rushing to ETFs–but in the form of newly converted IRAs.

Widespread adoption of ETFs is expected to continue as some of the 78 million baby boomers retire and look to roll over their 401(k) accounts. We also see some silver lining (at least for financial advisors) stemming from the currently difficult economic backdrop. With the massive number of layoffs announced by companies left and right, we think as much as 10% of the 401(k) market could “hit the street,” so to speak. As of 2008 year-end, there was about $2.5 trillion in 401(k) plans, according to estimates from the Employee Benefit Research Institute. In our scenario, this would represent $250 billion in assets poised to leave the umbrella of corporate retirement plans. Then, let’s assume that only half of this money coming from retirement accounts goes into ETFs. Such a case would result in about $125 billion flowing into the ETF industry. Excluding the market’s impact, this alone would represent 23% growth in assets under management; the ETF industry closed out 2008 with approximately $541 billion in assets. Add to that the fund flows from retiring baby boomers, and we can forecast at least another $75 billion flowing into ETFs.

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We understand some may be critical of this very rough estimate, so let’s look at the numbers in a different way. Another way to gauge the potential market opportunity would be to do a simple calculation based on the number of jobs recently lost. According to the Bureau of Labor Statistics, total nonfarm payrolls have fallen by an astounding 3.7 million over the past six months. For our back of the envelope calculation, let’s assume that the average account balance is $75,000. Given that many of the layoffs were in the high-paying financial sector as well as the fact that many of these individuals were long-tenured employees, we think our assumption could prove conservative. In any case, if we take the total amount of jobs lost and multiply that by $75,000, the amount of assets poised to “hit the street” is $278 billion. Again, assuming half of that money makes its way to the ETF industry, we’re looking at about $139 billion flowing into ETFs. Note that this crude estimate of industry growth–26% year over year–is based solely on recent job losses.

In our view, any way you slice it, there is a substantial amount of assets poised to move from 401(k) plans into other self-managed account structures, and savvy financial advisors can capitalize on this by educating these folks about the numerous advantages of using ETFs. If recent fund flow activity is any indication, many investors will be looking to roll over their money and park it in low-cost, transparent, and liquid securities–and ETFs fit the bill.

An argument against ETFs versus mutual funds is that transaction costs with ETFs could drag down returns, thereby negating any benefit from their lower expense ratios. This is a valid argument when frequent and small purchases are made, much like in 401(k) plans. However, because we are looking at large one-time rollovers, we think it would make sense for many of these investors to go the ETF route. Also, with income grinding to a halt (job cuts) or declining significantly (retirees), we doubt that unemployed or retired folks looking to roll over their accounts will be interested (or have the means) to consistently “drip” money into their accounts each month.

So who stands to benefit from this shift? The financial advisors at wirehouse firms such as  Morgan Stanley (MS) and Bank of America’s (BAC) Merrill Lynch and even do-it-yourself brokerages such as Charles Schwab (SCHW) and  TD Ameritrade (AMTD) are probably licking their chops. Financial advisors have been migrating more and more toward using asset-allocation models, and ETFs allow them to execute these strategies at a low cost. Advisors would also earn a small take on transaction costs because ETFs trade on an exchange just like stocks. Of course, we would caution investors against patronizing any financial advisor who trades excessively in order to generate fee income.

By: John Gabriel

Source: www.morningstar.com


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