ETFs as Investment Options in DC Plans CONSIDERATIONS FOR PLAN SPONSORS

PRICE PERSPECTIVE August 2017 In-depth analysis and insights to inform your decision-making. ETFs as Investment Options in DC Plans CONSIDERATIONS FOR PLAN SPONSORS EXECUTIVE SUMMARY The exchange-traded funds (ETFs) market has experienced increased demand and heavy new issuance over the past two decades. However, these investment vehicles have yet to penetrate the nearly $7.0 trillion defined contribution (DC) market in a meaningful way. 1 While ETFs offer benefits, many of these benefits are still difficult to realize in the context of today s retirement plans. Matthew Garrity CFA, CAIA, T. Rowe Price Defined Contribution Investment Specialist Looking ahead, the ETF market can be expected to evolve further. Plus new types of investment vehicles are already being developed, including actively managed vehicles that trade on exchanges, called exchange-traded managed funds (ETMFs). When considering the use of ETFs and any investment structures in an investment lineup, plan sponsors should weigh the benefits and risks in terms of how the vehicles may or may not help participants save and invest for retirement. Additionally, sponsors should consider the practical issues of offering ETFs and how the use may affect their fiduciary responsibilities and plan costs. TWO DECADES OF GROWTH AND STILL EVOLVING It s hard to believe that the ETF industry has been around for more than two decades. First launched in 1993 in the U.S., the ETF market has experienced explosive growth, with $1.8 trillion of the category s $2.5 trillion being issued in the past 10 years. 1 That s a growth rate of over 19% per year, compared with a growth rate of 4.60% for the U.S. mutual fund market over the same time period. 1 U.S. ETFs make up 73% of the global ETF landscape of $3.5 trillion. Although growing fast, the ETF market is still less than 20% of the estimated $16 trillion in U.S. mutual fund assets. 1 Individual ETFs, which total over 1,700, 1 are offered in a variety of asset classes, across nearly every equity market capitalization, sector, and industry. The category has seen the addition of currency- and commodity-focused ETFs for exposure to the commodity spot and futures markets, as well as leveraged ETFs for directional exposure (long or short the market). Some even offer multiples of exposure (two or three times the market). 2 More recently, actively managed ETFs have come to market. Although their popularity has been slow to take off since their initial introduction in 2008, many notable asset management firms are expected to enter this market. 1 Investment Company Institute, 2017 Investment Company Fact Book. 2 In the context of investments, leverage is the use of borrowed money (margin) or derivative instruments (options, futures, and forward contracts) to multiply exposure to investment assets.

The attributes driving the growth of the ETF market are prompting plan sponsors to take a look at how these investment vehicles might fit into their retirement plans. This paper examines each of the key attributes in the context of qualified plans. PRIMARY ETF ATTRIBUTES AND THEIR VALUE IN DC PLANS Potentially Lower Expense Ratios ETFs generally benefit from lower underlying operating costs. Unlike mutual funds that process shareholder transactions and bear the costs of recordkeeping shareholder information, ETFs can avoid these costs, as they are sold directly to investors via the market. Plan sponsors must consider how to provide and pay for recordkeeping services if ETFs are added to a plan. It is important to note that, on an assetweighted basis, average expense ratios for equity mutual funds have declined over the last 10 years, from 0.88% in 2006 to 0.63% in 2016, a decline of over 28%. Conversely, similar ETFs have seen a decline of a little more than 20%. 4 This has brought the margin of advantage for mainstream equity ETFs to a low level. However, one can find a wide range of expense ratios among more peripheral asset styles and classes. Additional transaction costs. While many ETFs feature lower costs than mutual funds in the form of expense ratios, these cost advantages could be offset by commissions paid to buy and sell ETF shares. Further, some low-volume ETFs trade at wide bid/ask spreads that negatively affect returns. ETF transaction costs pose unique problems in DC plans due to the incremental way in which participants typically purchase their investments via dollar cost averaging and dividend reinvestment. However, the DC industry is providing ways to mitigate the commission impact on participants. Dollar cost averaging: Typically, participants contribute to their plans each pay period over the period of their employment. This discipline has proven to be beneficial by spreading the cost basis over market cycles and by promoting consistent investing habits. Using ETFs to implement a dollar cost averaging strategy is less practical, given the transaction fees involved, especially for smaller dollar amounts. Although recordkeepers may be able to partially offset these costs by pooling assets and trading ETFs in larger blocks, these costs will remain a disadvantage versus mutual funds. Dividend reinvestment: Most DC plans offer mutual funds that allow for automatic dividend and capital gain reinvestment that occurs at the NAV price, with no added transaction cost or expenses. ETFs, however, would require recordkeepers to execute market orders, which would incur commission costs. To combat these added costs, many brokerage firms offer discounted or commission-free reinvestment programs for common stocks and ETFs. INTRADAY LIQUIDITY ETFs trade intraday in the secondary markets, on centralized stock exchanges (NYSE and AMEX), and on the Nasdaq market. They can be traded at current market prices, and limit and stop-loss orders can be used. While the intraday trading flexibility is attractive for short-term investors, DC plans are long-term investments. Intraday trading is not necessary and may even counter a plan sponsor s intentions to discourage participants from engaging in short-term speculation and markettiming activities. Although liquidity of ETFs is generally adequate, it is important to know that volume is primarily concentrated in a few of the largest ETFs. Many new ETFs have very low volume, resulting in wide bid/ask spreads, which can negatively affect performance. WHAT ARE ETFs? Exchange-traded funds (ETFs) are typically registered investment companies whose shares are publicly traded on stock exchanges and priced by the market. Today, ETFs hold stocks, bonds, commodities, currencies, derivatives, and even other ETFs. Although the market continues to be dominated by index-based ETFs that are designed to passively track a specific index or commodity, the SEC has granted exemptions for the creation of actively managed ETFs. An ETF is designed by a sponsor who develops the investment objective of the ETF. This entails choosing passive (index-based) or active management and selecting the representative benchmark index. The sponsor publishes a creation basket each day, which is a list of securities and weights that seek to replicate the underlying target portfolio. The ETF is created when an authorized participant, typically a large broker-dealer, deposits the securities composing the creation basket with the ETF. In turn, the authorized participant receives a creation unit, consisting of a specified amount of shares of the ETF. The authorized participant can then hold the ETF shares or sell them in the secondary market. It is in the secondary market (stock exchanges) where retail investors can buy and sell ETF shares. Broker-dealers and other arbitrageurs play an active role by trading in ETF shares and creating baskets, which have the effect of narrowing any 3 The Cost of Owning ETFs and Index Mutual Funds, Morningstar, based on data as of each fund s fiscal year 2013. 42017 ICI Fact Book 2

pricing differences between the ETF and the basket of the underlying securities. LEVERAGED AND INVERSE ETFS Leveraged and inverse ETFs are not designed for buy-and-hold investors who seek to track an index over a long period of time. Rather, they are intended for more aggressive, sophisticated investors who actively manage their investments on a daily basis. Due to the effect of compounding, the returns of leveraged and inverse ETFs can differ significantly, both positively and negatively, from those of their benchmark index, especially over longer investment periods. Although potential returns are increased by leveraging, so are the potential losses. It is important to keep in mind that leveraged and inverse ETFs typically use derivatives, some of which may involve the risk of losing more than the principal amount invested in the derivative. ACTIVELY MANAGED ETFS These ETFs are constructed to closely follow particular portfolios that are managed actively. In other words, the asset manager can make decisions to seek performance and risk parameters that may be different from the portfolio s benchmark (index), similar to how actively managed mutual funds differ from their benchmarks. A number of investment managers, including T. Rowe Price, have been approved to provide nontransparent, actively managed ETFs. TAX EFFICIENCY Most ETFs, like passively managed index mutual funds, tend to have lower capital gain distributions than actively managed funds. This is largely due to their low portfolio turnover and the benefit of not having to raise cash to meet redemptions like open-end mutual funds. However, DC plans are tax-deferred investment accounts. There is no added benefit from reducing capital gain distributions. HEDGING POTENTIAL ETFs can be sold short and purchased on margin, and many have options available on them. Buying on margin, selling short, and trading options are all forms of leverage. While some knowledgeable investors may benefit from such leverage, ETFs that are leveraged are subject to extreme volatility and are generally intended for short-term investors (as such, they may not be prudent investments for retirement accounts). TRANSPARENCY The SEC requires all ETF sponsors (those that create and administer them) to publish holdings on a daily basis, unlike mutual funds that report their holdings quarterly. However, in 2014, the SEC allowed exchange-traded managed funds (ETMFs) to disclose their holdings on a quarterly basis. While added transparency is generally perceived as a positive for investors, there are practical reasons why investors should not want their actively managed mutual funds or ETMFs to provide daily holdings to the public. Revealing holdings on a daily basis would provide open access to the active manager s portfolio decisions and may lead others to attempt to capitalize on the positioning, thus potentially harming the existing shareholders investments. Indeed, this is why some managers have requested permission to sell nontransparent, actively managed ETFs. The point is moot, however, for passive (index) strategies, as they replicate indices that publish their holdings on a real-time basis. VARIETY The first ETFs focused on passive replication of the U.S. large-cap equity markets. Now ETFs tracking nearly every sector of the global equity, bond, currency, and commodity markets are available. Leveraged ETFs, as noted earlier, are typically highly sensitive to market shifts and are often referred to as bull and bear funds. Many of the newer ETFs have proven attractive by providing the ability to gain targeted market exposures through vehicles that can be traded intraday. While these attributes are appealing, there are other issues that investors need to consider, particularly diversification and costs: Diversification. Sector- and regionspecific ETFs often feature outsized country and individual stock exposures. Take, for example, the ishares MSCI Taiwan Capped ETF with $2.7 billion in assets. (Reference is the ishares MSCI Taiwan Capped ETF 12/31/2016 Fact Sheet.) Even after recent changes were made at MSCI to limit single-stock exposure, one very large semiconductor stock represents over 22% of the ETF s total assets. This is a very large singlecompany exposure within an ETF that, on the surface, many investors would think is a diversified exposure to the Taiwanese equity market. Costs. This concern relates to the illiquidity and the resulting wider bid/ ask spreads associated with the more narrowly focused ETFs. Investors should focus on net returns, which include expense ratios, commissions, and, most importantly, the size of the bid/ask spread. Thinly traded ETFs, or those in which trading activity is limited, can be very costly for investors to trade into and out of. While providing more choices may be appealing in many respects, much of the variety offered by the ETF markets more narrowly focused 3

strategies does not fit well in the context of a DC plan that seeks to provide welldiversified, low-cost investment options. KEY PLAN SPONSOR CONCERNS When considering the addition of ETFs to DC plan lineups, one must weigh the advantages and disadvantages not only for participants but also for plan sponsors. Here are three key factors: Fiduciary risks. Sponsors considering the addition of ETFs to their DC lineups need to be aware of potential underlying portfolio risks and relative diversification. Further, many of the newer ETFs are still relatively untested in the marketplace, and plan fiduciaries should use caution in making wholesale shifts from established mutual funds to a full lineup of ETFs. This is especially important in light of the flash crash experienced on May 6, 2010, when several ETFs share prices plummeted far below their net asset values (NAVs). Many unfortunate investors who had stop-loss orders in place saw their shares sold at prices far below the stop price. Similarly, plan sponsors need to understand the implications of participants making panic sales from such products only to see the markets rebound as they did on May 6, 2010. This concern is heightened for ETF products that trade intraday. Total costs. For ETFs to gain traction in DC plans, they will need to prove that all the associated costs, including commissions and administrative expenses, truly make them the economical choice. Many mutual funds charge an expense ratio that covers both management and other fees for such items as recordkeeping and legal and accounting expenses. ETF expense ratios currently do not cover recordkeeping and administrative fees. This means plans may need to explore additional ways to cover these expenses if they are to include ETFs. Technology issues. Most recordkeeping systems are built specifically for mutual funds that are priced only daily and after the market close. Therefore, significant investment may be needed to build or update current systems to handle the intraday trading of ETFs. These added costs are yet another hurdle before ETFs gain a larger foothold in DC plans. CONCLUSION While ETFs have proven to be a viable investment option, they have not yet become a significant investment vehicle for DC plans. This is due largely to unique DC plan conditions that diminish the value of ETF attributes for participants and pose challenges for plan sponsors. However, interest in adding ETFs, to DC plans could increase as additional solutions, including actively managed ETFs and large-block buying, become available. Despite explosive growth of ETFs, generally, there is evidence that the pace may be slowing. Indeed, several ETF developers have been forced to shutter recent offerings due to lack of participation. Nonetheless, ETF assets continue to grow, and there is no doubt that ETF developers and marketers will seek new and fertile areas for asset growth. Call 1-800-225-5132 request a fact sheet, a prospectus, or, if available, a summary prospectus; each includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. 4

T. Rowe Price focuses on delivering investment management excellence that investors can rely on now and over the long term. To learn more, please visit troweprice.com. All investments involve risk, including possible loss of principal. T. Rowe Price Investment Services, Inc., distributor, T. Rowe Price mutual funds. This article has been prepared by T. Rowe Price Retirement Plan Services, Inc., for informational purposes only. This material does not provide fiduciary recommendations concerning investments or investment management. T. Rowe Price (including T. Rowe Price Group, Inc., its affiliates, and its associates) does not provide legal or tax advice. Any tax-related discussion contained in this article, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article. C1FX8HLLW 201706-188200 8/17