Last Updated: July 27, 2009
Don't be surprised if the mix of investments in your employer-sponsored retirement plan start to change this year. According to Hewitt Associates, nearly one in five employers plan to replace at least one of the actively managed mutual funds in your plan with index funds, exchange-traded funds (ETFs) or other some other low-cost investment.
There's plenty of appeal to low-cost investments such as ETFs, but before you start investing in such funds you should do some diligence, according to FPA member, Ed Green, CFP®, ChFC, AIF®, of Foster Group, Inc. "We believe ETFs can serve a purpose in investors' portfolios when used properly," said Green. "They are somewhat like power tools; in the hands of someone who's taken the time to understand how they work and when to use them, they can be very useful and effective. In the hands of someone unfamiliar with them, they have the possibility of doing damage."
So, what are index funds and ETFs? According to the Investment Company Institute (ICI), "ETFs are a relatively recent innovation to the investment company concept." First introduced in 1998, these investments typically track the performance of a designated index such as the S&P 500 index. But ETFs, which are publicly traded securities, are also actively managed ETFs as well. Learn more about ETFs from ICI's 2009 Investment Company Fact Book.
Meanwhile, index funds are open-end mutual funds that — like ETFs — track the performance of an index. The big difference between the two types of investments, according to the ICI is this: "One major difference is that retail investors buy and sell ETF shares on a stock exchange through a broker-dealer, much like they would with any other type of stock. In contrast, mutual fund shares are not listed on stock exchanges."
Besides knowing what you are buying, Green suggests that you do the following if offered the chance to invest in ETFs in your 401(k) plan:
Understand that ETFs are simply a "structure"; they are not inherently better, or worse, than mutual funds.
Using ETFs vs. mutual funds does not negate basic rules of investing such as:
- Investing regularly without respect to whether you think the market is headed up or down.
- Maintain a pre-determined asset mix to which you periodically rebalance — or, an investment policy statement. An investment policy statement, according to FPA Press' Creating an Investment Policy Statement, written by FPA member Norm Boone, CFP®, is a document crafted for a specific investor. It is a statement of the investor's investment philosophy and investment goals, while also establishing the investment management procedures." It serves four basic purposes, according to Boone's book: setting objectives; defining the asset allocation policy; establishing management procedures; and determining communication procedures.
- Remember that costs matter in the long run — all other factors being equal, choose the lower-cost alternative.
- Maintain as broadly a diversified portfolio as your plan allows — don't speculate on which sector or country you think may do better next month or next year.
- Don't use investment vehicles you don't understand.