Jim McCool, Charles Schwab Corp.'s (NYSE: SCHW - News) executive vice president of institutional business, made waves at an asset-management conference in March when he announced that the brokerage firm soon would offer 401(k) retirement plans stuffed solely with exchange-traded mutual funds—and let investors trade them without charge.
"You could tell the rest of the room was nervous about it," says Mike Alfred, co-founder and chief executive of BrightScope Inc., an independent rater of 401(k) plans, who heard the comments. "The idea is disruptive."
ETFs, which typically carry low fees and trade like stocks on exchanges, have exploded in popularity, a rare source of growth in the otherwise stagnant mutual-fund industry. ETFs now hold a total of $997 billion in assets, up from $65.6 billion a decade ago. Still, ETFs have yet to make a dent in employer-sponsored 401(k) accounts, a $2.8 trillion market.
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Schwab, just a bit player in 401(k)s now, sees ETFs as a way to edge closer to giants such as Fidelity Investments, Aon Corp.'s Aon Hewitt and Vanguard Group. According to consulting firm Cerulli Associates, those three had a combined market share of about 43% in 2009, the latest year for which data are available.
Schwab doesn't disclose publicly how much of its $4.2 billion in annual revenue comes from the 401(k) business. Cerulli ranks the San Francisco company 10th by assets, at $72.5 billion.
Many 401(k)s, particularly those offered by Vanguard, already offer a thick menu of low-cost index mutual funds. So Schwab's main targets are companies where 401(k) plans consist largely of actively managed mutual funds. Such funds charge higher fees than index funds or ETFs.
Adding ETFs to 401(k) plans could put more pressure on actively managed fees, a trend that began with the introduction of index funds in the 1970s.
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"Moving to an ETF-based 401(k) program is something new and certainly could have profound impacts for the asset-management industry," says Alex Kramm, an analyst with UBS Securities.
ETF critics say the offerings can be more volatile than regular mutual funds, as seen in last year's May 6 "flash crash," when some ETFs briefly plummeted to near zero, only to roar back moments later. And because ETFs can be bought and sold at any time in the trading day, rather than just once a day like regular mutual funds, ETFs tend to encourage rapid-fire trading, critics say.
The volatility and heavy trading have caused some ETFs to stray from their benchmark indexes. For example, in the days after the March earthquakes in Japan, three U.S.-sold ETFs that broadly track the Japanese stock market all recorded losses even as the indexes they mirror rose.
Skeptics warn that active trading of ETFs in 401(k)s could subject investors to unnecessary volatility. "There will be a lot of resistance," Mr. Kramm says.
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By opening ETFs to so many investors, critics say, Schwab's plan could leave the market more vulnerable to these forces. It also could eat into Schwab's core retail-brokerage arm, which holds the bulk of the firm's $1.65 trillion in client assets.
"Schwab is betting it all," says Mr. Alfred of BrightScope. "They could cannibalize their own business. Compared to other players, they're a chipmunk among gorillas. The question is whether they're going to be a chipmunk that is growing."
"For a long time, people haven't been able to figure out the ETF and 401(k) mix," says Schwab Chief Executive Walter Bettinger. "I think we're the one company who is entrenched in the industry today who has a motivation to do so."
Rival TD Ameritrade Holding Corp. began offering ETFs in April to plan sponsors and 401(k) participants alongside standard mutual funds. Fidelity last year began offering some commission-free ETF trades in an effort to build up its brokerage operations.
To allay concerns about ETF risks, Schwab plans to provide investors with access to financial advice. The company also will let plan sponsors offer a menu consisting solely of index funds. Schwab officials are discussing, among other options, a partnership with Financial Engines Inc. (NASDAQ: FNGN - News), a provider of retirement advice launched by Nobel Laureate William Sharpe that would provide Financial Engines' advice to Schwab customers, according to people familiar with the matter.
Mr. McCool says the advice will buffer aggressive trading, adding that investors will appreciate the transparency of seeing an ETF's holdings at any given moment.
While some ETFs are sophisticated products geared toward active or professional investors, Schwab says it will stick to plain-vanilla index ETFs, including domestic and international stocks and bonds.
The company will offer ETFs issued by Schwab and other firms. Schwab is a small issuer of ETFs, with about $4.2 billion in assets, or less than 1% of the market, according to a report from BlackRock Inc., the largest ETF provider.
Schwab, of San Francisco, expects to begin meeting with plan sponsors this fall.
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