Charles Schwab Corp., is looking to dramatically increase its share of the 401(k) retirement plan market using an innovative and "disruptive" strategy that's centered around exchange-traded funds.  Beginning this fall, it will offer 401(k) retirement plans stuffed solely with ETF's, and let investors trade them without charge.  Schwab, a relatively small player in 401(k)s, sees ETFs as a way to edge closer to the giants like Fidelity Investments, Aon Corp.'s Aon Hewitt and the Vanguard Group.

Many 401(k)s, particularly those offered by Vanguard, already offer a thick menu of low-cost index mutual funds.  But "moving to an ETF-based 401(k) program is something new and certainly could have profound impacts for the asset-management industry," says UBS Securities analyst Alex Kramm.  Schwab's main targets would be companies where 401(k) plans consist largely of actively managed mutual funds - that typically incur 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.

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 nearly $1 trillion in assets, up from $66 billion a decade ago.  Still, ETFs have yet to make a dent in employer-sponsored 401(k) accounts, a nearly $3 trillion market.

Critics and Skeptics.   Critics counter by saying that ETF offerings are likely to generate a lot of resistance from 401(k) sponsors.  ETFs, for example can be more volatile than regular mutual funds - e.g., during last year's "Flash Crash" of May 6, some ETFs briefly plummeted to near zero before roaring back moments later.

A second factor is that ETFs tend to encourage rapid-fire trading, because they're traded throughout the day, subjecting investors to unnecessary volatility.  Mutual funds, however, are priced once a day - at the close of the market. 

A third concern is that some ETFs can stray from their benchmark indexes.  For example, right after the March earthquakes in Japan, 3 U.S.-sold ETFs that broadly track the Japanese stock market all recorded losses even as the indexes they mirror rose. 

Finally, 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.

"Betting it all."    Mike Alfred, co-founder and CEO of BrightScope, an independent rater of 401(k) plans, said Schwab " 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."  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., 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.

"For a long time, people haven't been able to figure out the ETF and 401(k) mix.  I think we're the one company who is entrenched in the industry today who has a motivation to do so."  -- Schwab CEO Walter Bettinger.

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.   [WSJ Online, 5/31/11]