EXCHANGE-TRADED FUNDS

are the current rock stars of the investment world. Assets held in ETFs topped $330 billion by March 31, according to Citigroup, up from $16 billion in 1998. Considering the wider acceptance they're gaining among individual investors, it's not surprising that some firms are trying to push ETFs into the lucrative arena of 401(k) retirement plans, long the domain of mutual funds.

XTF Advisors and Avatar Advisors, both based in New York, are among those leading the charge. Earlier this month the pair launched competing 401(k) plans based strictly on ETFs. Founded in 2000, XTF began as a market maker for ETFs. Eight months ago it became one of the first firms to provide asset-allocation strategies using only ETFs. Avatar, just now jumping on the ETF bandwagon, has 36 years of experience in managing investment portfolios. The effort is in its infancy three companies have signed up with Avatar so far; none with XTF but an indication of the potential for ETF-only 401(k) plans is the involvement of Fidelity Investments. Perhaps in a bid to keep tabs on the ongoing evolution of ETFs, which compete directly with mutual funds, Fidelity has agreed to provide custodial services for both XTF and Avatar.

Mutual funds, especially index-based funds, dominate 401(k) plans because they epitomize the passive buy-and-hold philosophy most workers saving for retirement follow. Sock away pretax dollars at regular intervals, the logic goes, and build a nest egg through the power of compounding interest and the stock market's tendency to climb over the long haul. Yet it's this passive mentality that hinders the growth of assets in 401(k)s, according to Avatar and XTF.

Another problem with 401(k)s is a lack of professional investment advice. Employers, known as plan sponsors, like 401(k)s because they cost less than traditional pension plans. Instead of being responsible for managing and maintaining pension portfolios, employers shift the onus for asset allocation to employees, often to workers' detriment, according to Avatar and XTF. Many participants lack the knowledge to adequately manage a financial portfolio of retirement savings. In the end, many workers invest large portions of their portfolios in their own company stock, index mutual funds or perhaps the equity fund du jour with little regard for diversification. Many workers also fail to shift allocation for years even though market fundamentals have changed and holdings are out of balance.

"The retirement law says if a plan sponsor provides participants with an education they have met the requirements, and a lot of plan sponsors think they have discharged their fiduciary responsibilities by offering a full menu of options [without education]," says Ted Theodore, president of Avatar. "But a significant portion of participants are frozen at the switch. They have so many choices they are not actively maneuvering between them."

That's where ETFs, which are anything but passive, come in. Since they trade on exchanges just like stocks, ETFs can be bought and sold throughout the day. Mutual funds price just once daily. Avatar and XTF don't expect workers to spend their days charting ETFs, however. Rather, Avatar and XTF actively manage investments in 401(k) plans based on participants' individualized risk profiles. Using proprietary models they build so-called lifestyle funds, which are portfolios comprised of several ETFs that suit a particular risk level. Avatar offers five lifestyle funds ranging from very conservative to very aggressive. XTF is finalizing its offerings. So-called lifecycle funds are similar and based on plan participants' proximity to retirement. As workers gets older, lifecycle funds become more conservative.

Lifestyle and lifecycle funds aren't new. Many mutual-fund companies offer them. But they aren't actively managed like the ETF offerings from Avatar and XTF. Every quarter or every year, the mutual funds are mechanically rebalanced based on a preset asset-allocation ratio, with little concern for market conditions.

"Because we use ETFs we can be more precise in allocations to various sectors," says Daniel Carlson, managing director of New York-based Proctor Investment Managers, Avatar's strategic partner. "We can move in and out of sectors more quickly, gaining more flexibility from a management point of view."

Nor are Avatar and XTF the first companies to offer ETFs in 401(k) plans. Invest n Retire, a Portland, Ore., provider of retirement plans, has been doing this for more than a year. Invest n Retire offers asset-allocation portfolios that seek to hit specific monetary targets by retirement, but unlike Avatar and XTF it lets participants trade individual ETFs in the 401(k)s. The new guys say they cost less than funds because they work through a scalable platform called a collective trust. Collective trusts are similar to mutual funds, but they are maintained by a bank or trust, controlled by bank regulators instead of the Securities and Exchange Commission, and only available to retirement plans.

"Collective trusts provide a scalable structure and platform that can widely distribute the products to serve a wider range of clients," says Steve Ferber, executive vice president of AST Trust, a Phoenix company providing the collective trusts for Avatar and XTF. "By pooling money from different clients into a group of funds, we can buy in larger chunks, which can bring down transaction costs."

Fees for the Avatar and XTF plans range from 0.55% to 1.05%, compared with Invest n Retire, whose plans range from 0.80% to 1.10%. These fees include record keeping, administration, custodial services, portfolio management and an average expense ratio for the ETFs.

Despite the promise, don't expect ETFs to appear in your company's 401(k) plan anytime soon. A recent survey of retirement plan sponsors by Hewitt Associates, a human-resources consulting firm, found little demand for ETFs in the biggest corporate plans. Only 4% of the 227 large companies polled were interested in adding ETFs. Even Fidelity, which is providing back-office services to Avatar and XTF, expressed caution.

"Our plan sponsors have expressed limited demand for ETFs in their plans," says Fidelity spokeswoman Erika Soto. "And with index funds priced at a level often below comparable ETFs, mutual funds are the better investment vehicle to those who want index returns. It's a matter of cost-effectiveness."