Discussions of the relative merits of passive investing versus active investing are ubiquitous these days and – as long as the discussions are thoughtfully added to the debate – we at the Institute of Investment Companies (ICI) rarely feel compelled to offer a critical response.
But some publications force us to speak up.
In Defined Contribution Plans: Challenges and Opportunities for the Plan Sponsors of CFA Institute Research FoundationJeffery Bailey, CFA, and Kurt Winkelmann focus on the plan sponsor’s role in managing defined contribution (DC) plans and provide lots of helpful information that plan sponsors may find useful.
But when it comes to the topic of investment selection in 401(k) plans, they make conclusive statements about actively managed funds that can only confuse the plan sponsor community.
The authors state that “(h)iring and firing actively managed funds imposes a significant management cost (the opportunity cost of time) on the board.” They go on to state “that sponsors should adopt passively managed funds as the default choice for their plans” and “(a) in the absence of a strong belief that actively managed investment options are useful to plan participants, sponsors should only offer passively managed options.”
As we will discuss in more detail below, plan trustees cannot ignore certain types of investments simply because selecting them might require more effort. Moreover, the critical decision making inherent in choosing investments for 401(k) plans is much more complex than Bailey and Winkelmann suggest.
Actively managed mutual funds, such as index mutual funds, can be great investments. And the Employees Retirement Income Security Act (ERISA) requires plan trustees to act solely in the best interests of plan participants and beneficiaries when selecting investments for a 401(k) plan. ERISA offers no caveats for decisions that might make the work of trustees easier.
In its rule on when plan trustees can avoid liability for participants’ investment decisions, the Department of Labor (DOL) explains that trustees wishing to be covered by the rule’s protections should offer a set of alternatives. of investment which, taken as a whole, allow the participants to “build a portfolio with risk and return characteristics appropriate to their situation.” For this reason, plan trustees feel compelled to present a wide range of investment alternatives to plan participants.
Plan sponsors consider several factors when selecting investment lines for their 401(k) plans. These go beyond simple questions of cost and difficulty of selection. Below we look at several factors that demonstrate why actively managed funds can serve plan members well and why the suggestion that plan sponsors should exclude them is misguided. Of course, this analysis is far from exhaustive. Actively managed funds can be useful additions to DC plan investment lines for many other reasons. But these alone prove that generalizations about the lack of usefulness of actively managed funds in DC plans should be viewed with skepticism.
Plan sponsors typically consider net returns — not just costs — when choosing investments.
Net returns are the total return minus the fees and expenses associated with the investment. Take, for example, the 10 largest actively managed funds and the 10 largest index funds. The chart below shows that actively managed funds have had three-, five-, and 10-year annualized net returns that are almost identical to those of the top 10 index funds.
Average returns of the top 10 actively managed and index mutual funds, as of July 2021
|Number of funds
Note: Average returns are annualized and measured as simple averages.
Source: Tables HERE from Morningstar data
These figures may not represent what investors can expect in the future and therefore do not suggest that plan sponsors should prefer one type of mutual fund over another. But they do imply that 401(k) plan participants may want to choose from a range of actively managed funds and index funds.
Indeed, John Rekenthaler referred Defined contribution plans demonstrate the dangers of focusing solely on the cost of the fund rather than the net returns. After analyzing the net returns of several large funds maturing in 2030 (TDF), Rekenthaler – showing great humility – admitted that he had earlier overstated the case for indexing in 401(k) plans.
Second, plan sponsors generally understand that index funds track market indexes — a factor that can affect performance variability.
The following table compares the performance variability of the same 10 largest actively managed mutual funds and the 10 largest index mutual funds. Measured as the standard deviation of monthly returns over three-, five-, or ten-year periods, return variability has been somewhat lower for actively managed funds.
Variability in the average return of the 10 largest actively managed and index-tracking mutual funds, as of July 2021
|Number of funds
Note: Mean standard deviations are measured as simple means.
Source: Tables HERE from Morningstar data
This type of risk, the variability of returns, is another factor that plan trustees may consider when choosing the plan’s investment menus. They can reasonably assume that, all things being equal, some plan participants will prefer investments with less market variability.
There are few or no index mutual funds in certain investment categories.
Global allocation funds, high yield bond funds, global bond funds, small cap growth stocks and diversified emerging market stocks have very few index funds to choose from. Thus, at least 75% of the assets of these categories are in actively managed funds.
If they wish to include such investments on plan menus, plan trustees will generally need to consider actively managed funds.
In addition, certain investment categories benefit from active management. For example, the type of value investing pursued by Warren Buffett is central to an active management strategy. And target date mutual funds, representing $1.1 trillion in DC plan assetsincluding 401(k) plans, are arguably all actively managed: each fund must select and manage its assets according to a “glide path”. Admittedly, some TDFs invest primarily in underlying index funds, others in underlying active funds or a combination of active and index funds. This is why simplistic categorizations of funds should be avoided, especially when determining their suitability for 401(k). Investments in index funds and actively managed mutual funds can complement each other.
The inclusion of actively managed options gives participants greater choice. This can help build the portfolio that best reflects their personal circumstances, whether it’s their level of risk aversion, their desire to manage their own portfolio, their proximity to retirement, or any other factor. .
Portfolios of index and actively managed funds can vary significantly from each other and have different risk/return profiles. A participant can achieve higher long-term returns with lower risk by investing in a combination of index funds and actively managed funds. An employee of a Fortune 500 company who owns sizable stocks, for example, could benefit from diversifying funds that invest in large-cap stocks, for example, the S&P 500 index funds.
The math of choosing an appropriate menu of investment options for a 401(k) plan — whether index-linked or actively managed — requires more than a generalized view of performance versus cost. Plan trustees balance a host of other considerations to accommodate the variety of participants and beneficiaries a plan serves..
Urging plan sponsors to avoid actively managed funds shows a lack of understanding of the legitimate role these funds play in ensuring plan members have the ability to structure a retirement portfolio that meets their needs and goals. Screening actively managed funds is simply incompatible with the fiduciary principles of ERISA and the critical decision-making inherent in choosing investments for 401(k) plans.
Finally, in “Active equity: “reports of my death are greatly exaggerated”C. Thomas Howard and Jason Voss, CFA, say passive funds generally lag their actively managed counterparts after periods of market turmoil and since 2019 the environment has been positive for active management . They also observe that market inefficiencies that result from more stocks being held by passive investors create greater opportunities for active investors who are better able to weed out poorly priced stocks.
We mention this article and its findings not to suggest that active management is better than passive investing, but rather to show that there are diverse and sometimes conflicting opinions on the subject and that plan sponsors can choose rational and appropriate for a plan’s investment menu a mix of active and index funds. Broad generalizations that plan sponsors should avoid when funds are actively managed do a disservice to the plan sponsor community.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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