The discussion of the relative merits of passive vs. active investment is ubiquitous nowadays and – as far as discussions add thought to judgment – at the Investment Companies Institute (ICI) we rarely feel compelled to respond critically.
But some publications force us to speak up.
Inside Defined Contribution Plan: Challenges and opportunities for planning Sponsor From the CFA Institute Research Foundation, Jeffrey Bailey, CFA, and Kurt Winkelman focus on the role of plan sponsors in defining contribution (DC) plan management and provide a lot of thought-provoking information that plan sponsors can use.
But when it comes to 401 (k) plan investment selection, they make decisive statements about actively managed funds that can only sow confusion in the plan sponsor community.
The authors claim that “[h]Imposes a significant management cost (time opportunity cost) on actively managed funds and the firing committee. They say that “sponsors’ passively managed funds should be taken as the default choice for their plans” and “[a]While there is a strong belief that actively managed investment options are valuable for participants to plan, sponsors should only provide passively managed options.
As we discuss in more detail below, plan trustees cannot ignore certain types of investments because more effort may be required to select them. Moreover, the underlying critical decision in choosing an investment for a 401 (k) plan is much more complex than the advice of Bailey and Winkelman.
Actively managed mutual funds, such as index mutual funds, can be excellent investments. And Employees Retirement Income Protection Act (ERISA) 401 (k) requires plan trustees to act in the best interests of plan participants and beneficiaries when selecting investments for the plan. Irisa warns of a decision that could make it easier for believers.
To control when the plan may avoid liability for believing participants to make investment decisions, the Department of Labor (DOL) explains that under the protection of controls, trust seekers seeking coverage should be given a set of investment options that, overall, enable participants to build a “portfolio” appropriate to their situation. Including risk and return features. “For this reason, plan trustees feel compelled to present a broad investment option to plan participants.
Plan sponsors consider multiple factors when selecting an investment lineup for their 401 (k) plan. The cost and difficulty of selection go beyond simple questions. Below we examine a number of factors that show why actively managed funds can serve plan participants well and why plan sponsors should dismiss them as advice is misguided. Of course, this analysis is far from complete. Actively managed funds can make useful additions to the DC Plan investment lineup for many other reasons. But these alone prove that generalizations about the lack of utility in the DC planning of actively managed funds should be viewed with suspicion.
Plan sponsors will usually consider a net return on investment – not just the cost –
Net return means any fees and costs associated with subtracting the total return. Take, for example, the 10 largest actively managed funds and the 10 largest index funds. The table below shows that actively managed funds have three, five- and 10-year annual net returns that are almost identical to the 10 largest index funds.
Average returns of 10 actively managed and indexed mutual funds as of July 2021
|Number of funds||Three years||Five years||10 years|
Note: Average income is measured as annual and simple average.
Source: Morningstar Data ICI Tabulation
These figures do not represent what investors might expect in the future and, therefore, do not suggest that plan sponsors should prefer one type of mutual fund over another. But they imply that participants in the 401 (k) plan may be willing to choose between actively managed funds and index funds.
Indeed, John Reckenthaler mentioned Defined contribution plan Demonstrating the danger of focusing only on fund costs instead of net returns. After analyzing the net returns of many large 2030 Target Debt Funds (TDFs), Reckenthaler – showing a high degree of humility – admits that he had previously exaggerated indexing in the 401 (k) plan.
Second, it is widely understood by plan sponsors that index funds track market indexes – a factor that can affect return variability.
The following chart compares the return variability of the same 10 largest actively managed mutual funds and the 10 largest index mutual funds. As the value of monthly returns is measured as deviations over a period of three, five, or 10 years, the return variability for actively managed funds has been somewhat reduced.
Average return variability of 10 actively managed and index mutual funds as of July 2021
|Number of funds||Three years||Five years||10 years|
Note: Average value deviations are measured as general averages.
Source: Morningstar Data ICI Tabulation
This kind of risk, variability of return, plan is another matter for the trustees to plan when choosing investment menus. They can reasonably assume that, like all others, some plan participants will prefer to invest with less market volatility.
There are some if there is an index mutual fund in a particular investment category.
There are very few index funds to choose from, including World Allocated Funds, High Yield Bond Funds, World Bond Funds, Small-Cap Growth Stocks, and Diversified Emerging Market Stocks. So at least 75% of the resources of these departments are in actively managed funds.
If they want to include such investments in the plan menu, plan believers usually need to consider actively managed funds.
Furthermore, some investment departments benefit from active management. For example, the type of value that is invested by Warren Buffett is the key to active management strategies. And Target Debt Mutual Fund, which represents $ 1.1 trillion in DC plans, of which 401 (k) plans are reasonable. All Actively managed: Each fund must select and manage its resources for the “glidepath”. To be sure, some TDFs invest primarily in indexing index funds, others in underlying active funds or a mixture of active and index funds. This is why simple classification of funds should be avoided, especially when relying on their appropriateness for 401 (k) seconds. Investing in index and actively managed mutual funds can complement each other.
Gives participants a wider choice with actively managed options. It can help create a portfolio that best reflects their personal situation, be it their level of risk, willingness to manage their own portfolio, closeness to retirement or any other reason.
The portfolios of index and actively managed funds may vary significantly from one another and may have different risk / return profiles. A participant can achieve higher long-term returns at lower risk by investing in a combination of index and actively managed funds. An employee of a Fortune 500 firm who holds a significant number of company stocks may benefit from diversification from investor funds in large-cap stocks, for example, the S&P 500 Index Fund.
The calculation of choosing a suitable menu of investment options for a 401 (k) plan – whether indexed or actively managed – requires more than performance vs. cost generalization. Plan trustees balance a host of other considerations with different combinations to serve a plan to participants and beneficiaries.
Requesting plan sponsors to avoid actively managed funds shows a lack of understanding of the legitimate role these funds play so that plan participants have the ability to build a leisure portfolio that meets their needs and goals. Screening of actively managed funds is simply inconsistent with ERISA’s trustworthy policy and the underlying important decision to select investment for the 401 (k) plan.
Finally, “Active Equity: ‘My Death Reports Are Exaggerated’,” c. Thomas Howard and Jason Voss, CFA, create the fact that passive funds have generally become an environment conducive to active management, following the market volatility of their actively managed peers and since 2019. They further observe that market inefficiencies as more stocks are held by passive investors create greater opportunities for active investors who are able to deactivate stocks at the wrong price.
We do not refer to this article and its conclusions that active management is better than passive investing, but rather to show that there are different and sometimes conflicting opinions on the subject and that plan sponsors can reasonably and appropriately choose a mix for a plan investment menu. Funding. Extensive generalizations planned by sponsors should avoid actively managed funds to the detriment of the planning sponsor community.
If you liked this post, be sure to subscribe Entrepreneurial investors.
All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
Photo Credit: © Getty Images / DNY59
Professional education for CFA Institute members
Members of the CFA Institute have the ability to earn self-assessment and self-reporting professional education (PL) credit, including content Entrepreneurial investors. Members can easily record credit using their online PL tracker.