Discussions of the relative merits of passive vs. active investing are ubiquitous these days and — so long as discussions thoughtfully add to the debate — we at the Investment Company Institute (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 Plan Sponsors from the CFA Institute Research Foundation, Jeffery Bailey, CFA, and Kurt Winkelmann focus on the plan sponsor’s role in managing defined contribution (DC) plans and provide much thoughtful information that plan sponsors may find useful.
But when it comes to the topic of 401(k) plan investment selection, they make conclusionary statements about actively managed funds that can only sow confusion among the plan sponsor community.
The authors contend that “[h]iring and firing actively managed funds imposes a significant management cost (the opportunity cost of time) on the committee.” They go on to state “that sponsors should adopt passively managed funds as the default choice for their plans” and “[a]bsent a strong belief that actively managed investment options are of value to plan participants, sponsors should make available only passively managed options.”
As we discuss in greater detail below, plan fiduciaries cannot ignore certain types of investments simply because their selection 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, like index mutual funds, can be excellent investments. And the Employee Retirement Income Security Act (ERISA) requires plan fiduciaries to act solely in the interests of the plan’s participants and beneficiaries when selecting investments for a 401(k) plan. ERISA offers no caveat for decisions that might make the fiduciaries’ jobs easier.
In its regulation on when plan fiduciaries can avoid liability for participant investment decisions, the Department of Labor (DOL) explains that fiduciaries intending coverage under the regulation’s protections should offer a set of investment alternatives that, in the aggregate, enable participants to “construct a portfolio with risk and return characteristics appropriate to their circumstances.” For this reason, plan fiduciaries feel obligated to present a broad range of investment alternatives to plan participants.
Plan sponsors consider multiple factors in selecting investment lineups for their 401(k) plans. These go beyond simple questions of cost and selection difficulty. Below we examine several factors that demonstrate why actively managed funds can serve plan participants well and why the suggestion that plan sponsors should rule them out is misguided. Of course, this analysis is far from exhaustive. Actively managed funds may make useful additions to DC plan investment lineups for many other reasons. But these alone prove that generalizations about actively managed funds’ lack of utility in DC plans should be viewed with skepticism.
Plan sponsors will generally consider net returns — not solely cost — in selecting investments.
Net returns mean the total return minus any fees and expenses associated with the investment. Take, for example, the 10 largest actively managed funds and the 10 largest index funds. The table below shows that actively managed funds have had three-, five-, and 10-year annualized net returns that are nearly identical to those of the 10 largest index funds.
Average Returns of the 10 Largest Actively Managed and Index Mutual Funds, As of July 2021
|Number of Funds||Three-Year||Five-year||10-year|
Note: Average returns are annualized and measured as simple averages.
Source: ICI tabulations of Morningstar data
These figures may not represent what investors may 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 wish to select from among a range of actively managed funds and index funds.
Indeed, John Rekenthaler referenced Defined Contribution Plans to demonstrate the dangers of focusing solely on fund cost rather than net returns. After analyzing the net returns of several large 2030 target date funds (TDFs), Rekenthaler — showing a high degree of humility — conceded that he had earlier overstated the case for indexing in 401(k) plans.
Second, it is widely understood by plan sponsors that index funds track market indexes — a factor that may influence return variability.
The following chart compares the return variability of the same 10 largest actively managed mutual funds and 10 largest index mutual funds. Measured as the standard deviation of monthly returns over three-, five-, or 10-year periods, return variability has been a bit lower for the actively managed funds.
Average Return Variability of the 10 Largest Actively Managed and Index Mutual Funds, As of July 2021
|Number of Funds||Three-Year||Five-Year||10-Year|
Note: Average standard deviations are measured as simple averages.
Source: ICI tabulations of Morningstar data
This type of risk, the variability of returns, is another factor that plan fiduciaries may consider in choosing plan investment menus. They may reasonably assume that, all else being equal, some plan participants will prefer investments with less market variability.
There are few if any index mutual funds in certain investment categories.
World allocation funds, high-yield bond funds, world bond funds, small-cap growth stocks, and diversified emerging market stocks have very few index funds from which to choose. Thus at least 75% of the assets in these categories are in actively managed funds.
If they want to include such investments in plan menus, plan fiduciaries will generally need to consider actively managed funds.
Moreover, certain investment categories benefit from active management. For example, the kind of value investing pursued by Warren Buffett is at its core a strategy of active management. And target date mutual funds, which represent $1.1 trillion in assets in DC plans, including 401(k) plans, are arguably all actively managed: Each fund must select and manage its assets to a “glidepath.” To be sure, some TDFs invest predominantly in underlying index funds, others in underlying active funds or a mix of active and index funds. That’s why simplistic categorizations of funds should be avoided, especially when weighing in on their appropriateness for 401(k)s. Investments in index and actively managed mutual funds can complement one another.
Including actively managed options gives participants greater choice. This can help build the portfolio that best reflects their individual circumstances, whether it’s their degree of risk aversion, their desire to manage their own portfolio, their closeness to retirement, or some other factor.
The portfolios of index and actively managed funds can and do vary substantially from one another and have different risk/return profiles. A participant may achieve higher long-term returns at lower risk by investing in a mix of index and actively managed funds. An employee of a Fortune 500 firm who holds considerable company stock, for example, could benefit from diversifying away from funds that invest in large-cap stocks, say, for example, S&P 500 index funds.
The calculus of choosing an appropriate menu of investment options for a 401(k) plan — whether index or actively managed — requires more than a generalized view of performance versus cost. Plan fiduciaries 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 that plan participants have the ability to structure a retirement portfolio that meets their needs and goals. Screening out actively managed funds is simply inconsistent with ERISA’s fiduciary tenets 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, make the case that passive funds generally lag their actively managed peers following periods of market turmoil and that, since 2019, the environment has been favorable for active management. They also observe that market inefficiencies that result as more stocks are held by passive investors create greater opportunities for active investors who are better able to weed out mis-priced stocks.
We mention this article and its conclusions not to suggest that active management is better than passive investment, but rather to show that there exist varying and sometimes contradictory opinions on the topic and that plan sponsors may rationally and appropriately select for a plan’s investment menu a mix of active and index funds. Broad generalizations that plan sponsors should avoid actively managed funds 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, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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