Whether you’re a plan sponsor evaluating your 401k or an employee trying to figure out what investment options (mutual funds) you should select, there are numerous sources that state one of the primary criteria for evaluating a 401k are the actual costs of the plan and each of the investment option choices. For plan participants the two major costs are the investment option expenses and the cost of the investment advisor, if there is one on the plan. This post will focus on the investment option choices’ expenses which can amount anywhere from as low as 15% to as much as 80% (if there is no advisor on the plan) or more of the total costs to plan participants.
There is no shortage of opinions on what expenses are reasonable when it comes to investment options. This focus has a lot of studies to back up the premise that excessive investment costs can severely impact long term performance of a participant’s retirement account. Perhaps the largest proponent of low cost funds is the Vanguard Group, the largest provider of index funds in the industry. In Vanguard’s Principles for investing success, principle number three (of four) covers the effects of cost on investment performance.
Essentially, the principle asserts that the average investor will earn the same returns of the market over the long run. In other words, all things being equal it is extremely difficult for the active investor (someone who picks individual stocks) to outperform the market in the long run. Certainly, there will be some years where an active investor outperforms the market, but over the long run there will also be years where this same investor will underperform the market, in affect canceling out the the years he did better than the market. As a result, these studies conclude that since the average investor will earn the market return, the one variable the investor can control is cost. The lower the cost the higher the performance.
This assertion though does not explain the performance of legendary investors like Warren Buffet, Peter Lynch and Sir John Templeton to name a few. These active “stockpickers” have been able to outperform the market over the long run. Does this mean the studies done by so many sources are wrong? Not necessarily – in fact the majority of the time those studies are correct. More specifically, the majority of actively managed funds do not outperform the market. Indeed, another legendary investor George Soros, asserted that “most money managers (90%) on Wall Street should find another job” in his book “The Alchemy of Finance”.
However, a study conducted by researchers at Yale University and Notre Dame University, “How Active is Your Fund Manager? A New Measure That Predicts Performance” concluded that a great many active managers underperform the market because they essentially mimic their respective benchmarks, the S&P 500 for example. In industry jargon this approach is referred to as “closet indexing” – essentially a manager chooses industry weightings and securities very similar to their index, resulting in performance close to their benchmark. Because these funds are classified as “actively managed”, with their expenses ranging from .7% to 1.5% or more, they tend to underperform their passively managed fund counterparts due to their ultra low fees ranging from .05% to .2%. They took these funds out of their study in order to get a more accurate assessment of how true active managers did against their benchmarks.
The study found that:
- Funds with the highest “Active Share”, which they defined as funds where 80-100% of the holdings significantly differed from their indices beat their benchmarks by 2 to 2.7% before expenses and 1.5 to 1.6% after expenses. Over the long term this added performance can have a significant impact on assets accumulated at retirement.
- Those funds with the least “Active Share”, (0-20%) matched their benchmarks before expenses and underperformed the indices by -1.4 to -1.8% after expenses and fees.
- The study’s data set (from 1980 to 2003) further found that funds with high Active Share were nearly 80% of the funds in the study in 1980 vs. 53% having the same Active Share in 2003, indicating a clear migration towards “closet indexing”.
So, what does this all mean to you?
- The argument by some plan providers and financial advisors regarding, in their opinion, investment expenses playing the only role in determining performance, is in fact an argument regarding the effectiveness of utilizing active money managers with higher expenses vs. utilizing a passive index funds with lower expenses.
- While a great many “actively” managed funds underperform their benchmarks, further studies reveal that true active management has better odds of outperforming its benchmark then some would have you believe.
- Index funds do in fact yield performance roughly equal to the actual indices. However, these funds also carry all of the volatility of those same indices which has a direct impact on absolute performance (the actual account values at retirement). I will cover why minimizing volatility is important in a future post.
- Careful selection of active funds with a focus on portfolio composition, the management process and expenses by an advisor can often yield as good and in some cases better performance than low cost index funds.
Finally and most importantly, no matter which camp you’re in, if you have a plan provider with an open fund selection, there is no rule saying you can’t include both passive and active choices in your 401k or profit sharing plan. Those participants who chose passive funds would keep the lower expenses even though their plan carried both active and passive fund choices. In either case, I would argue that having a capable, available and active Investment Advisor to not only assist in the design, monitoring and updating the plan, but also help participants in choosing investments appropriate to their goals and risk tolerance is key in having a successful 401k or profit sharing plan. I will cover pros and cons of having an Investment Advisor as well as what factors you should consider when selecting an advisor for your 401k in my next post.
Lastly, if you’re a plan sponsor or administrator, talk with your plan provider or advisor on the plan regarding your current approach and whether or not some changes are appropriate. Likewise if you’re the participant and you’re unhappy with the investment choices, talk with your administrator about your concerns. Individual Fund choices that are not doing the job can be replaced if they are not delivering the performance you expect! As always, comments and questions are appreciated and encouraged.