Discussions about the relative merits of passive versus active investing are ubiquitous these days, and whenever the discussions add to the debate, at the Investment Company Institute (ICI) we rarely feel compelled to offer a critical response.
But some posts force us to talk.
In Defined contribution plans: challenges and opportunities of the 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 a lot of thoughtful information that plan sponsors may find useful.
But when it comes to the topic of 401(k) plan investment selection, they make sweeping statements about actively managed funds that can only sow confusion among the plan sponsor community.
The authors state that “[h]Taking out 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 option for their plans” and “[a]If we strongly believe that actively managed investment options are of value to plan participants, sponsors should only make passively managed options available.
As we discuss in more detail below, plan fiduciaries cannot ignore certain types of investments simply because their selection may 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 excellent investments. And the Employee Retirement Income Security Act (ERISA) requires plan fiduciaries to act solely in the best interests of plan participants and beneficiaries when selecting investments for a 401(k) plan. ERISA provides no caveats for decisions that might make fiduciaries’ jobs easier.
In its regulation on when plan fiduciaries can avoid liability for participants’ investment decisions, the Department of Labor (DOL) explains that fiduciaries seeking coverage under the regulation’s protections should provide a set of investment alternatives that, as a whole, allow participants to “build a portfolio with risk and return characteristics appropriate to their circumstances.” For this reason, plan fiduciaries feel obligated 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. Next, we examine several factors that demonstrate why actively managed funds can serve plan participants well, and why the suggestion that plan sponsors dismiss them is misguided. Of course, this analysis is far from exhaustive. Actively managed funds can make useful additions to DC plan investment lines for many other reasons. But this alone shows that generalizations about the lack of utility of actively managed funds in DC plans should be viewed with skepticism.
Plan sponsors will generally consider net returns, not just costs, when selecting investments.
Net returns mean the total return minus 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 ten-year annualized net returns that are nearly identical to the 10 largest index funds.
Average returns of the 10 largest index and actively managed mutual funds, as of July 2021
| Number of funds | three years | five years | 10 years | |
| Actively managed | 10 | 14.6% | 14.5% | 12.8% |
| index | 10 | 14.7% | 14.2% | 12.6% |
Note: Average returns are analyzed and measured as simple averages.
Source: ICI tabulations of Morningstar data
These figures may not represent what investors can expect in the future and therefore do not suggest that plan sponsors prefer one type of mutual fund over another. But they do imply that 401(k) plan participants may wish to select from a range of actively managed funds and index funds.
He actually referenced John Rekenthaler 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 target-date funds (TDFs) to 2030, Rekenthaler, displaying a high degree of humility, admitted that he had previously overstated the case for indexing in 401(k) plans.
Second, plan sponsors widely understand that index funds track market indices, a factor that can influence performance variability.
The chart below compares the return 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 10-year periods, return variability has been somewhat lower for actively managed funds.
Average return variability of the 10 largest index and actively managed mutual funds, as of July 2021
| Number of funds | three years | five years | 10 years | |
| Actively managed | 10 | 15.6% | 12.7% | 11.7% |
| index | 10 | 16.6% | 13.5% | 12.3% |
Note: Mean standard deviations are measured as simple means.
Source: ICI tabulations of Morningstar data
This type of risk, the variability of returns, is another factor that plan fiduciaries may consider when choosing plan investment menus. They can reasonably assume that, other 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 in these categories are in actively managed funds.
If they wish to include these investments in plan menus, plan fiduciaries will generally need to consider actively managed funds.
In addition, certain investment categories benefit from active management. For example, the type of value investing that Warren Buffett pursues is at its core an active management strategy. And target-date mutual funds, which account for $1.1 trillion in assets in DC plans, including 401(k) plans, are possible. all actively managed: each fund must select and manage its assets according to a “travel path”. Of course, 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 evaluating their suitability for 401(k)s. Investments in actively managed mutual funds and indices can be supplemented.
Including actively managed options gives participants more options. This can help you build the portfolio that best reflects your individual circumstances, whether it’s your level of risk aversion, your desire to manage your own portfolio, your proximity to retirement, or some other factor.
Index portfolios and actively managed funds can differ substantially 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 and actively managed funds. For example, an employee of a Fortune 500 company who owns substantial company stock could benefit from diversification in funds that invest in large-cap stocks, such as S&P 500 index funds.
The calculation of choosing an appropriate menu of investment options for a 401(k) plan, whether index or actively managed, requires more than a blanket view of performance versus cost. Plan fiduciaries balance a number of other considerations to accommodate the variety of participants and beneficiaries served by a plan.
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. Eliminating actively managed funds is simply inconsistent with ERISA’s fiduciary principles 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, argue that passive funds generally lag their actively managed peers after periods of market turbulence and that, since 2019, the environment has been favorable for active management. They also note that the market inefficiencies that result as passive investors hold more stocks create more opportunities for active investors who are better able to dispose of mispriced stocks.
We mention this article and its conclusions not to suggest that active management is better than passive investing, but rather to demonstrate that there are diverse and sometimes conflicting views on the subject and that plan sponsors can rationally and appropriately select a mix for a plan investment menu. of active funds and indices. 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. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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David Abbey
