Discussions concerning the relative merits of passive vs. energetic investing are ubiquitous as of late and – so long as the discussions contribute thoughtfully to the talk – we at Institute for Investment Companies (ICI) rarely feel compelled to offer a critical answer.
But some publications force us to precise our opinions.
But on the subject of choosing investments within the 401(k) plan, they make conclusions about actively managed funds that may only cause confusion amongst plan sponsors.
The authors claim that “[h]The establishment and termination of actively managed funds incurs significant administrative costs for the committee (the opportunity cost of time).” They further state that “sponsors should choose passively managed funds as the default choice for their plans” and “[a]Because sponsors firmly believe that actively managed investment options provide value to plan participants, they should make only passively managed options available.”
As we discuss in additional detail below, plan administrators cannot ignore certain varieties of investments just because choosing them may require more effort. Moreover, the critical decision-making involved in choosing investments for 401(k) plans is far more complex than Bailey and Winkelmann suggest.
Actively managed mutual funds, akin to index funds, may be excellent investments. And the Employee Retirement Income Security Act (ERISA) requires plan administrators to act solely within the interests of the plan’s participants and beneficiaries when choosing investments for a 401(k) plan. ERISA doesn’t provide a reservation for decisions which may make the fiduciaries’ jobs easier.
In its regulation addressing the problem of when plan administrators can avoid liability for participants’ investment decisions, the Department of Labor (DOL) states that fiduciaries searching for coverage under the regulation’s protection should offer a variety of investment alternatives that, in aggregate, enable participants to “to place together a portfolio with risk and return characteristics appropriate to their circumstances“For this reason, the plan’s trustees are committed to presenting plan participants with a wide selection of investment alternatives.
Plan sponsors consider quite a few aspects when choosing investment constellations for his or her 401(k) plans. These transcend easy questions of cost and difficulty of selection. Below, we examine several aspects that display why actively managed funds may be useful to plan participants and why the suggestion that plan sponsors should exclude them is inaccurate. Of course, this evaluation is way from exhaustive. Actively managed funds could be a useful addition to DC plan investment constellations for a lot of other reasons. But these alone display that generalizations concerning the lack of advantage of actively managed funds in DC plans must be viewed with skepticism.
When choosing investments, plan sponsors generally consider net returns moderately than simply costs.
Net returns are the whole return minus all fees and expenses related to the investment. For example, let’s take the ten largest actively managed funds and the ten largest index funds. The table below shows that actively managed funds have produced annualized net returns over three, five, and 10 years which might be nearly equivalent to those of the ten largest index funds.
Average returns of the ten largest actively managed and index mutual funds, as of July 2021
| Number of funds | Three years | Five years | ten years | |
| Actively managed | 10 | 14.6% | 14.5% | 12.8% |
| index | 10 | 14.7% | 14.2% | 12.6% |
Note: Average returns are annualized and measured as easy averages.
Source: ICI tables of Morningstar data
These numbers may not reflect investors’ future expectations and due to this fact don’t mean that plan sponsors should favor one particular variety of mutual fund over one other. However, they do suggest that participants in 401(k) plans will want to pick from a variety of actively managed funds and index funds.
In fact, John Rekenthaler has identified how dangerous it’s to focus exclusively on Fund costs as a substitute of net returnsAfter analyzing the online returns of several large 2030 Target Funds (TDFs), Rekenthaler admitted – with a high degree of modesty – that he previously the arguments for indexing in 401(k) plans were exaggerated.
Second, it’s widely known amongst plan sponsors that index funds track market indices – an element that may affect return variability.
The following chart compares the return variability of the identical 10 largest actively managed mutual funds and the ten largest index mutual funds. Measured as the usual deviation of monthly returns over three, five, or ten years, the return variability was barely lower for the actively managed funds.
Average return variability of the ten largest actively managed and index mutual funds, as of July 2021
| Number of funds | Three years | Five years | ten years | |
| Actively managed | 10 | 15.6% | 12.7% | 11.7% |
| index | 10 | 16.6% | 13.5% | 12.3% |
Note: Average standard deviations are measured as easy averages.
Source: ICI tables of Morningstar data
This variety of risk, the variability of returns, is one other factor that plan administrators can consider when choosing investment options. They can reasonably expect that, all else being equal, some plan participants will prefer investments with less market variability.
In certain investment categories there are few, if any, index funds.
In the worldwide allocation, high yield, global bonds, small cap growth and diversified emerging market funds, there are only a few index funds to pick from, so no less than 75% of the assets in these categories are in actively managed funds.
If plan administrators want to incorporate such investments of their plan offerings, they typically must consider actively managed funds.
In addition, certain investment categories profit from energetic management. For example, the variety of value investing that Warren Buffett pursues is basically an energetic management strategy. And goal funds, representing $1.1 trillion in assets in DC plansincluding 401(k) plans, are arguably actively managed: Each fund must select and manage its assets on a “glide path.” Certainly, some TDFs invest predominantly in underlying index funds, others in underlying energetic funds, or a combination of energetic and index funds. Therefore, simplistic categorizations of funds must be avoided, especially when assessing their suitability for 401(k)s. Investments in index and actively managed mutual funds can complement one another.
By including actively managed options, participants have more alternative. This can assist construct the portfolio that best reflects their individual circumstances, whether it’s their level of risk aversion, their desire to administer their very own portfolio, their proximity to retirement, or one other factor.
The portfolios of index funds and actively managed funds can differ significantly and have different risk/return profiles. A participant may achieve higher long-term returns with lower risk by investing in a combination of index funds and actively managed funds. For example, an worker of a Fortune 500 company who holds significant company stock might profit from diversifying away from funds that spend money on large-cap stocks, akin to S&P 500 index funds.
The calculation for choosing an appropriate set of investment options for a 401(k) plan—whether indexed or actively managed—requires greater than a general consideration of the connection between performance and price. Plan administrators consider a wide range of other facets to accommodate the range of participants and beneficiaries served by a plan.
Those who urge plan sponsors to avoid actively managed funds display that they don’t understand the legitimate role these funds play in ensuring that plan participants can construct a retirement portfolio that meets their needs and goals. Screening out actively managed funds is solely inconsistent with ERISA’s fiduciary principles and the critical decisions involved in choosing investments for 401(k) plans.
We mention this text and its conclusions to not suggest that energetic management is healthier than passive investing, but to display that there are differing and sometimes conflicting opinions on this topic and that plan sponsors can rationally and appropriately select a combination of energetic and index funds for a plan’s investment offerings. Sweeping generalizations that plan sponsors should avoid actively managed funds do the plan sponsor community a disservice.
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