When it comes to selecting funds for a 401(k) or other defined contribution plan, determining the major asset classes (stocks, bonds, cash, etc.) and their related sub-styles is the first step for plan sponsors. This provides the basic building blocks for the asset allocation process and will have the greatest impact on the risk/return characteristics of employee portfolios. Once the asset allocation policy is set, the focus can turn to implementation…and so begins one of the fiercest debates in the investment industry: Should the menu be built around actively managed funds or low-cost index-tracking (i.e., passive) funds, or both?
• Passive management. Funds that use a passive strategy do not attempt to “beat the market.” Instead, they select a market benchmark, such as the S&P 500 for large U.S. stocks and the Russell 2000 for small U.S. stocks, and try to track the index closely without incurring high expenses. Index funds are typically chosen on the basis of having the lowest fees and tracking error relative to the index.
• Active management. Funds that use an active strategy will select an asset class benchmark and then attempt to outperform that benchmark by making better investment decisions. These funds have a larger range of potential outcomes—the possibility of significantly outperforming, or underperforming, the benchmark—and will have higher fund management fees (i.e., expense ratios).
The crux of the active vs. passive debate is the fundamental disagreement about whether a fund manager can beat a specified asset class benchmark over the long term in excess of fees charged, or whether the performance discrepancies vs. the benchmark index are random and will equalize over time.
Some data suggest that the opportunity to outperform a benchmark may vary by asset class. For instance, it is interesting to note that over a recent 20 year period, three of four portfolios in the Morningstar foreign large blend category have outperformed the benchmark MSCI EAFE (Europe, Australia, Far East) international stock index, while only one of four intermediate-term U.S. bond managers was able to beat the BarCap U.S. Aggregate Bond index. This certainly does not mean that U.S. bond managers cannot beat the benchmark over long periods of time; it simply suggests that it may take a higher level of investment management skill to overcome the expense headwind in a low dispersion asset class.
The style of a stock fund is generally classified as value (with a price that's inexpensive relative to its earnings and cash flow), growth (its higher price reflects the expectation of above average growth prospects in its business) or blend (falling somewhere in between). The well-known "style box" classification,popularized by fund analysts at Chicago-based Morningstar Inc., uses nine style boxes with the vertical axis denoting size (large capitalization, mid cap or small cap) and the horizontal axis denoting value, blend or growth.
Retirement Plan Design
When designing an investment plan lineup, there are a number of issues to consider beyond past performance. In many circumstances, it may be advantageous to offer both active and passive investments within the same lineup. For example, a plan could structure its domestic stock fund offerings to include active "growth" and "value" portfolios complemented by passive blend options. This structure would allow a participant to build a diversified portfolio implemented with active or passive managers based on the personal views of the employee.
An additional consideration is that there may be plan costs associated with passive investments that are not reflected in the index returns. Expense ratios typically consist of investment manager fees and the "revenue sharing" (i.e., direct transfer of revenue from investment funds to the third-party recordkeeper administering the plan) used to offset plan expenses. However, revenue sharing is often not added onto passive investments, so those plan costs must be paid from other sources such as a check from the plan sponsor or a deduction from participants' accounts.
The debate on the superiority of active or passive management is one that will never be fully settled as there will always be market participants who have a strong view either way. Importantly, there are many investment situations where it is beneficial to use active, passive or a combination of the two. In the end, if using active management, plan sponsors and consultants have an obligation to work together to identify and monitor funds (and fund managers) that have shown an ability to consistently outperform their benchmark.
Frank W. Salb, Jr., CFA, is the national manager of investment services for Lockton Retirement Servicesin Kansas City, Missouri.
(Securities offered through Lockton Financial Advisors, LLC, a registered broker-dealer and member of FINRA, SIPC. Investment advisory services offered through Lockton Investment Advisors, LLC, a federally registered investment advisor. For California, Lockton Financial Advisors, LLC, d.b.a. Lockton Insurance Services, LLC, license number 0G13569.)