25 April 2024

Passive Investing May Not Optimize Participant Outcomes

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Mark Steburg, senior vice president in American Funds’ retirement plan services business, points out there are only a few levers plans sponsors can pull to affect participants’ retirement readiness—automatic plan features and professionally managed investments, such as target-date funds (TDFs), are two of those levers. But, he contends, the retirement plan industry is not thinking enough about the how the right active managers can really help participants maximize investment returns.

In a comprehensive study, American Funds sought to identify active manager traits associated with a track record of outpacing indexes over long periods. It studied 20 years of active large-cap equity fund returns over various rolling periods. According to Steve Deschenes, director of product development at American Funds, and author of the study, “The Active Advantage: More from the Core,” the research looked at a range of screens from the simple and intuitive to the mathematical and complex.

The study used data provided by Morningstar to examine 3,037 actively managed funds over a 20-year period ending in January 2014. Focusing on funds whose expense ratios were in the lowest quartile and firms whose manager ownership was in the highest quartile reduced those 3,037 funds to just 105—85 actively managed large-cap domestic equity and 20 actively managed large-cap international equity, all of which outpaced the broad market averages over that period. Deschenes notes that American Funds was proud to find 100% of its funds qualified for both screens.

The research also looked at two scenarios, one for an investor in the retirement savings accumulation phase and another for an investor in the decumulation phase. In the first, a lump-sum $100,000 was invested in two portfolios in January 1994 with a 50/50 allocation to U.S. and international large-cap equities. One portfolio was all exchange-traded funds (ETFs), while the other was composed entirely of actively managed funds in both the highest ownership and lowest-cost quartiles of the Morningstar universe. Twenty years later, the actively managed portfolio would have grown to $551,409—31% more than the ETF portfolio.

The second scenario began with a $500,000 nest egg and made annual withdrawals of 5%, increasing that amount by 3% each year to account for inflation. Over 20 years, the actively managed portfolio would have generated 57% more wealth than the portfolio invested in ETFs.

Passive strategies and ETFs have attracted retirement plan investors because of their low costs, but Deschenes says cost is not the only criteria of value; plan sponsors have to look at performance. In addition, he says in the study report, low-cost investing is not the exclusive province of passive strategies. American Funds believes low-cost investing is part of the reason some active managers have outpaced indexes frequently.

Deschenes also notes that manager ownership in a fund correlates to how much managers’ interests are aligned with investors. He says ownership information has been available since 2005, when the Securities and Exchange Commission (SEC) required all managers to reveal ownership in the funds they manage. Information is available on the Morningstar database, and Morningstar incorporates ownership in its annual stewardship survey.

Deschenes recommends plan sponsors work with their consultants or advisers to review their plans’ investment lineups and add low expense ratio and manager ownership to the list of criteria for actively managed fund in their investment policy statements (IPS).

Even in choosing or creating TDFs, all index is not the answer, Steburg adds, there are low-cost active managers that can have a huge impact on participants’ retirement readiness.

Click here to access the full article on PlanAdviser.

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