Active vs. Passive Investment Funds: Should You Let Participants Decide?

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by / Monday, 09 October 2017 / Published in Blog

Based on a report from Casey Quirk by Deloitte and McLagan, 72% of money invested into funds went into passive funds in 2015. While the issue for plan sponsors isn’t clear cut, some may see this as a strong case for passive investing.

Trending Passive

Similar to indexes like the S&P 500 and the Dow Jones Industrial Average,  passive investing involves investing in the same securities in the same proportions, as opposed to active investing, which attempts to outperform the stock market. Passive investment portfolio managers don’t make decisions about which securities to buy and sell.

Over the past 20-plus years, there has been an increase in the trend toward passive investment strategies. In every year since 1993, there has been a net inflow of dollars to passive mutual funds and exchange-traded funds. In contrast, every year since 2006, there has been a net outflow of dollars from actively managed funds.

What’s the explanation for this trend? The biggest driver seems to be the growing recognition that market averages — especially for large cap, heavily traded and researched stocks — are tough to beat.

Outperforming the Indexes

The Wall Street Journal published an article last year showing a chart highlighting the percentage of actively managed U.S. large company mutual funds that beat the S&P 500 Index over various time spans. The chart summarized time segments of 1, 3, 5, 10, 15, 20 and 25 years, ending on June 30, 2016. Only in the 10-year time segment did the percentage of actively managed funds outperform the S&P 500 by more than 30%. In all the  other time segments, the proportion of actively managed funds that outperformed the stock market ranged from around 11% to 25%.

In another significant data set, over a period of 10 years ending on December 31, 2015, of the 20 best-performing (relative to their peers) actively managed U.S. stock funds, only seven beat the average performer in the subsequent decade.

Fighting the Odds

Choices based on participants’ risk tolerance, investment objectives and investment strategies to meet the perceived needs of plan participants is the reason why we include actively managed stock funds (in addition to passive funds) in your retirement plan’s investment lineup. As the Wall Street Journal stated in its compilation of performance data, “The prospect of beating the market — and maximizing your investment potential — is a tantalizing one.”

Is it a fiduciary’s place to deny the participant the opportunity to fight the odds against superior returns with an active manager? Not necessarily, assuming you’ve carefully researched the actively managed fund or funds you select, and you provide participants with sufficient information to make an informed choice. If given the choice of some active funds, participants who consider themselves smart investors, might put more in their 401(k) account than they otherwise would have.

Another reason for possibly including actively managed funds is that, in a down market, passive funds will suffer the same fate as the market, while active funds can cushion the blow by moving to cash. In addition, managers of actively managed funds may find good investments in niche stock sectors where stocks are more illiquid and fewer analysts are paying attention.

Getting It Right

Not only should you monitor the performance of your plan’s funds, you should also keep an eye on how your participants allocate their retirement dollars. If you do offer volatile, actively managed funds, and a significant proportion of participants appear to be taking on greater risk than might be appropriate, step-up investment education programs can be used to help equip risk-takers while considering their investment strategy.

© 2017

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