Plan sponsors adopting passive strategies may be overlooking the style’s potential pitfalls.
The current economic cycle may favor an active management approach.
SVP, Retirement Marketing
The dominant focus on fees for defined contribution plan sponsors began roughly five years ago, was fueled by the final Department of Labor fee disclosure regulations, and endures thanks to a parade of lawsuits alleging excessive fees. This focus has led to an increased use of passive investment strategies. While plan sponsors still prefer actively managed options by a wide margin,1 more plan sponsors increased the proportion of passive funds in their plan in 2012, following a similar increase the previous year.2
Yet many plan sponsors electing passive investment approaches as a litigation safeguard may not be completely fulfilling their fiduciary responsibilities to act in the best interest of the plan participants. Reflexively choosing passive investment strategies to help manage costs and avoid lawsuits does not necessarily reflect fiduciary prudence, and may deprive participants of much-needed alpha as they face the challenge of funding lengthy retirements.
As our President and Chief Investment Officer, Art Steinmetz, demonstrates in the recently published Active Investing: The Case for a High Conviction Approach, certain highly active managers—“diversified stock pickers”—have outperformed their benchmarks, even net of fees. A look at the three-year Morningstar index percentile rankings confirms that passive strategies seemed to perform well over select short-term periods. But, over the longer time horizons shared by most retirement investors, rankings for the common large-cap, small-cap and global benchmarks tracked by passive fund strategies ranged from just fair to poor.
The prudent plan sponsor may also want to consider additional potential shortcomings of passive funds as they design their plan’s investment lineup. While all investments carry costs, plan sponsors should understand that a fund that tracks an index most likely will underperform that index after fund fees are considered. In addition, the prevalence of market-cap weighted approaches to indexing may tilt sector allocations, depriving investors of the broad index exposure they’re seeking. Similarly, index tracking error can vary widely by strategy, depending on such variables as the method used to mimic index exposure, transaction costs and cash drag. Of course, closely replicating a poorly designed index will also lead to unsatisfying outcomes.
Historical correlations between the S&P 500 Index, the most widely emulated passive strategy, and U.S. corporate profit margins suggest that the upcoming market environment may favor active managers. The S&P 500 Index has typically underperformed as economic cycles mature and profit margins decline, as appears to be the case since the middle of this year. Given where we appear to be in the market cycle and the potential shortcomings of passive investments, plan sponsors may feel confident hiring active investment managers and offering plan participants the opportunity to get exposure to the potential long-term benefits of active strategies.
1 Cogent DC Investment Manager Brandscape, May 2013.
2 Callan Investments Institute: 2013 Defined Contribution Trends, 2