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

08.24.17

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

Trending passive
Active investing attempts to outperform the stock market, while passive investing involves investing in the same securities in the same proportions as an index like the S&P 500 or Dow Jones Industrial Average. Passive investment portfolio managers don’t make decisions about which securities to buy and sell.

Over the past 20-plus years, the trend has shown an increase 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 — particularly for large cap, heavily traded and researched stocks — are tough to beat.

Outperforming the indexes
A Wall Street Journal article last year brought this point home in 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 1, 3, 5, 10, 15, 20 and 25 years, ending on June 30, 2016. In only the 10-year time segment did the percentage of actively managed funds outperform the S&P 500 by more than 30%. Over the other time periods, the proportion of actively managed funds that outperformed the stock market ranged from around 11% to 25%.

In another telling data set, of the 20 best-performing (relative to their peers) actively managed U.S. stock funds over the 10-year period ending on December 31, 2005, only seven beat the average performer in the subsequent decade.

Fighting the odds
In the face of this data, why include actively managed stock funds (in addition to passive funds) in your retirement plan’s investment lineup? For starters, you’re providing choice based on participants’ risk tolerance, investment objectives and investment strategies to meet the perceived needs of plan participants. As the Journal stated in its compilation of performance data, “The prospect of beating the market — and maximizing your investment potential — is a tantalizing one.”

If some participants are willing to fight the odds against superior returns with an active manager, is it a fiduciary’s place to deny them that opportunity? 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. Participants who consider themselves astute investors might put more in their 401(k) account than they otherwise would have if given the choice of some active funds.

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, in niche stock sectors where stocks are more illiquid and fewer analysts are paying attention, managers of actively managed funds may find good investments.

Getting it right
In addition to monitoring the performance of your plan’s funds, 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 to equip risk-takers to consider their investment strategy.

BPM is one of the largest California-based accounting and consulting firms, ranking in the top 50 in the country. It has served the San Francisco Bay Area's emerging and mid-cap businesses, as well as high-net-worth individuals, since 1986. Our Employee Benefits team consists of professionals with extensive knowledge of ERISA guidelines and deep expertise performing employee benefit plan audits. We can help you craft a smooth-running plan that serves your employees while mitigating associated risk. For more information or for a free expert consultation, contact Jenise Gaskin at (925) 296-1016, Michelle Ausburn at (707) 524-6588 or visit us at bpmcpa.com/ebp.