Thoughts on Constructing a Fund Line-up and Why I Don’t Recommend Actively Managed Funds

While this headline seems to suggest where I fall on the Active vs. Passive Debate, I actually I don’t take a side and find the debate woefully incomplete when it comes to thoroughly discussing how to properly construct a fund line-up for group retirement plans.  A more accurate title should be “The Simplicity vs. Complexity Debate” because this dichotomy truly gets at the heart of the question on how employers should set up retirement plans that benefit plan participants rather than solely the service providers.

Let’s start with the ideal number of investment options.  Chris Carosa, author, journalist, investment adviser, and chief contributing editor of Fiduciary News wrote a fantastic three part series to help answer this question.  I can summarize as follows:

  1.  Service providers can assess greater fees based having more investment options.
  2.  Too many choices confuses participants, causing them to split their dollars evenly among several funds, creating a portfolio similar to a low cost index fund, yet much more expensive.
  3.  Too many choices adversely affects participation rates and leads to sub-optimal decisions.
  4.  Retirement plans ideally should have no more than 10 investment options.
  5.  Limited choices gives participants greater satisfaction.

I would also add that I typically see at least 15 investment options in plans I review, and often more.  And in each case, I have seen that most of these investments have a high degree of correlation, which is defined as:

“a statistic that measures the degree to which two securities move in relation to each other.”

Consequently, because participants tend to spread their money out throughout different funds which are often actively managed, likely because they believe that doing so creates greater diversification, they have a false sense of security.  On the contrary, they could actually achieve an extremely similar portfolio with greater diversification and fewer funds (not to mention far lower costs!), as exemplified by the Schwab Total Stock Market Index Fund (SWTSX) which holds 2,423 securities and costs 0.03% and the Schwab International Market Index Fund (SWISX) which holds 948 securities and costs 0.06%.  If participants knew they could spread their money out throughout over 3,000 companies while incurring minimal costs with only two funds, they would likely make different decisions.

From an employer standpoint, simplicity makes sense from a compliance perspective because it’s easier to construct an investment policy statement (a written description of a plan’s investment-related decision-making process) that employers can consistently follow.  I have explained more in a previous post.

Financial advisors thrive on adding additional and unnecessary complexity as well as keeping employers in the dark about simpler, lower cost options because most if not all of their value proposition hinges upon selecting and monitoring the funds that will continue to outperform the market.  Granted, as Chris Carosa has also pointed out,

There you have it. In short, this one paper (Broker Incentives and Mutual Fund Market Segmentation), perhaps not as well read as it should be, almost accidentally seals the deal for the fiduciary standard, exposes the conflict-of-interest created by 12b-1 fees and, dare we say, touches the forbidden third rail of all investment research: it shows – within the direct-sold fund channel – index funds have no inherent advantage over actively managed funds (and suggests past studies may have reached opposite conclusion by over-weighing the impact of broker-sold funds); thus, adding another nail to the coffin in the all-too-often repeated misconception that passive consistently outperforms active.

So yes, lower costs for the funds don’t matter if you are comparing direct sold funds to index funds, but because this same paper “concludes direct-sold mutual funds (including institutional funds) outperform broker-sold mutual funds by 1%”, it is clear that fund costs DO matter if they are sold their brokers.  And yet, the registered investment advisors who recommend a litany of actively managed funds will charge more for the additional work of selecting and monitoring a more complex line-up which has no  inherent advantage over comparable index funds.

Carosa willingly admits, however, in his book “Hey! What’s My Number” that the primary questions that influence an investor’s wealth include:  when to start saving, how much to save, and when to retire – all of which a good behavioral coach can help effectively answer throughout an investor’s lifetime.

He also cites a study from the Center for Retirement Research at Boston College which states:

“Assuming a CRRA (coefficient of relative risk aversion) of 5, the amount required to compensate a household for a retaining a typical portfolio (where 36 percent of assets are invested in equities) rather than switching to an optimal portfolio allocation (where 51 percent of assets are invested in equities), is $5,600, or approximately the additional amount the household would earn if it delayed retirement by one month.  In contrast, when the comparison is between a typical portfolio and an all-stock portfolio, the household is better off by approximately $3,600, or under one month’s salary.  That is, an all-stock portfolio is even more sub-optimal than the typical conservative portfolio.  The key message, however, is that the dollar amounts are small, suggesting that asset allocation is relatively unimportant for the typical risk-averse household.  Even if the household is less risk-averse (CRRA equals 2), the story is similar.  In this case, as shown in Table 10, the optimal portfolio is all in stocks.  The cost of retaining a typical portfolio (57 percent in equities), rather than switching to an optimal portfolio (100 percent in equities), is $25,700, or just over four months’ salary.  As the optimal portfolio is 100 percent in equities, the cost of retaining a typical portfolio relative to an all-stock portfolio is also $25,700.  In short, regardless of the degree of risk aversion, asset allocation is relatively unimportant for the typical household.”

My Value Proposition pages of my website providers a fuller account, but in summary, retirement plans simply need to have a few low cost index funds and no more than 10 funds in total.  Any plan more complicated than what I have stated aims to benefit the service providers at the expense of plan participants.

 

 

 

 

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