By Todd Flynn, CPA, CFP
Investment Advisor Representative, Soundmark Wealth Management

Since 401(k) plans were enacted into law in 1978, Wall Street firms and mutual fund companies have increasingly promoted the idea of an “active investing” strategy, in which portfolio managers aim to outperform the stock market.

This is exemplified in sensational news headlines, five-star stock ratings, and financial TV shows with hyperactive hosts and careening camera angles—all of which tend to focus on short-term fluctuations of the market.

Investors are encouraged to evaluate the one-, three-, five-, and 10-year performance of mutual funds and select the fund that will beat the market long-term. Retirement plan investment policies are often even structured to evaluate the performance of managers and mutual funds and replace funds that underperform a stated index or benchmark.

Indeed, Wall Street has a vested interest in this approach, with $1.712 trillion in 401(k) assets at the end of 2000 , according to the Investment Company Institute.

The Failure of Active Management

Yet evidence suggests that such active investing strategies don’t work. Not only must an “active” portfolio manager—who is competing with thousands of other active managers—be able to select the next top-performing stock or mutual fund from the myriad of available choices, but their returns must exceed the added cost of frequent trading, turnover, marketing, and management fees.

Though a manager may be able to do this for a period of time, the ability to do so consistently over a 10-, 20-, or 30-year investment horizon is almost impossible. In fact, this approach frequently results in underperforming the market due to added costs and poor market timing.

Research has shown, both with equity and bond funds, that actively managed funds failed to beat their comparable indexes. This is demonstrated in the following charts, which show the percentage of actively managed public funds that failed to outperform their respective market benchmarks over a five-year period ending December 2010. As you can see, all but one major fund category (international small-cap equity funds) failed to beat the index.

Passive Investing: A Better Choice

At Soundmark, we believe there is a better way to structure your retirement plans—one that is gaining ground with many employers, and that involves participating in the capital markets in a diversified and efficient manner. This is referred to as an “index” or “passive asset class” approach to investing. Though these terms are sometimes used interchangeably, we feel that passive asset class investing is the best way to create a diversified portfolio.

There are many benefits to this approach:

• It’s structured along the premise of the Uniform Prudent Investors Act, which offers a framework for the trustees and fiduciaries of a retirement plan to properly manage the trust’s assets.
• It’s less costly then active management. Based on several studies, fees are the single most significant factor in fund performance.
• It’s based on diversification—a key tenet of the Uniform Prudent Investors Act and a necessary element in any 401(k) or retirement investment plan. This approach avoids the guesswork involved in trying to predict markets.

An asset class fund defines a specific asset class, such as the small cap value asset class, and buys a representative sample of stocks in that class. The fund adheres to the definition and buys or sells stocks that fall outside the asset class , therefore maintaining the purity of the allocation.

By properly combining asset classes, you can capture the returns of the market—which, over the long term, have provided investors with a substantial increase in value—without trying to outperform the market. And because the funds don’t involve chasing returns, actively selling stocks, or extensive marketing, the costs are low.

It is important to note that passive does not mean static. On the contrary, an important element in building and maintaining any portfolio is to rebalance regularly and evaluate the portfolio’s risk in comparison to your goals.

“A Relationship of Trust and Confidence”

The Uniform Prudent Investors Act—which provides guidelines to retirement-fund trustees, and which was approved and recommended for enactment nationwide in 1994—advocates such passive investing strategies.

For many people, their 401(k) plan is their single largest—and maybe their only—investment portfolio. Trustees of such plans are considered fiduciaries because they have accepted the responsibility to “act for and on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence.”

This responsibility is to be taken seriously, and it is important that retirement-plan trustees offer appropriate investment options for plan participants. The act directs trustees to use reasonable care, skill, and caution, with the interests of the beneficiary being paramount.

In particular, the Prudent Investor Rule gives guidance to investment managers on the standards for managing an investment portfolio in a legally satisfactory manner. The rule contains five basic principles:

• Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
• Risk and return are so directly related that trustees have a duty to analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.
• Trustees have a duty to avoid fees, transaction costs, and other expenses that are not justified by needs and realistic objectives of the trust’s investment program.
• The fiduciary duty of impartiality requires a balancing of the elements of return between production of income and protection of purchasing power.
• Trustees may have a duty, as well as the authority, to delegate as prudent investors would.

In total, these principles suggest a passive investing approach based on a broadly diversified portfolio of low-cost funds with different risk characteristics.

Fees Matter

Because of their greater trading, research, management, and marketing costs, active funds tend to be more expensive than passive funds. According to a 2008 study by Morningstar, the average expense ratio for an actively managed stock mutual fund is 1.41 percent—approximately 1 percent more than a similar set of passively managed mutual funds.

In a Morningstar Advisor article titled “How Expense Ratios and Star Ratings Predict Success,” Russel Kinnel concludes that “investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”

Diversification Is Key

By offering a select list of passive asset class funds across various dimensions of the market, you can enable your plan participants to build properly diversified investment portfolios. Such portfolios should include large- and small-cap funds, growth and value funds, international funds, and mid-term and short-term bond funds.

A globally diversified allocation harnesses the power of markets, manages risk/return tradeoffs, provides broad diversification, and offers calculated exposure to compensating risk factors through structured investing.

Furthermore, at Soundmark, we believe that providing participants with model portfolios structured across various risk tolerances helps take the guesswork out of fund selection.

We Can Help

Many retirement plan investment offerings are far too extensive and expensive, resulting in participant confusion, underperformance, and lack of diversification. At Soundmark, we offer employers a limited yet diversified selection of passive asset class funds for participants to choose from.

This approach helps simplify individual fund selection, and it allows participants with limited understanding of the financial markets to invest in a properly diversified portfolio. In addition, we establish a well documented investment policy statement and meet with trustees and participants regularly to ensure that the plan complies with agreed-upon standards.

Contact us to learn how passive investing strategies can benefit your company’s retirement and profit-sharing plans.