401(k) advisers value active management in some categories, despite indexing craze

Index funds are continuing their push into 401(k) plan menus, but some retirement plan advisers and analysts still see areas where active management makes sense.

The number of 401(k) plans offering index funds to employees swelled to 89.4% of plans in 2014, an increase of 10 percentage points from 2006, according to a joint study conducted last year by the Investment Company Institute and BrightScope Inc. Over that same period, participant assets held in index funds climbed to 29% from 17%.

In 2016, DC plan sponsors increased the presence of passive funds in their plans nearly five times more than active funds (11.9% versus 2.4% of plans) — a trend that’s expected to continue in 2017, according to Callan Associates, a consulting firm.

There are several reasons for the shift. For one, funds using an active-management style are often more expensive than funds that track a market index. In an environment of hyper-sensitivity toward fees, due in part to the proliferating excessive-fee litigation targeting plan sponsors, lower-cost funds reap the rewards.

Advisers relying on active funds may also be swimming upstream, since such funds haven’t done well demonstrating long-term outperformance.

Robert E. Pike, president and chief investment officer at Stratford Advisors, said hard data “proves that passive wins.”

Over the 15-year period ending Dec. 2016, roughly 92% of large-cap, 95% of mid-cap, and 93% of small-cap managers trailed their respective benchmarks, according to the SPIVA (S&P Indices Versus Active) U.S. Scorecard report.

“The data is stunning,” Mr. Pike said.

Whatever the data suggests, though, Mr. Pike believes the overarching issue is how advisers choose to provide market exposure to plan participants.

Retirement plan advisers are primarily using actively managed funds in categories such as fixed income and emerging markets, said Chris Brown, founder and principal of Sway Research, which studies asset management distribution in defined contribution plans. These advisers see any additional fund costs as worthwhile given the funds’ potential to outperform the market, he said.

Jamie Greenleaf, principal and lead consultant at Cafaro Greenleaf, which oversees roughly $2.3 billion in DC assets, believes active management can be prudent in all asset classes, but tends to work best in small- and mid-cap markets, as well as international markets associated with higher risks. In contrast, there’s not as much value in an actively managed large-cap fund, she said.

A DC plan’s investment committee tends to see value in active management when members understand there are trade-offs to their decisions, Ms. Greenleaf said. Her firm uses a 13-item questionnaire to formulate appropriate criteria and weightings. It also shifts the focus from strictly performance or fees to more strategic goals.

Many plan advisers with large defined contribution books of business are addressing the cost stigma of active management by using passive mixes in some domestic stock-blend categories to lower plan expenses, Mr. Brown said.

David Blanchett, head of retirement research at Morningstar Investment Management, warned of caveats to consider when assessing the true value of active management for DC plans. Some sponsors could be sold a false bill of goods.

“A lot of active funds that have higher expense ratios aren’t always that active, and so you want to make sure you’re actually getting active exposure to the market,” Mr. Blanchett said.

But, “the most important alpha is helping clients accomplish their goals,” Mr. Blanchett said.

A solid set of investments in a core menu will be meaningless if participants are using them inappropriately, for example.

The indexing trend is certainly pushing advisers to reach beyond their investment prowess in order to demonstrate value to plan sponsors. Specialist advisory firms such as SageView Advisory Group or Captrust, large DC-focused advisory networks managing tens of billions of dollars in plan assets, don’t generally tie their worth to investment-management selection as much as they did in the past, Mr. Brown said.

Investment menus are often worked out by the home offices, and advisers tend to follow their recommendations, he said. Rather, these firms’ focus is more squarely on plan design, vendor selection, compliance and benchmarking fees against similar sized plans, and boosting participant enrollment and deferral rates.

Bruce Shutan is a Los Angeles freelance writer.