Index Funds or Active Funds for 401(k) Plans?

There is an increasing pressure on 401(k) fees and I heartily welcome that. In fact, I am part of that movement – replacing bundled plans charging a % of assets with flat fee providers. I love to get rid of provider fees that grow rapidly every year without a corresponding increase in service. I think every prudent fiduciary must consider that strongly.

Part of that fee pressure is weighing on the internal fees of 401(k) mutual fund options. Actively managed mutual funds are rapidly being replaced by passive index funds with much lower operating expense ratios (OERs). I also support that in general, but not necessarily in whole. Though I have also moved toward using more index funds, replacing all the actively managed mutual funds with index funds is not always the best idea.

Those responsible for prudently running the retirement plan at companies, if they understand their fiduciary role to act solely in the best interests of plan participants, are understandably nervous about having any funds that are higher cost, especially if the investment returns are similar to low-cost index funds.

Index funds do best when the market has many stocks and bonds moving together at the same time – the “all one market” theme that has been prevalent in recent years. Index funds also tend to outperform active funds when the market is rising. And partly because the overwhelming allocation of dollars to index funds ends up in S&P 500 index funds and other funds dominated by larger stocks, index funds tend to do best when large companies are doing better than mid-size and small companies. That’s because the S&P 500 and the vast majority of other indexes weight their components by market capitalization, i.e. how large the company is in terms of stock market value. So, the weightings of big firms in the index dominate the smaller firms and end up carrying the whole index.

Even total market funds are usually weighted by market cap, so again, the bigger boys have a very out-sized influence on how the index performs.

On the other hand, sometimes small and/or mid-size stocks outperform the overall market and it is then that the best active managers tend to outperform the indexes. Because of the lesser available research on smaller and international companies, active mangers may outperform the indexes in these two areas.

The same active outperformance by active funds is often seen when markets are falling. This period may be of more interest to risk-averse investors.

The same goes for bond indexes. Bond indexes are fixed in what sectors they contain and in what weightings those sectors have. But, there can be huge differences in performance between fixed income sectors at times. Flexible fund managers can benefit from overeweighting those, while index funds cannot. A perfect example is a time of rising rates and falling bond prices, which at some point we hope we will see as the economy strengthens. That is a time when you really want your fund manger to be flexible in order to avoid losses and to find those areas that are producing positive returns.

From what I have seen, plan committees for most plans and nearly all  plans under $25 million, do a terrible job with choosing income-oriented funds for the 401(k). Not knowing about more flexible funds or about funds that are less affected by rising rates, these plans almost always have too few income funds that are too similar, providing little shelter or true diversification.

Alternative funds should also be finding their way into committee discussions as bond alternatives and diversifiers. These are almost always actively managed funds.

So, yes – look at lowering fund costs as much as possible. However, don’t just go whole hog into index funds without thinking it through. Understand the role and importance of having some actively managed funds, especially in the fixed income and alternatives areas. Then use the operating expense ratio as one factor in individual fund selection, not the only factor. While returns and expenses are strongly correlated, particularly for fixed income funds, other factors like flexibility and consistently good net performance over a long period are also well worth paying close attention to.