Actively managed funds still represent the largest chunk of most 401(k) investment lineups, but passively managed investments have risen in recent years because of fee disclosure regulations, target-date funds and the notion that managed accounts have been unable to beat the returns of index funds.

Because of the 408(b)(2) fee disclosure regulations that went into effect in 2012 and the number of class action lawsuits that have been filed by participants against defined contribution plan sponsors, “plan sponsors and investment committees are hyper-focused on fees and continue to be hyper-focused on fees,” says Matt Sommer, vice president and director of retirement strategy at Janus Capital in Denver. “The trend is greater adoption of passive investments to help keep those fees down.”

Also see: States helping workers save for retirement

And while fees are an important component of an employer’s retirement plan, they aren’t the only thing companies should consider when putting together their investment lineup, he says.

There are some downsides to passive investments, Sommer says. Index funds are market-weighted, meaning those holdings that have appreciated the most in recent history are going to represent the largest percentage of the investment. They can become over-weighted over time, making the drops, when they happen, even more dramatic.

On the fixed income side, if interest rates go up, the index goes down, and in this low interest rate environment the market has been in the past few years, interest rates are likely to go higher rather than lower in the long-term, Sommer says.

“That’s one of the benefits of having an active manager for bond investing,” he says. Those managers can move money from corporate bonds to government treasuries or vice versa based on which one is less sensitive to an expected rise in interest rates.

Also see: How to drive better engagement in benefits program among millennials

Over the past few years, it has become increasingly difficult for active managers to consistently beat their index, Sommer says. “One of the reasons is because we are in a seven-year bull market and so what has happened is that the rising tide has raised all boats. In that environment it is difficult for active managers to consistently beat the index,” he says.

Over time, active managers have a better chance of beating their index when the market is constantly moving through different market cycles. “It is really over that longer period of time you encounter different sorts of market cycles where we believe active managers can provide 401(k) participants a much smoother experience over that length of time,” he says.

Kevin Jestice, a Vanguard principal and head of Vanguard Institutional Investor Services, says that his company has seen a tremendous increase in the number of companies offering index/passive investments in their 401(k) plans over the past 10 years.

“We’re in an environment that is placing increasing scrutiny on fees and costs,” he says. Unfortunately, he says, it is “hard to pin down what is ‘low cost.’[Is it] 20 basis points? Forty basis points? By offering very low-cost index funds, plan sponsors are ensuring they have options available to participants at a very low cost. That said, the vast majority of [plan sponsors] have a blend of active and passive funds from Vanguard. We are agnostic in the active vs. passive debate.”

Also see: DOL’s ‘ambitious time frame’ for fiduciary rule raises questions

He points out that it isn’t just participants who are jumping on the passive bandwagon by choosing those funds for their retirement accounts. Plan sponsors are also putting more index funds in their plans.

Vanguard takes a three-tiered approach to investing when it comes to DC plans. The first tier is a target-date fund, a diversified fund that does all of the work for plan participants, including rebalancing to become more conservative as a worker nears retirement.

The second tier is what Jestice calls the “index core or passive core.” That includes a U.S. equity fund, a U.S. bond fund and a cash money market fund. In 2005, 28% of the plans for which Vanguard handles recordkeeping offered an index core. In 2014, 52% of its plans offered an index core, which is an 86% increase, Jestice says.

The third tier is more sector- or style-based funds or capitalization funds, such as large-cap value, large-cap funds, equity funds and active bond funds.

On average plans offer participants 18 funds to choose from when they are setting their 401(k) plan allocations, “despite the fact that the average number of funds used by an individual is 2.9 or three,” he says.

“I think plan sponsors have to navigate the opposing points of view of simplicity vs. breadth of selection. The fewer funds you have, the better it is. As an employee benefit, they like choices. Not all participants want to invest the same way,” Jestice says.

Also see: GE explores sale of pension manager overseeing $115 billion

The increased use of target-date funds in plans has also increased the trend toward passive investments in 401(k) plans. Most TDFs are passively managed. Vanguard offers a large selection of active and passively managed TDFs. The company manages $3.5 trillion in assets. About 40% of them are actively managed, Jestice says.

Brian Leite, head of equity/high income institutional portfolio management at Fidelity Investments, says that there is “no question we’ve seen a trend toward passive products within DC lineups the past few years. Even though a majority of our assets are still active, it is more pronounced on the defined benefit side than the defined contribution side.”

Plan sponsors are “very concerned with litigation, real or imagined,” he says. Because of that it is easier for plan sponsors to defend their use of passive solutions in their investment lineup, even if it isn’t necessarily the right investment decision for plan participants, because “you don’t have to defend performance.”

At Fidelity, 29% of DC plan assets are in passive investments, a rise from 10% about a decade ago, says David Thompson, vice president, investment consultant for Fidelity Investments. Much of that movement to passive gets attributed to fee disclosure and plan sponsors attempting to manage their fiduciary risk.

One factor that largely gets ignored is that “the past few years have been very challenging for active management as an industry,” said Leite. “We’ve done some work that would suggest that it is not quite as one-sided as the popular press may make it out to be. It certainly has been a challenging environment for active, especially during recovery from the recession.”

Also see: Kraft Heinz pushes retirees to health exchanges to cut costs

In the past seven years, the “difference between the highest-performing and worst-performing stocks has been relatively tight. There is less opportunity for active management to add value in that environment,” Leite says.

Fidelity believes there are cycles, which can last multiple years, where one side or other may be advantaged or disadvantaged. Leite says that the U.S. has been in a long cycle where passive management was more advantaged than active management but that won’t always be the case.

Most investment managers advocate for a mix of active and passive investments in a portfolio so that participants are better able to weather the storms, no matter which way the wind is blowing.

More than 80% of active equity managers underperformed the S&P Index over a 15-year time period, according to a recent study by BlackRock, citing data gleaned from eVestment Alliance in December 2013. It also found that nearly 95% underperformed over a 30-year time period.

BlackRock’s study,“Balancing Index and Active: Helping plan sponsors navigate a new set of choices” also found that “flows into index equity and fixed income mutual funds have exceeded flows into actively managed funds by $500 billion” in recent years. “While the shift has been notable across asset classes, the index share of equity strategies has grown faster than the index share of fixed income strategies,” BlackRock found.

BlackRock estimated that 25% of DC  assets “are expected to be managed in index strategies in 2015, compared to 17% of invested assets globally.”

Where active management shines is in outcome-oriented strategies or for asset classes that are relatively inefficient, according to BlackRock. Examples include “inflation hedges, top-down macro asset allocation, high-conviction active strategies, and other strategies that cannot be effectively replicated by an index.”

 Janus Capital’s Sommer advocates for a hybrid strategy.

“Rather than starting with fees, we have a discussion about whether or not in certain asset classes it is possible for active managers to add value. It is proven that some asset classes are more efficient than others. The more efficient they are, the harder they are for active managers to provide value,” he says.

Small plans typically offer fewer passive options than larger plans. The biggest reason is that small plans rely more on revenue-sharing to compensate the recordkeeper. “If a small plan were to go to an all passive lineup, typically those investments aren’t going to pay revenue sharing, so now the plan sponsor has to think about it from an economic perspective, how to compensate the recordkeeper,” Sommer says. That means either the company has to pay the recordkeeper out-of-pocket or it needs to debit employee retirement accounts, which is much harder to explain, he says.

“I think the active vs. passive discussion will continue to play out,” he says. “The good news is that even for investment committees and plan sponsors who believe they have done their due diligence and believe active managers should comprise all or part of their lineup, fees are coming down.”

Paula Aven Gladych is a freelance writer based in Denver.

Register or login for access to this item and much more

All Employee Benefit Adviser content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access