Index Investing

Evaluating costs, benefits and options
L to R: Barnett, Shores, Fraundorf and Revare

Conventional wisdom says index funds are all the same—passive investment vehicles that track benchmarks, right? Wrong! Index funds have proliferated, and retirement plan advisers must now do more than work through the question of active vs. passive management. To be of utmost value to their clients, advisers must understand fund composition, the benchmarks used, the analysis needed when benchmarks change, the role of target-date funds (TDFs), manager selection and more. On a recent webcast, moderated by PLANADVISER Global Editor-in-Chief Alison Cooke Mintzer, Robert Barnett, sales leader for Wilmington Trust Retirement and Institutional Services Company; Sara Shores, CFA, director and head of U.S. Index Strategy within BlackRock’s Beta Strategy Group; R. Samuel Fraundorf, president of Wilmington Trust Investment Advisers; and Scott Revare, CEO of the Center for Fiduciary Management, explained the nuances of indexing.

PA: What, specifically, should financial advisers know and understand about indexing in today’s defined contribution (DC) plans?

Barnett: We’ve seen a growing popularity in the use of indexing in defined contribution and defined benefit (DB) plans over the last decade. As we’ve seen that growth, we’ve learned the advantages and disadvantages of both active and passive management—and how fund managers should be evaluated and monitored.

Shores: There’s been a dramatic increase in the presence of index funds, both in the defined benefit and the defined contribution market.

A recent McKinsey study estimated that the footprint of index funds in defined contribution portfolios would increase from 9% to 16% by the end of 2010—and to 24% by 2015.

In the aftermath of the credit crisis, the ability of an index fund to track its benchmark is really attractive to a lot of investors, so we expect we will continue to see index funds become an even more significant part of defined contribution portfolios.

If asset allocation is the most important decision to be made, index funds provide the desired exposure in a low-cost, efficient and transparent way. However, it is important to understand that not all index funds are created equal, and there can be a significant difference in the performance among what appear to be essentially identical funds.

Even for an index as straightforward as the S&P 500, there can be marked differences in the realized returns across providers. So, if not all index funds are created equal, how are advisers like you meant to select their next fund?

Performance is absolutely the most important thing to consider, alongside risk management and costs. And while a fund’s expense ratio is important, the difference in performance between one fund and another can be multiple times the difference in expense ratio. So it’s very important to consider the total performance experience of participants, and that includes the expense ratio, the total returns and consistency of those returns.