Vanguard Sees Increase in Use of Index Fund Investments

The use of low-cost index funds by participants in Vanguard 401(k) plans increased noticeably between 2004 and 2012.

The average participant now invests 60% of his or her account balance in such index funds, according to a new Vanguard study. The study, “Behavioral Effects and Indexing in DC Participant Accounts 2004–2012,” indicates that this percentage has doubled from 30% in 2004, largely as a result of the growing popularity of index based target-date funds.

The study also finds that the assets in actively managed funds and non-indexable assets, such as money market funds, stable value funds and company stock, decreased over that same eight-year period, going from 32% in 2004 to 19% in 2012.

“The movement to index investing is good news for participants who are obtaining broadly diversified exposure to the market at a low cost, which can ultimately help them accumulate more money for their retirement,” says Cynthia Pagliaro, lead author of the study and an analyst in Vanguard’s Center for Retirement Research, based in Valley Forge, Pennsylvania.

The study highlights a steep drop in the number of participant accounts invested solely in actively managed funds and finds a concurrent increase in all-index accounts. In 2004, 39% of participants were invested exclusively in active funds. By 2012, this all-active group had decreased to 19%, a relative decline of 51%. Conversely, in 2004, 10% of participants were invested solely in index funds. By 2012, that figure was 38%, a nearly fourfold increase.

The study also finds that older, longer-tenured participants held 100% active portfolios, likely as a result of inertia, meaning these participants never changed their investments. This “inertia effect” is common among existing participants, many of whom never alter their initial allocations. Younger, shorter-tenured participants tended to hold 100% index portfolios, largely because they were automatically enrolled in plans with index based target-date funds as the default investment.

Pagliaro and the other authors of the study also examine how participants allocated their ongoing contributions, which are a better indicator of their future investing intentions than the current composition of their accounts. From 2004 through 2012, the percentage of contributions that participants directed to index funds rose from 32% to 64%, while the percentage directed to active funds declined from 38% to 20%.

Another factor influencing participants’ transition to indexed investments is their plan’s investment menu, according to the study. In recent years, more index funds—primarily indexed target-date funds—have been added to plans because of the sponsors’ desire to reduce participants’ investment costs and exposure to active fund risk. The increased prominence of index funds in plan investment lineups has contributed to participants’ increased adoption of these funds. In addition, for participants who want to voluntarily choose their investments, target-date funds can offer a simplified choice because they can be chosen based on the investors’ expected retirement age.

“The results of this study highlight the critical role that plan sponsors play in the investment strategy of participants,” says Pagliaro. “Due to these behavioral effects, it is likely that the sponsor’s decision will have a profound influence on the investment choices made by their participants.”

More information about the study can be found here.