The argument for whether actively managed funds are appropriate in defined contribution (DC) plans has been going on for decades, and numerous excessive fee lawsuits against retirement plan sponsors have been pushing the needle toward the use of passive funds on DC plan investment menus.
Now, a recent publication from the CFA Institute Research Foundation asks the question, “Is active management worth it?” The paper, titled “Defined Contribution Plans: Challenges and Opportunities for Plan Sponsors,” notes that passive management proponents argue active fund managers rarely possess the investment skill to achieve superior performance net of fees. Active management proponents argue the opposite.
The CFA Institute Research Foundation’s publication says that because passively managed funds hold portfolios of securities intended to track an index, passive fund managers need an effective portfolio construction process to achieve their goals. It explains that the fixed costs associated with managing this process mean both the manager and investors benefit by building scale. The natural way for the manager to do that is to lower the barriers to entry for investors by lowering fees, the institute says.
On the other hand, the publication explains, “the central proposition for actively managed funds is that their unique research and execution put them in a position to add value for their investors.” However, the CFA Institute Research Foundation says that at a certain amount of assets under management (AUM), an actively managed fund would generate the same return as a passively managed fund, minus any difference in fees.
“Hence, for an active manager to generate positive active returns (sometimes called ‘alpha’) for their investors, at some point they need to close the fund to new investors, i.e., they have what is called a capacity constraint,” the publication says. This capacity constraint, as well as the research and skill of fund managers, is why actively managed funds cost more than passive funds.
Also weighing in on the active versus passive management debate, with a focus on target-date funds (TDFs)—which hold the majority of participant assets—Maddi Dessner, head of global asset class services at Capital Group, says while cost is one lens through which plan fiduciaries need to evaluate investment managers, it’s not the only thing to consider. She says plan fiduciaries also need to determine what investors will receive in returns net of fees. “Cost is a limiting way to consider active versus passive management and what value participants will receive,” she adds.
Dessner points to Department of Labor (DOL) guidance on fees, which says plan sponsors should think about what value participants receive for the cost. She also notes that the DOL’s tip sheet for selecting TDFs recommends plan sponsors consider what strategies are in alignment with the goals and objectives of the plan and plan participants.
The CFA Institute’s publication argues that selecting and monitoring actively managed funds is more complex and time consuming for plan sponsors. “Managers use a wide variety of approaches in conducting investment research, constructing portfolios and controlling trading costs,” the paper says. “One of the challenges in selecting active managers is understanding those approaches.” The authors contend that DC plan investment committees rarely have the investment knowledge to distinguish among managers, and while larger sponsors may have knowledgeable staff and access to consultant advice, smaller sponsors have fewer, if any, of those resources.
Dessner says the selection and monitoring of passive funds also involves rigorous due diligence for DC plan committees. Especially for TDFs, plan sponsors must monitor the funds’ glide path and underlying investments.
“Also, fiduciaries can’t get away from the fact that the structure of a glide path is an active decision,” she adds. “This also produces differences in results. In the past five years, older participants have seen returns vary by 12% or more at a critical time in their lifecycle.”
The CFA Institute’s publication includes the results from one of many studies of active manager performance, focusing on U.S. large-cap blend managers. Although some managers were able to add value, the average realized active performance was negative. The institute notes similar types of studies have been done for other asset categories and that results will vary by asset class. “The lesson for sponsors is that finding skilled active managers is challenging and likely to be very time consuming,” it says.
To the argument that active fund managers have a hard time outperforming benchmarks, Dessner says a recent study by Morningstar looking at active and passive TDFs found their performance didn’t meaningfully differ. “The average expense ratio for our R6 share class is around 25 bps higher than some of the largest passive TDF providers, yet over the past decade, American Funds has outpaced some of those providers by 100 to 150 bps, annualized, net of fees,” she adds.
Even in the core investment menu, Dessner says it is not wrong for plan sponsors to include actively managed funds if they deliver net-of-fee results better than benchmarks. She says concentrations in particular investments have significant risks, and that’s what is embedded in passive exposures, so finding more ways to diversify from a benchmark is a good thing.
“When selecting from the core menu, participants tend not to select investments to get diversification from concentration risk,” Dessner adds. “The option for plan sponsors is to simplify the investment menu and offer investments that will deliver returns net of fees.”
The authors of the CFA Institute’s paper recommend a DC plan committee should select actively managed investment options only if it can answer yes to the four following belief statements:
- Active managers that can add value exist (after fees) in the asset category;
- The committee can identify and hire those managers;
- The committee can adequately monitor and, when necessary, replace poorly performing managers; and
- The committee can educate participants on how to appropriately use those actively managed investment options in their accounts.
Dessner says it is important for plan sponsors to make appropriate decisions that lead to participant success, not just decisions based on cost or litigation fears. “Plan sponsors should be thinking not just of cost,” she says. “In [the CFA Institute’s book] itself, it says important elements are cost, risk and returns, so plan sponsors need to think about results for participants.”