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401(k) Participants Pay Dearly for the Crime of Underperformance

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The vast majority of 401(k) plans are populated with actively managed funds, where the fund manager attempts to beat a designated benchmark, like the S&P 500 index. These funds are included as investment options based on advice of brokers, registered investment advisors or insurance companies responsible for advising the plan sponsor. A recent article by Charles D. Ellis questions this practice and raises issues that have been troubling me for a long time. The article is titled: Murder on the Orient Express: The Mystery of Underperformance.

According to his biography, Mr. Ellis has taught investment management courses at Harvard and Yale. He is the author of 16 books and many articles for professional publications. Ellis has served on the governing boards of Yale University, Stern Schools of Business at New York University, and Phillips Exeter Academy. He earned a Ph.D from New York University and an MBA from Harvard University.

It is my view that a 401(k) plan that has any actively managed funds as investment options reflects negligence by both those advising the plan and the plan sponsors who blindly accept this flawed advice. Ellis notes the daunting odds of beating the benchmark. Over a ten year period, only 30 percent of actively managed funds outperform. That percentage falls to 20 percent over a 20 year period.

Even those numbers are deceptive. In their seminal analysis of luck versus skill in mutual fund returns, Eugene F. Fama and Kenneth R. French evaluated 819 actively managed funds over 22 years and found that 97 percent could not be expected to beat a risk-appropriate benchmark.

It's bad enough that only 3 percent of active fund managers demonstrate evidence of investment skill. It's worse that no one has figured out a way to identify these outperforming fund managers prospectively. And here's the nail in the active fund managers' coffin: Even if you could miraculously look into a crystal ball and determine the next outperforming fund manager with investment skill, there's no payoff. According to Fama and French: "... going forward we expect that a portfolio of low cost index funds will perform about as well as a portfolio of the top three percentiles of past active winners, and better than the rest of the active fund universe."

Ellis views the charade of relying on advisors to pick outperforming actively managed funds as part of what he calls "the crime of underperformance". He allocates blame to investment committees, investment managers, investment consultants and fund executives, noting: "No one suspect is guilty; they are all guilty."

Ellis' paper should be required reading for all plan sponsors.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book is The Smartest Money Book You'll Ever Read. The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.