Updated below.
Morningstar is supposed to know more about mutual funds than anyone else. All the more surprising that it would proudly publicize the criteria it used to select mutual funds in its own 401(k). A recent blog by Russel Kinnel, Morningstar's director of mutual fund research, noted the committee selecting these funds for the plan tries hard to keep it "in peak form." The funds are chosen for "strong fundamentals such as cost, management, stewardship, and strategy."
I feel sorry for Morningstar's employees. The fund selections represent everything that is wrong with 401(k) plans in this country. Here are some suggestions for Morningstar's committee. They reflect finance 101. It's sad the committee is so clueless about them:
Your Employees Need Portfolios, not funds.
Very few employees have the ability to put together a risk-adjusted portfolio from a selection of a large number of fund options. Instead of giving them twenty-three funds to choose from, why not offer globally diversified portfolios of stock and bond funds at different risk levels, ranging from conservative to aggressive?
Get rid of all your actively managed mutual funds.
How can you possibly justify having twenty-one actively managed funds and only two index funds as investment options in your plan? You create a lot of the mutual fund data, do you simply ignore it when it comes to the welfare of your employees?
The likelihood of your actively managed funds outperforming their benchmarks over a ten year period is statistically extremely small. Only about five percent of actively managed funds equal their benchmarks over a decade. It's hard to believe your committee is using past performance as a benchmark. There is precious little data indicating that stellar performance persists. I assume you are familiar with the SEC mandated caveat that "past performance is no guarantee of future results."
I'm sure your committee believes it's doing something useful when it engages in the kind of analysis detailed in your article. It really is just wasting time, feeling important and populating your 401(k) plan with expensive funds likely to enrich mutual funds and reduce the returns of participants.
Do you pay any attention to academic research?
Instead of doing an analysis of historical fund performance which has no predictive value, consider paying attention to the overwhelming research supporting index based investing. The portfolios in your plan should consist solely of low management fee stock and bond index funds. If you are serious about wanting a plan that is in "peak form", take a look at the SuperSmart Portfolios set forth in my book, The Smartest Portfolio You'll Ever Own. Those portfolios are based on the extensive research of Professors Fama and French. This research is taught in virtually every business school in this country and is the basis for how over a $1 trillion of really smart money is invested. By tilting portfolios towards small company stocks and value stocks, you could increase the expected returns of your employees for a given level of risk. I've done all the work for you. How difficult would it be for you to implement this simple plan? If you need more support, it is exhaustively set forth in my books and in books by John Bogle, Burton Malkiel, Larry Swedroe, Mark Hebner, Jason Zweig, Allan Roth, William Bernstein and many others. This research is endorsed by many Nobel Laureates in Economics. Does your committee have any research justifying its methodology?
Are you worried about being sued?
If you don't care about the best interest of your employees, maybe you should be guided by self-interest. Your line-up of primarily actively managed funds makes you a target for a lawsuit from employees alleging that you are breaching your fiduciary duty to them. I don't know if you use an advisor for your plan. When I see these kinds of investment options, I usually find that the advisor is receiving "revenue sharing" payments from the mutual funds. If your advisor is receiving these funds, he cannot be a 3(38) ERISA fiduciary. If I were you, I would insist that any advisor to my plan be a 3(38) ERISA fiduciary because only these fiduciaries accept 100 percent of the liability for the selection and monitoring of the investment options in the plan. 3(38) ERISA fiduciaries cannot accept revenue sharing payments or have any conflict with the best interest of plan participants. Don't you want this assurance?
In my opinion, your plan is in the best interest of your advisor and the actively managed mutual funds populating your plan. I give you credit for writing about your selection process, but you really should be ashamed to tout this plan as an example for others to follow.
Update:
Russel Kinnel, Morningstar's Director of Research, has taken issue with some of the assertions in my blog. My position on his views is as follows:
Morningstar offers Target Date Funds and "low cost actively managed funds" in addition to the funds mentioned in my blog.
There was no reference to these options in the article by Mr. Kinnel, which was the focus of my blog. Target date funds can be an excellent choice, but only if the underlying funds are index funds. I don't know the details of the "managed portfolios." If they are "managed" by active fund managers, that would be sub-optimal.
By offering these options, Morningstar's employees are not "overwhelmed" by the number of investment options.
I don't agree. Giving employees a choice of 21 actively managed mutual funds, 2 index funds, target date funds and "managed accounts" is overwhelming and unnecessary.
The actively managed funds offered in Morningstar's 401(k) plan are "low cost" institutional shares.
I don't agree that these actively managed funds are "low cost." According to data in Mr. Kinnel's blog, fifteen of the twenty-one actively managed funds have expense ratios of 0.50% or higher. Six of them have expense ratios of 0.99% or higher. The two index funds in its line-up are low cost, with expense ratios of 0.29% and .04%. All of the actively managed funds in its plan have higher expense ratios than its most expensive index fund. The expense ratio of many index funds ranges from .04% to 0.30%.
Here's what Mr. Kinnel wrote in a Morningstar report : "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds." I find it curious that Morningstar departs from these findings and selects primarily actively managed funds for its 401(k) plan, when these funds have higher expense ratios than comparable index funds.
Morningstar believes the data shows that "35% of actively managed funds have beaten their benchmarks over the trailing 10 years. For several large categories, the number crosses 50%."
The data on this issue is not entirely consistent. I was relying on this chart for my lower percentage, which shows that over a ten year period, only 2.4% of large cap blend mutual funds beat the S&P 500 index. However, it really doesn't make much difference. Trying to identify in advance which actively managed funds are likely to outperform is exceedingly difficult, and that is precisely what Morningstar's investment committee believes it can do. As indicated in an article in the New York Times:
- After fees and taxes, it is "the extremely rare actively managed fund" that will beat the returns of a comparable index fund;
If I am a plan participant, I don't like those odds. I would also be asking my plan administrator, why they believe they can beat them.
Dan Solin is a Senior Vice President of Index Funds Advisors (ifa.com). He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.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.