07/28/2010 09:58 am ET Updated Dec 06, 2017

Upton Sinclair's Insight for Improving Your 401(k) Returns

It's surprising that Upton Sinclair would provide today's investors with an insight for investing success. He was born on September 20, 1878. His parents were very poor. His father was an alcoholic. His grandparents were quite wealthy. The stark difference in the financial circumstances of his parents and grandparents influenced him to become one of the most prominent socialists of his time. He even ran (without success) as the Socialist's Party's candidate for Congress from New Jersey.

What can this avowed socialist teach us about investing? Here's a quote attributed to him. It says it all:

"It is difficult to get a man to understand something when his salary depends upon his not understanding it."

The salaries of brokers and insurance company representatives depend on persuading employers with 401(k) plans to include actively managed funds (where the fund manager attempts to beat a designated benchmark) as investment options in the plan. Billions in fees is generated in this way. The overwhelming evidence supports the view that most of this money is wasted. Plan participants would achieve significantly greater returns if no actively managed funds were in their plans. Instead,the plans should offer a limited number of pre-allocated, globally diversified portfolios of low cost index funds, Exchange Traded Funds or passively managed funds.

People who make a living selling actively managed funds react to this news much like a speech by a vegetarian is received at a cattlemen's convention.

One reader (a broker) patiently explained that I didn't understand the math. He believes the support for index funds in the press is caused by its willingness to accept glib statements from bloggers (like me). He provided no data to support his view.

Two distinguished finance professors who clearly do "understand the math" are Eugene F. Fama, a Professor of Finance at the University of Chicago, Booth School of Business, and Kenneth F. French, a Professor of Finance at Dartmouth College, Tuck School of Business. In their recent study, Luck Versus Skill in the Cross Section of Mutual Fund Returns, they attribute outperformance of actively managed funds to luck and not skill. Because there is no evidence of skill, it's not surprising those funds that do perform well over a given period of time typically cannot repeat their stellar performance.

The ramifications of this study hit brokers and insurance companies right where it hurts -- in their pockets. If employers understood this data, they would not include actively managed funds in their 401(k) plans because those funds are likely to underperform passive benchmarks by almost 1% per year.

The reaction to studies of this sort is interesting. Another reader explained his strongly held view that "managed funds" should be in all 401(k) plans. He bragged his credentials included an M.B.A. He was a consultant to corporations and boards on how to reduce their fiduciary risk.

I responded with a number of studies (including some by Nobel Prize winners in Economics) rebutting his views. I encouraged him to send me peer reviewed studies with contrary data. I told him I had an easy solution for eliminating fiduciary liability, rather than simply mitigating it: Require investment advisors to 401(k) plans to be 3(38) ERISA fiduciaries and to accept 100% of the liability for the selection and monitoring of plan assets.

Here's his response: He doesn't believe in academic studies. He has no confidence in the committee that appoints Nobel Prize winners. He sent me no data.

The pattern is very familiar. Research is responded to with rhetoric, but no contrary data. Unfortunately, their clients often don't have the sophistication to confront them with studies that demonstrate what they are selling is in their best interest, but not in the best interest of the participants in the plan.

Employers need to appreciate their potential exposure as fiduciaries to plan participants. It's only a matter of time before an enlightened court reviews the studies and concludes the inclusion of any actively managed fund in a 401(k) plan violates the duty of prudence.

Brokers and insurance companies will never "understand" this evidence. Their salaries depend on their not understanding it.

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.

Here is the trailer for my new book, Timeless Investment Advice.