Passive index funds slowly gain traction

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The move toward passive investment options continues to gain momentum but remains a relatively small percentage of the monies invested in workplace retirement accounts.

There are a number of reasons why retirement plan sponsors have started moving fairly strongly into passive investments like index funds. “They are faced with a lot of fee pressure from regulators, their own plan participants and from the competition. Using passive is a very simple way of reducing overall fees that are embedded in an institutional program,” says Christopher Philips, head of Institutional Advisory Services at Vanguard.

Because of the 408(b)(2) fee regulations that went into effect in 2012, plan sponsors and plan providers have had to become more transparent about retirement plan fees. The Department of Labor’s fiduciary rules, which go into effect in 2017, also will have an impact on how plan sponsors and investment committees do their job.

“If performance wasn’t skewing heavily in favor of passive, it wouldn’t be as strong a trend,” Philips says. “The fee pressure and the fiduciary aspect are strong. If passive was underperforming active [it would be a different story] but that is not the case. We have seen data point after data point over the last 10 to 15 years about the relative lack of success of active management in general.”

That said, actively managed funds continue to hold the largest amount of retirement assets.

“There are strong reasons why active will always be a core part of the strategy. The most obvious being that if an investor wants a chance to outperform the market, they have to be active. That is a strong reason,” Phillips says. “But that must be paired with an ability to actually pick managers and identify those types of funds that will give you the best chance to outperform because we know the odds are not in the average investor’s favor to pick those.”

The lower the cost of the active manager, the greater the probability they will add value after costs are taken into account, he adds.

“We offer active funds at a fraction of the cost of traditional active. Our success rate is actually pretty solid,” Phillips says.

Phil Chisholm, vice president of defined contribution product management at Fidelity Investments, says that from Fidelity’s perspective, not much has changed since last year when it comes to the number of participants choosing index funds.

“Last year, just under 29% of our total assets were on the passive side,” he says. Now it is just over 29%, which means that figure hasn’t moved a full percentage point from last year. One of the reasons for that is “we’ve had a lot of success among our actively managed funds in beating the benchmarks,” Chisholm says.

Seventy percent of Fidelity equity funds that have a manager that has been there longer than five years have beaten their benchmark, he adds.

“I think if you are a plan sponsor and are going through your investment policy review and how performance is doing, if you find out performance is doing better, there is less motivation to make a change,” Chisholm says.

The main reason to move toward index funds is that they are usually lower cost. Performance is another reason. Many actively managed funds have had a difficult time beating the benchmark in such a low interest rate environment. As a result many investors have shied away from them in favor of passively managed funds that track an index.

Matt Sommer, vice president and director of retirement strategy at Janus Capital in Denver, told EBN that plan sponsors need to keep track of the fees they are paying but fees aren’t the only consideration when they put their investment lineups together.

Index funds are market-weighted, meaning those holdings that have appreciated the most recently are going to represent the largest percentage of the investment. They can become over-weighted over time, making the drops in market value, when they happen, even more dramatic.

On the fixed income side, if interest rates go up, the index goes down, and in this low interest rate environment the market has been in the past few years, interest rates are likely to rise rather than drop in the long-term, Sommer says.

“That’s one of the benefits of having an active manager for bond investing,” he says. Those managers can move money from corporate bonds to government treasuries or vice versa based on which one is less sensitive to an expected rise in interest rates, Sommer adds.

The adoption of target-date funds and the growth of index-based TDFs has “been very robust,” according to Vanguard’s Philips. “Index-based TDFs are capturing the lion’s share of cash flow in defined contribution plans. That is driving that move to passive and also the adoption of tiered lineups in 401(k)s and a lot of plan sponsors focusing on that core index tier where they want to drive plan participants to make the best decisions.”

Index funds offer plans the opportunity to get exposure to different asset classes that are not available through active funds, Fidelity Investment’s Chisholm says.

“If funds are not performing in the active space, passive could be a way to attack that,” he adds.

One thing retirement plan managers must never forget with the passive model is it is the averaging of an index. By moving into passive investments, investors give up the opportunity to outperform the market with a talented active fund manager. But if an investor is not comfortable with that asset management approach, Chisholm says, passive is the way to go.

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