We all know how markets have traded most of the time since the 2008 crash. Risk-on, risk-off. One day everything is moving up in value, the next everything is falling. Regardless of what you were invested in stocks, bonds, commodities, international equities, etc. the correlation of movement in prices and values was high. Investors received little or no benefit from diversifying. Indexing outperformed active management most of the time.
Things are changing.
Recently correlations in U.S. equities have begun to diverge. In other words, the markets are returning to what most would consider normal. In normal markets, actively managed investment options tend to outperform. As we gradually move away from risk-on, risk-off roller coaster markets, 401(k) plan sponsors should keep the following in mind:
- Equity options. Make sure that your 401(k) plan offers an appropriate selection of actively managed equity options. Over the past six years investment menus have become index-fund heavy for cost management and performance reasons. Plan sponsors should remember to balance their investment menus with both actively managed and indexed options.
- Fixed income options. Plan sponsors need to offer more than just an intermediate-term bond fund. Actively managed international, short-duration, high-yield, corporate and multi-sector bond funds should be considered.
- Interest rates will rise. Very soon the Fed will begin to increase interest rates. Are the fixed income options that you offer in your 401(k) plan going to perform well in a rising interest rate environment?
- Employee education. Most studies have shown that active management outperforms passive by 2% to 3% per year. Doesn't seem like much? Think of it in terms of an additional fee participants might pay to select a passively managed approach. The implications over a 40-year career can be enormous. Make sure to re-introduce the benefits of active management into your employee education sessions.
- A place for indexing. Studies estimate that up to one-third of your plan participants may be passionate believers in indexing, regardless of market conditions. This isn't the time to dump all of your index options. A well-balanced portfolio should include a mixture of indexed and actively managed investments. It is likely that index options will continue to perform well in market segments where inefficiencies are low, while actively managed approaches can be expected to outperform in those market segments where inefficiencies are high.
Talk with your 401(k) plan investment adviser about making sure your investment menu is structured appropriately for a rising interest rate environment and markets where solid active management will once again outperform.
Robert C. Lawton is president of Lawton Retirement Plan Consultants, LLC (lawtonrpc.com), an RIA firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be contacted at firstname.lastname@example.org or 414.828.4015.
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