How to blend active and passive options in your 401(k) plan

Commentary: Many 401(k) plan participants are convinced that active management, where fund managers attempt to beat benchmark index returns, no longer works. They prefer to have low cost, passively managed or index options available in their 401(k) plans. Given the high degree of correlation between investments post-crash, being 100% invested in passive funds would probably have been a smart strategy.

But most experts believe it is not likely that markets will remain as highly correlated in the future. Recently the folks at BlackRock, the largest asset manager in the world, shared research that indicates that a blend between active and passive choices is probably best for most 401(k) plans.

Also see: Should 401(k) plans include index funds only?

When selecting active funds, BlackRock recommends:

• Look for broad market mandates. Regardless of whether you are considering an actively managed fixed income, equity or real assets fund, search for funds that provide the manager with a broad market mandate. Fund managers that can search a broad swath of the market for promising opportunities are more likely to outperform.

• Use actively managed funds for asset classes difficult to index. It makes sense to offer index fund options in some asset classes because it is difficult for a fund manager to find or take advantage of inefficiencies within those classes. U.S. large cap equities (value, growth and blend) are examples of asset classes where it would seem active management would have a difficult time beating passive. However, other assets classes, such as commodities and international equities, have enough inefficiencies to allow skilled fund managers to outperform.

Plan participants should also be made aware that they need to hold active funds through a full market cycle. Many active managers outperform when markets fall. Remember, the biggest negative in using passive investment options is that investors experience 100% of all down market moves.
Also see: There’s a perfect storm brewing in the 401(k) space

When selecting passive funds, BlackRock recommends:

• Select passive options for efficient asset classes. In those asset classes where active managers have very little chance of beating a benchmark, passive investment options should be offered. Examples include U.S. large-cap asset classes.

Consider using passive options when good active options aren't available. For example, it may be hard to find a good actively managed U.S. equity mid-cap fund. In those instances, consider using an index fund.
The next time you review your investment menu, make sure you are offering an appropriate balance of active and passive mutual fund options to your participants.

Robert C. Lawton, AIF, CRPS is president of Lawton Retirement Plan Consultants, LLC, a RIA firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be contacted at bob@lawtonrpc.com or 414.828.4015.