You may have heard that many experts believe retirement plan participants should only be allowed to invest in index funds. They say that the additional cost that participants pay for actively managed mutual funds is not justified by better performance. A number of employer plan sponsors have agreed, concluding that offering only index funds is the way to go. As a result, their fund line-ups are comprised almost entirely of index funds.

Recently, some academic studies have come to light which show that actively managed mutual funds are still a good value - provided you can find the funds that are truly actively managed.

Antti Petajisto, former NYU assistant professor and now vice president for BlackRock’s multi-asset strategies group and Yale Professor Martijn Cremers authored a paper which introduced a mutual fund management concept that helps identify so called "closet index" funds. An actively managed mutual fund posing as a closet indexer is essentially an index fund that charges too much in management fees. The authors have indicated that these closet index funds rarely outperform their benchmarks. Therefore, they are not good investment choices to offer retirement plan participants.

In addition, Michael Finke reported in his article "Why Hyperactively Managed Funds Outperform", that the percentage of index fund assets has risen from about 10% in the mid 1990s to about 50% now. The article goes on to explain that only about 20% of these fund assets are actually held in pure index funds—the other 30% are held in actively managed funds that are essentially closet index funds.

How can you make sure that your retirement plan is not offering a bunch of over-priced closet index funds to your plan participants? The Department of Labor expects that at least annually you perform an intensive review of the investment options in your retirement plan. When you do your review for 2013, ask your retirement plan advisor to focus on identifying funds in your line-up that could potentially be closet index funds. Once identified, these would be investment options that you would probably want to replace with either actual index funds or truly actively managed funds.

Active management works, provided you screen out those closet index funds masquerading as actively managed funds. 

Contributing Editor Robert C. Lawton is President of Lawton Retirement Plan Consultants, LLC a Registered Investment Advisory firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities.  Mr. Lawton has over 25 years of experience working with corporations on their retirement plans and is a Chartered Retirement Plan Specialist (CRPS) and Accredited Investment Fiduciary (AIF).  Mr. Lawton was named as a Top 100 Retirement Plan Adviser by PLANADVISER and a Top 300 Retirement Plan Adviser by 401(k) Wire.  Mr. Lawton may be contacted at bob@lawtonrpc.com or 414.828.4015.

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