The argument that actively managed funds are appropriate in Defined Contribution (DC) plans has been going on for decades, and numerous excessive fee lawsuits against pension plan sponsors have pushed the needle towards the use of funds. liabilities in the investment menus of DC plans.
Now, a recent publication from the CFA Institute Research Foundation asks the question, “Is active management worth it?” The paper, titled “Defined Contribution Plans: Challenges and Opportunities for Plan Sponsors,” notes that proponents of passive management argue that active fund managers rarely have the investment skills necessary to achieve superior performance net of fees. . Supporters of active management argue the opposite.
The CFA Institute Research Foundation publication states that because passively managed funds hold portfolios of securities intended to track an index, passive fund managers need an efficient portfolio construction process to achieve their goals. He explains that the fixed costs associated with managing this process mean the manager and investors benefit from the scale of the building. The natural way for the manager to do this is to lower barriers to entry for investors by lowering fees, according to the institute.
On the flip side, the publication explains, “the central proposition for actively managed funds is that their unique research and execution enables them to add value for their investors.” However, the CFA Institute Research Foundation says that at a certain amount of assets under management (AUM), an actively managed fund would generate the same return as a passively managed fund, minus any difference in fees.
“Therefore, for an active manager to generate positive active returns (sometimes called ‘alpha’) for his investors, he must at some point close the fund to new investors, that is, he has what’s called a capacity constraint, ”the publication said. said. This capacity constraint, along with the research and skill of fund managers, explains why actively managed funds cost more than passive funds.
Also weighing in on the debate over active versus passive management, with a focus on Target Date Funds (TDFs) – which hold the majority of participants’ assets – Maddi Dessner, Head of Class D Global Services ‘assets at Capital Group, says cost is a target. through which the plan trustees must assess the investment managers is not the only thing to consider. She says plan trustees must also determine what investors will receive in returns net of fees. “Cost is a limiting way of looking at active versus passive management and the value that participants will receive,” she adds.
Dessner points to the Department of Labor (DOL) guidelines on fees, which say plan sponsors should think about the value members receive for the cost. She also notes that the DOL TDF Selection Tip Sheet recommends that plan sponsors consider which strategies are consistent with the goals and objectives of the plan and plan members.
The CFA Institute publication argues that selecting and monitoring actively managed funds is more complex and time consuming for plan sponsors. “Managers use a wide variety of approaches to conduct investment research, build portfolios and control trading costs,” the paper says. “One of the challenges of selecting active managers is understanding these approaches. The authors argue that investment committees of defined contribution plans rarely have the investment knowledge to distinguish managers, and while large promoters may have knowledgeable staff and access to consultant advice, small developers have fewer, if any, of these resources.
Dessner says the selection and monitoring of passive funds also involves rigorous due diligence for DC plan committees. Especially for TDFs, plan sponsors need to monitor the sliding path of the funds and the underlying investments.
“Additionally, Trustees cannot ignore the fact that the structure of a descent path is an active decision,” she adds. “It also produces differences in the results. Over the past five years, older participants have seen yields vary by 12% or more at a critical point in their lifecycle.
The CFA Institute publication includes the results of one of several studies on the performance of active managers, focusing on mixed managers of large US caps. Although some managers were able to add value, the average active performance achieved was negative. The institute notes that similar types of studies have been carried out for other asset classes and that the results will vary by asset class. “The lesson for sponsors is that finding qualified active managers is difficult and will likely take a long time,” he says.
To the argument that active fund managers struggle to outperform benchmarks, Dessner says a recent Morningstar study of active and passive TDFs found that their performance did not differ significantly. “The average expense ratio for our R6 share class is about 25bp higher than some of the largest passive TDF providers, but over the past decade, American Funds has outperformed some of these providers by 100. at 150 bps, annualized, net of fees. ” She adds.
Even on the core investment menu, Dessner says it’s okay for plan sponsors to include actively managed funds if they offer better net expense results than benchmarks. She says that concentrations in particular investments come with significant risk, and that’s what is built into passive exposures, so finding more ways to diversify from a benchmark is a good thing.
“When selecting from the main menu, participants tend not to select investments to achieve concentration risk diversification,” Dessner adds. “The option for plan sponsors is to simplify the investment menu and offer investments that will generate returns net of fees. “
The authors of the CFA Institute article recommend that a DC plan committee select actively managed investment options only if it can answer yes to the following four belief statements:
- Active managers who can add value exist (after fees) in the asset class;
- The committee can identify and hire these managers;
- The committee can adequately monitor and, if necessary, replace poorly performing managers; and
- The committee can educate participants on how to appropriately use these actively managed investment options in their accounts.
Dessner says it’s important for plan sponsors to make the appropriate decisions that lead to member success, not just decisions based on cost or fears of litigation. “Plan sponsors shouldn’t just think about costs,” she says. “In [the CFA Institute’s book] himself, he says that the important things are costs, risks and returns, so plan sponsors need to think about the outcomes for plan members.