One way to help prepare participants for retirement, and thereby reduce employer costs, is to include several different passively managed index funds in their 401(k) investment menus. Unfortunately, it’s an often-overlooked opportunity.
The Fed’s suppression of interest rates, which has finally started to ease up recently, has helped to create a rising equity market since 2009, making a passive investment strategy a recipe for success over that time frame. By investing in one security you own 500 of the highest-capitalized companies across many industries. It’s a simple way to get broad exposure to the U.S. equity markets.
Empirical research proves the validity of index investing. Eugene Fama, often called “The Father of Finance,” states that short-term stock price movements are unpredictable and approximate a “random walk.” This makes it difficult for actively managed funds to outperform index investing over the long run.
There are many other reasons for adding index funds to the plan’s investment options:
Simplicity. A participant who invests in an index is, of course, subject to both the risk of underperformance and the reward of outperformance. But there is no need to research how well the fund did versus a benchmark the figuring out what fund’s investment strategy is.
Low cost. Index funds not only carry lower costs than managed funds, as a rule, but the associated fees continue to drop over time. That means more of the participant’s investment dollars are working toward his or her retirement goals.
Recognition. As index funds continue to grow in favor as an investment option, participants will feel more comfortable with them, which will facilitate long-term investing.
Access to target-date funds. Most new dollars going into 401(k) plans are invested in target-date funds, many of which include index funds. Constructed according to the investor’s anticipated year of retirement, the mix of investment types in a target-date fund adjust over time from a position of higher risk to one of lower risk as the retirement date approaches. These investment vehicles are very appealing to participants who have little investing experience and are seeking a simple, convenient approach to preparing for retirement. Target-date fund assets reached $880 billion in 2016, up from $125 billion just 10 years earlier.
Selection. Offering a variety of index funds in 401(k) plans allows participants to diversify their investments according to the different risk/reward profiles of various indexes. The most-often-cited is the S&P 500, which is up just over 300% from its March 2009 lows. However, the S&P Midcap 400 and Nasdaq 100 are up more than 350% and 450%, respectively, during the same time frame.
But, while adding index investments to your fund lineup will help participants become retirement ready, are they the only investment options you should have in your lineup? No. A well-diversified 401(k) plan lineup should contain both active and passive investment strategies, for the following reasons:
Choice. Many participants are willing to pay a premium for the chance to outperform an index, either through higher returns or better risk-adjusted returns. There are periods, such as in 2016, when it was extremely difficult for active managers to outperform passive strategies, but that can change year to year.
Downside protection. Index funds are fully invested at all times. If financial markets begin to slide, index investors will find their plan assets dropping as well. Actively managed funds can allocate assets to cash or modify industry allocations, reducing volatility and potential losses, and some can even short stocks to cushion downside risk.
Diversification. Although the widely held index funds are well diversified by their number of stocks, they are market-cap weighted, meaning the biggest companies have the greatest influence on index performance. This can help on the upside but hurt on the downside. For example, during the technology run-up in the late 1990s, it was difficult for active managers to outperform passively managed index funds.
However, when the technology bubble burst in 2000, those same stocks that drove performance during the boom were the ones that had the greatest negative effect on performance during the bust. Actively managed funds could have mitigated the severity of the price declines.
Kenneth Hoffman is a managing director and partner with HSW Advisors, a wealth-management boutique within HighTower Advisors, LLC.
The source for all data in this article is FactSet, May 2017.
HSW Advisors is a team of investment professionals registered with HighTower Securities, LLC, member FINRA, MSRB and SIPC & HighTower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through HighTower Securities, LLC and advisory services are offered through HighTower Advisors, LLC.
This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee.
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