Passive vs. Active Management: Three Myths in DC Plan Strategy Selection
Actively managed strategies should have a place at the core of well-designed retirement plans. That a broad cross-section of the industry continues to hold this view is evidenced in part by positive flows into many actively managed strategies, as well as the excess returns posted by them over the past 12 months. Many of these strategies continue to be prominently used in both defined contribution (DC) plans and target date funds.
Nevertheless, we recognize that recent studies and the substantial flow of assets into passive strategies over the past few years have kept front and center the question of whether active management has a role to play in retirement savings plans. Our view is that both active and passive strategies can play a role in retirement portfolios, and each approach brings distinct benefits.
We think that positing active versus passive as binary options is based on three myths:
- Active management cannot produce better results than passive management.
- The lowest possible cost is the primary criteria for a strategy’s selection.
- Active management is problematic from a fiduciary perspective and places extra burdens on plan sponsors.
Myth I: Active Funds Cannot Sustain Positive Results
Plan participants are often told that, on average, passive strategies produce better returns than similar active strategies. This argument is anchored primarily on the law of averages. But analysts know that their investments, passive or active, can and should have better-than-average returns. In the passive realm, it comes down to figuring out which manager and strategy can provide the cheapest and most efficient beta exposure with low tracking error to the benchmark.
We know that active strategies display much higher active return dispersion than passive strategies. Some active managers create value relative to passive management and some don’t. Our own research shows something striking: Even in US domestic large-cap equities — probably the most efficient public market in the world — active management produced excess returns a surprisingly high 39% of the time in the 25-year period from 1996 to 2020.
US Large-Cap Domestic Funds Annual Returns vs. the S&P 500, 1996–2020
The question then becomes: Can plan sponsors take advantage of active return and volatility dispersion to identify managers that were more likely to produce sustained results? In recent years, a growing body of literature has identified certain characteristics that were associated with better results for a subset of active managers. These relatively stable characteristics include:
- Stewardship characteristics, including Morningstar analyst ratings, particularly the “parent” pillar and fund expenses.
- Investment characteristics include security holding period; policies for managing growth (size); investment flexibility with respect to geography, size, sector, and factors; and cash and fund flow management, including liquidity and cash as an investment thesis.
In our research, we examined the effect on future (ex-ante) returns for active strategies that pass three simple screens:
- Lowest-quartile expenses (asset weighted by share class).
- Highest quartile of portfolio manager ownership (total assets of company strategies owned by an individual fund’s portfolio managers).
- Lowest quartile of downside capture (ratio of strategy return to benchmark return during all market downturns).
Active strategies that pass all three screens offered higher returns and greater downside protection than other active strategies.
Effects of Screening for Lower Fees, Higher PM Ownership, and Lower Downside Capture, 1996‒2020
This research is suggestive and illustrative rather than definitive. That said, when combined with solid academic evidence on the sources of mutual fund results, including the positive return persistence of a subset of active strategies, it helps us understand that plan sponsors should not base the active-passive decision on average returns alone. Rather, they should look to analytical resources such as those provided by experienced consultants, to screen candidates for both active and passive strategies. For plan sponsors and participants seeking better performance as well as improved downside risk management relative to passive strategies and benchmarks, this approach has been shown to add value.
Myth II: DC Plans Should Select Strategies with the Lowest Cost
Expenses are no doubt an important consideration and apply to both passive and active strategies. Passive strategies tend to cluster right below their respective benchmarks due to both expenses and tracking error. Expenses for active managers will be higher, but the differential between the lowest-expense active strategies run by large managers who pass on scale advantages to participants, and those of passive managers, may not be very substantial.
That said, expenses should not be the only consideration. Selecting a strategy based only on fees ignores other characteristics. These may include the portfolio’s ability to pursue a desired investment objective, such as accumulation, preservation, income, or a balance among them. For example, a portfolio designed to contribute to a retirement income objective should be evaluated on its ability to produce income while providing downside protection.
Lower fees can contribute to better returns, but as the previous section shows, they should be balanced with other characteristics important to achieving an appropriate mix of return and risk for such an objective. Through securities analysis and portfolio construction with respect to market cycles, geography, dividends, duration, and other elements, active management can be used to design a strategic objective for an equity or fixed-income strategy that aligns with participants’ investment objectives.
Investment objectives can vary, but the investment horizon for a DC plan participant mirrors a working life followed by retirement years and is inherently long term. To deliver on those long-term outcomes, the investment offering needs to evolve along with life stages. The investment committee needs to take this into account when assessing the investment lineup and any manager in that lineup.
Myth III: A. Passive Management Is “Safer” from a Fiduciary Perspective; B. Active Management Requires Far More Due Diligence and Effort to Select and Monitor
Whether retained or delegated, exercising fiduciary responsibility is fundamental to plan sponsorship. This has been underscored by the spate of litigation focusing on expenses and self-dealing. Some have inaccurately pointed to passive management having a lower potential for litigation. However, no regulatory safe harbor exists regarding passive versus active management and to our knowledge, no court has ruled that active strategies are inherently less appropriate for 401(k) plans than passive strategies.
Instead, it is our understanding that:
- Opting for passive management is no guarantee of fiduciary compliance. ERISA requires plan fiduciaries to act prudently in selecting and monitoring all investment strategies. The fiduciary responsibility is the same with regard to selecting an active or passive strategy. The selection and the ongoing monitoring should still be the same process. Moreover, the Department of Labor has never opined that a passive or active investment strategy is inherently better.
- Much of the recent 401(k) plan litigation has been about paying excessive fees for an investment fund when a less expensive alternative was available for the same investment strategy (i.e., less expensive share class). This type of claim could be made regardless of whether the strategy used is active or passive.
- Plan fiduciaries may reasonably conclude that an actively managed strategy has the potential to deliver better investment results on a net-of-fees basis than a passively managed strategy, including that the former could provide a measure of downside protection relative to a benchmark.1
In addition, an active structure is not inherently more challenging for fiduciaries to evaluate. Plan sponsors recognize that passive strategies also require numerous “active” decisions and comparable due diligence regarding benchmark and share class selection and fees, as well as knowledge and oversight of replication methodology, trading, and securities lending practices, to name a few. For fixed income strategies, there is an even smaller gap between passive and active strategies in terms of decision-making: few passive fixed income portfolios can efficiently own all the securities in their respective benchmarks and must actively replicate rather than duplicate the benchmarks, including determining which securities to own and when to trade them. And, as is the case with active management, fiduciaries are responsible for monitoring passive management results, including the ability to contribute to plan and participant investment objectives.
It should be noted that many defined contribution plans have experience with evaluating active strategies, including access to analytical tools and talented experts. In short, both passive and active strategies require due diligence to identify and balance costs versus investment objectives and results.
The three myths of active versus passive management tell us that the dichotomy is a false one. There are ways to identify active managers that have produced better-than-average results over time. Actively managed strategies can assist plan sponsors and participants in achieving investment objectives that a purely benchmark-centric approach may not be able to provide.
Finally, oversight and plan management for active strategies is not fundamentally different than for passive strategies. All require the exercise of fiduciary responsibility, including a clear decision-making process and careful monitoring. Building a retirement plan entirely with passive strategies may be an overly simplistic response and, carried to an extreme, could even backfire from a fiduciary perspective. We see a place in defined contribution plans for both active and passive options working together to improve participant outcomes.
29 C.F.R. § 2550.408c-2(b)(1)
Braden v. Wal-Mart Stores Inc., 590 F. Supp. 2d 1159, 1164 (W.D. Mo. 2008) vacated and remanded, 588 F.3d 585 (8th Cir. 2009).
ERISA §408c-2(b)(1). Employee Retirement Income Security Act of 1974.
1. Fees have to be considered in light of the “particular facts and circumstances of each case.” Quoted from 29 C.F.R. § 408c-2(b)(1). See also Laboy v. Bd. of Trustees of Bldg. Serv., 2012 WL 3191961, at *2 (S.D.N.Y. Aug. 7, 2012) and Taylor v. United Techs. Corp., 2009 WL 535779, at *10 (noting that the “selection process [for actively managed mutual funds] included appropriate consideration of the fees charged on the mutual fund options, and of the returns of each mutual fund net of its management expenses”).
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