Passive strategies have become popular in retirement plans, but actively managed strategies still have their place. Positive flows into actively managed strategies, as well as their excess returns over the past year, demonstrate that many investors and industry professionals still believe in the value of active management.
Recent studies and the significant flow of assets into passive strategies have led to the ongoing debate about the role of active management in retirement savings plans. However, we believe that both active and passive strategies can complement each other and offer unique benefits.
There are three myths that are often associated with the active versus passive management debate:
- Active management cannot outperform passive management.
- Lowest cost is the most important factor in strategy selection.
- Active management is burdensome for fiduciaries and plan sponsors.
Myth I: Active Funds Cannot Sustain Positive Results
Investors are often told that passive strategies consistently outperform active strategies. This argument is based on the law of averages. However, it is possible for active managers to generate above-average returns. In the world of passive management, the focus is on finding the cheapest and most efficient beta exposure to a benchmark with low tracking error.
It is important to note that active strategies tend to have higher return dispersion than passive strategies. Some active managers are able to add value relative to passive management, while others struggle to do so. Our research shows that even in the highly efficient US domestic large-cap equities market, active management produced excess returns 39% of the time from 1996 to 2020.
US Large-Cap Domestic Funds Annual Returns vs. the S&P 500, 1996–2020
Methodology: The database built to represent the universe of large-cap domestic drew from Morningstar’s US Domestic Open-End Large Value, Large Blend, and Large Growth categories, with live and dead funds combined to eliminate survivorship bias. For live funds, only the oldest share class was used. For dead funds with multiple share classes, the median monthly returns were used. Then, we calculate returns on an equal-weight basis.
The key question is whether plan sponsors can identify active managers that are more likely to consistently deliver positive results. Research has identified certain characteristics associated with better outcomes for a subset of active managers. These stable characteristics include:
Our research shows that active strategies passing three simple screens – lowest-quartile expenses, highest portfolio manager ownership, and lowest downside capture – have historically offered higher returns and better downside protection than other active strategies.
Effects of Screening for Lower Fees, Higher PM Ownership, and Lower Downside Capture, 1996‒2020
Methodology: The database built to represent the universe of large-cap domestic drew from Morningstar’s US Domestic Open-End Large Value, Large Blend, and Large Growth categories, with live and dead funds combined to eliminate survivorship bias. For live funds, only the oldest share class was used. For dead funds with multiple share classes, the median monthly returns were used. Then, we calculate returns on an equal-weight basis.
For fund grouping, the group of funds with low downside capture was composed of the top 50% of funds with the highest average rank when ranking all funds by returns over all three-year rolling periods during periods of market decline. The fund group with high manager ownership, low fees, and low downside capture was created by, first, screening for low downside capture, followed by the cross section of low quartile expense and highest quartile of firm manager ownership (ranking of firms by amount of assets managers invest in any of the firm’s funds).
While this research provides insight, it is not definitive. However, it does suggest that plan sponsors should not solely rely on average returns when making the active-passive decision. Instead, they should seek analytical resources, such as those provided by experienced consultants, to screen and evaluate both active and passive strategies. This approach has been shown to add value by delivering better performance and improved downside risk management compared to passive strategies.
Myth II: DC Plans Should Select Strategies with the Lowest Cost
Fees are an important consideration for both active and passive strategies. Passive strategies tend to have lower expenses due to their focus on tracking a benchmark. On the other hand, active strategies usually have higher expenses. However, the difference in expenses between the lowest-cost active strategies and passive strategies may not be significant.
Selecting a strategy solely based on fees overlooks other important factors. For example, a strategy should be evaluated based on its ability to achieve specific investment objectives, such as capital preservation, income generation, or a balance of both. A retirement income-focused portfolio, for instance, should be assessed based on its ability to produce income and protect against downside risks.
While lower fees can contribute to better returns, they should be balanced with other important characteristics. Active management allows for strategic portfolio construction that aligns with participants’ investment objectives, considering factors like market cycles, geography, dividends, duration, and more.
Investment objectives may vary among participants, but the time horizon for retirement plans is typically long-term. To achieve long-term outcomes, the investment offering should evolve to align with different stages of life. The investment committee should consider this when evaluating the investment lineup and selecting managers.
Myth III: A. Passive Management Is Not Fiduciarily Safe; B. Active Management Requires More Due Diligence and Effort
Exercising fiduciary responsibility is essential for plan sponsors, whether they retain or delegate it. While some argue that passive management is less likely to lead to litigation, there is no regulatory safe harbor that favors passive strategies over active strategies. No court has ruled that active strategies are inherently less suitable for 401(k) plans.
Most recent 401(k) litigation has focused on excessive fees for investment funds, regardless of whether the strategy is active or passive. Furthermore, fiduciaries can reasonably conclude that actively managed strategies have the potential to deliver better investment results, including downside protection relative to benchmarks.
Active strategies are not inherently more challenging for fiduciaries to evaluate. Passive strategies also require active decisions and due diligence, including benchmark and share class selection, fee analysis, replication methodology, and monitoring of results. For fixed-income strategies, the gap between passive and active strategies is even smaller, as many passive fixed-income portfolios cannot fully replicate their benchmarks and require active decision-making.
It is worth noting that many defined contribution plans have experience evaluating active strategies, and they have access to analytical tools and experts. Both passive and active strategies require due diligence to balance costs, investment objectives, and results.
Conclusion
The active versus passive management debate is often framed as a binary choice, but it is not that simple. Active and passive strategies can coexist and offer unique advantages. Active managers can deliver sustained results, and their strategies can help participants achieve investment objectives that benchmarks alone may not provide. Fiduciary obligations apply to both active and passive strategies, and both require careful evaluation and monitoring. A retirement plan comprised solely of passive strategies may oversimplify the investment approach and potentially expose fiduciaries to risks. Therefore, a combination of active and passive options can enhance participant outcomes in defined contribution plans.
References
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.
Footnotes
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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