Active vs. Passive Asset Management in 401(k) Accounts

Active vs. Passive Asset Management in 401(k) Accounts

Can portfolio managers add value through active security selection?

Recent research suggests no, active management is unlikely to produce returns that beat passive index investing. In particular, this paper looked at the composition of target date funds that would be hypothetically used in retirement accounts (i.e. 401(k)s). The passive indexes were comprised of common industry benchmarks with modest fees deducted, and several methods of choosing active managers were pitted against the passive returns.

The researchers used three methods of picking active managers – and two of the methods appear have been selected to match simplified methods that an experienced portfolio manager might use. These results were then compared against the hypothetical, post-fee, returns that the passive management would have achieved.

The three active methods chosen were:

Median managers – funds that performed in the middle of the pack, as picked by a series of three year look backs. It appears that this segment was picked to approximate what an average portfolio manager might choose when constructing a portfolio.

Top quartile managers – funds that were in the top quartile for their specific asset classes, once again, as picked by a series of three year look backs. Looking back at recent, multi-year performance is a common method of constructing 401(k) investment options, so this methodology seems designed to approximate a simplified process that a typical retirement planning portfolio manager use.

Top quartile (as defined by a Sharpe Ratio) managers – funds that were in the top quartile for their asset classes as measured by the Sharpe Ratio (which is a method of analysing returns and volatility). Once again the researchers used a three year look back to pick the funds under this analysis. The Sharpe Ratio was developed by Nobel Laureate William Sharpe, one of the founders of Financial Engines. ForUsAll’s founders also came from Financial Engines, and they were part of the team that helped develop Financial Engine’s core robo-advisor product.

What were the results of the actives vs. passive investment analysis?

Quoting directly from the paper: “It is clear from the scoreboard that active management across this time frame, using admittedly simple backward-looking metrics, did not add value.”

Passive ManagementMedia ManagersTop Quartile ManagersTop Quartile Sharpe Ratio
Estimated Retirement Savings$629k$546k$626k$582k
Indeed, other studies have shown that actively managed funds that outperformed in one 5-year period are actually significantly more likely to underperform in the next 5-year period. These actively managed funds can have wildly volatile returns, creating unnecessary fiduciary risk for employers and exposing employees to unnecessary risk. Not to mention the fact that actively managed funds can be expensive, leading to an even great potential for lower retirement savings.