401(k) Participants Pay Dearly for the Crime of Underperformance

Day 236: K'nex
Day 236: K'nex (Photo credit: -Snugg-)

Most 401(k) plan providers use performance as a selling point. These sales people will list of top performing, actively managed funds and sell, sell, sell. What they will not do is sign on as an ERISA 3(38) investment manager and take responsibility for their choices. They will simply replace the poor performers with the new top performers. And the cycle continues on and on. Stop this damaging cycle. Stop empowering the Wall Street bullies.

It is my view that a 401(k) plan that has anyactively managed funds as investment options reflects negligence by both those advising the plan and the plan sponsors who blindly accept this flawed advice. Ellis notes the daunting odds of beating the benchmark. Over a ten year period, only 30 percent of actively managed funds outperform. That percentage falls to 20 percent over a 20 year period.Even those numbers are deceptive. In their seminal analysis of luck versus skill in mutual fund returns, Eugene F. Fama and Kenneth R. French evaluated 819 actively managed funds over 22 years and found that 97 percent could not be expected to beat a risk-appropriate benchmark.

It’s bad enough that only 3 percent of active fund managers demonstrate evidence of investment skill. It’s worse that no one has figured out a way to identify these outperforming fund managers prospectively. And here’s the nail in the active fund managers’ coffin: Even if you could miraculously look into a crystal ball and determine the next outperforming fund manager with investment skill, there’s no payoff. According to Fama and French: “… going forward we expect that a portfolio of low cost index funds will perform about as well as a portfolio of the top three percentiles of past active winners, and better than the rest of the active fund universe.”

Ellis views the charade of relying on advisors to pick outperforming actively managed funds as part of what he calls “the crime of underperformance”. He allocates blame to investment committees, investment managers, investment consultants and fund executives, noting: “No one suspect is guilty; they are all guilty.”

This is also true of investors outside their 401(k) plan. No one can consistently predict the future, so finding top performers is a matter of luck and not skill.

Please comment or call to discuss how this affects you and your portfolio.

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