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.

Posted via email from Curated 401k Plan Content

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Their Confidence Is Killing Your Returns

English: Eugene Fama receiving the inaugural M...
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There is a scientific method of building a risk adjusted gloablly diversified portfolio. Trying to find the next hot asset class or stock or fund manager is a futile exercise. To succeed in reaching your long term financial goals you must remain disciplined to a prudent strategy.

At the request of a prospective client, I proposed a risk adjusted portfolio, consisting of low management fee, passively managed stock and bond funds. I tilted the portfolio towards small and value stocks, consistent with the research of Eugene Fama and Kenneth French. Their research explained the relationship between risk and return for stocks. It is known as the Fama-French three-factor model. Distilled to its essence, the Fama-French three-factor model holds that a portfolio tilted toward small and value stocks (which increases risk) has a higher expected return than a portfolio without this tilt, over the long term. You can read more about the Fama-French three factor model here. In my recent book, The Smartest Portfolio You’ll Ever Own, I recommended portfolios of index and exchange traded fundsat different risk levels that investors could implement themselves. These portfolios are based on the research of Fama and French.My prospective client showed my recommendations to a friend who is a well-known financial advisor. He derided them as “possibly” suitable for those who wanted to preserve wealth, but not to grow it. In order to grow wealth, he advised retaining his firm because of its ability to time the markets and “customize an individually tailored portfolio of stocks and bonds.”

The research supporting my recommended portfolio is extensive and is summarized in the bibliography to my book. His advisor friend provided no research validating his approach to investing, but he made up for the lack of data with his air of infallibility and aura of expertise.

We all want to know what will happen next. Who will be the best ‘stock picker’? There is a scientific method to developing you portfolio for superior long term results.

Your comments are welcome or as well as your calls.

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