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Rich and Co.

Professional Mutual Fund Managers, Not Very Good Investors

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Conclusions

  • The mutual funds that 401(k) administrators select achieve investment returns that are worse than comparable indexes but superior to the returns of comparable, randomly selected funds.
  • A significant part of this latter result is explained by choosing funds that charge lower fees.
  • When making changes to a plan’s funds, administrators chase returns and do not end up improving investment performance.
  • Like their employers, 401(k) plan participants also tend to chase returns, transferring assets into higher-performing funds, rather than rebalancing to restore their original asset allocations. And their investment performance is no better than they would have achieved using variations on the 1/N rule to allocate assets among funds.

HOW DO EMPLOYERS’ 401(k) MUTUAL FUND SELECTIONS AFFECT PERFORMANCE? 

Introduction
Defined contribution plans, predominantly 401(k)s, are the primary source of personal retirement savings for American workers, making the investment decisions within these accounts a salient policy concern. These decisions are a result of two separate actions:

  1. the mutual fund options selected by the employer’s plan administrator
  2. the specific funds chosen by the participant.

While considerable research has examined 401(k) participant decisions in isolation, surprisingly little attention has been focused on the choices made by plan administrators. The administrator’s role is clearly influential, particularly if, as indicated by prior research, 401(k) participants themselves do not make good choices.

This brief, based on a prior study, addresses this research gap by focusing on the fund choices of plan administrators and participants’ reactions to these choices.
The discussion proceeds as follows.

  • The first section reviews existing research on investment decisions
  • The second section explains the data and the metric used to analyze how employer and employee fund choices affect investment performance
  • The third section explores how well plan administrators do in choosing mutual funds
  • The fourth section assesses how well participants do
  • The fifth section concludes that employers select mutual funds that perform better than comparable, randomly selected, funds but worse than passive index funds, and participants do not add any value through their own decisions.

401(k) Investment Decisions: What We Know
Due to the growing influence of 401(k)s, researchers have examined numerous aspects of the investment choices made by plan participants. Virtually all the findings suggest that the individual investor does not make very good decisions.

  • One study found that participants restrict their investing to three or four mutual funds – regardless of how many funds their employer offers
  • Other research finds that employees simply divide their savings evenly among the number of funds (N) their employers offer – a strategy known as the 1/N Rule.’
  • Other studies examining asset allocation find that plan participants infrequently adjust their allocations;
  • that their ages and cohorts influence their stock allocations
  • they over-invest in their employer’s stock, which reduces diversification.

In short, the consistent message is that participants often make poor choices.  All of these previous studies examined participant decisions only.  But plan administrators also have a major role as they select a limited menu of mutual funds to offer participants from the large number of available funds.  One study that did examine administrator choices found that about one half of plans do not provide sufficient categories of investments to their participants. This brief builds on this study by examining whether, given the categories of investments offered, the fund choices selected by plan administrators are good investments per se, and how participants react to the choices.

How Well Do Funds Perform?
The results for the sample plans show that the average alpha over three years of investment performance is -31 basis points annually. The negative alpha, as expected, confirms that the plans’ performance falls below the performance of comparable indexes.

The size of this negative alpha is larger than normal expenses for low-cost index funds, suggesting that performance would be improved if passive funds had been substituted for the active funds that were selected.

The average differential alpha for the sample 401(k) plans, however, was 51 basis points annually. This result shows that plan administrators, overall, chose mutual funds that outperformed the randomly selected set of funds by about one-half of percentage point annually. Lower investment fees are a large part of the explanation for the superior performance of the employer selections compared to the random set of funds.  Lower fees, by definition, improve returns by leaving more money in the investor’s account. The fees in the employer-selected mutual funds were 23 basis points per year lower than the fees for the random set of funds, accounting for almost half of plan administrators’ superior results.

Do Fund Changes Improve Performance?
401(k) investment performance can also be influenced by changes in mutual fund offerings over time. During the period analyzed, the employers in the sample added 215 mutual funds and dropped 45 funds. Many of the additions seem to be motivated by a desire to add a new type of fund, as over half were selected from an investment category not held by the plan at the time of the addition.

The analysis looked at the performance of the added and dropped funds for three years before the change was made and three years after the change. Not surprisingly, newly added funds outperformed randomly selected funds before the change was made: the differential alpha of the added funds is 134 basis points annually for three years prior to being added to the sample’s plans. In contrast, before the dropped funds were dropped, they under-performed the random funds by -143 basis points annually.  Thus, the added funds outperformed the dropped funds by a total of 277 basis points annually prior to when the changes were made.

Interestingly, though, this performance bonus essentially disappeared after the fund changes were made as the added funds did worse while the dropped funds did better. The differential alphas after the changes are

  • +44 basis points for the added funds
  • +17 for the dropped funds
  • the difference between them is not statistically significantly different from zero.

This finding suggests that plan managers were chasing returns, but their efforts to tinker with their fund selections had essentially no impact on overall performance. The outcome underscores the traditional investor’s caveat that “past performance does not predict future returns.”

Performance of Plan Participants
This section turns to the performance of participants to see whether their behavior is consistent with that depicted in the existing literature and to assess whether they add value to the decisions made by plan administrators.

The first exercise evaluates whether participants rebalance their portfolio in response to market fluctuations or, instead, chase returns. The second exercise compares the participants’ investment strategies, at an aggregate level for each plan, to naïve investment strategies.

Do Participants Chase Returns?
Three factors influence asset allocation: annual returns, participant contributions,+ and participant transfers. For all sample plans, the median change in the percent of assets allocated to particular investments over all the years analyzed is:

  • 3.8 percentage points for investment returns,
  • 1.6 percentage points for participant contributions
  • 3.1 percentage points for participant transfers.

These numbers indicate how the distribution of assets between mutual funds changes over time. While investment performance has the largest impact on the weightings, participants also have a significant impact when they alter their contributions or transfer assets. 

The next step is to determine whether participants’ actions magnify or offset the change in allocations caused by investment returns. A regression analysis relates the combined effect of participants’ contributions and transfers to the effect of returns for each of the sample plans.

The results show that participants’ contributions and transfers magnify the change in allocations caused by returns by 57 percent.  That is, participants shift their assets toward the best- performing funds and decrease their holdings in the funds that do not perform as well, causing the fund allocations to diverge further from the plans’ initial weightings.

Do Participants Outperform Naive Investment Strategies?
The final analysis examines whether participants’ decisions, in aggregate, improve or worsen their investment performance. Participants’ impact on performance is gauged through a comparison with what their returns would have been if they had instead adopted the simple 1/N Rule, in which investors spread their assets evenly across all of the funds…

The results in show that the participants’ actual selections performed no better than any of the 1/N strategies.  In fact, the participants’ results were lower in all cases, though only the difference with the “top performers” strategy was statistically significant….

These results suggest that participants in aggregate do not add value to the investment performance through their own decisions, underscoring the importance of the choices made by plan administrators.

Conclusions

  • The mutual funds that 401(k) administrators select achieve investment returns that are worse than comparable indexes but superior to the returns of comparable, randomly selected funds.
  • A significant part of this latter result is explained by choosing funds that charge lower fees.
  • When making changes to a plan’s funds, administrators chase returns and do not end up improving investment performance.
  • Like their employers, 401(k) plan participants also tend to chase returns, transferring assets into higher-performing funds, rather than rebalancing to restore their original asset allocations. And their investment performance is no better than they would have achieved using variations on the 1/N rule to allocate assets among funds.
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Written by Rich and Co.

January 9, 2013 at 9:59 pm

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