Investment in equity index funds – and other passively-managed investments designed to track a market index – is exploding. According to a Morningstar study, these investments took in a record $504.8 billion in 2016. That’s in contrast to actively-managed funds, which are designed to outperform an index. These funds experienced outflows of $340.1 billion in 2016.
Why are investors flocking to index funds? The answer is simple – when compared to their actively-managed counterparts, index funds that track the broad stock market indices are more likely to offer superior returns, net of fees charged. According to the latest SPIVA U.S. Scorecard, over a 10-year investment horizon, 85.36% of large-cap managers, 91.27% of mid-cap managers, and 90.75% of small-cap managers failed to outperform their respective index benchmark.
If you are a small business 401(k) fiduciary, this trend is great news. While it can be difficult for 401(k) fiduciaries to insulate themselves from investment-related liability using actively-managed funds, this job can be dead simple using index funds. I’ll explain.
Minimizing Investment-Related 401(k) Fiduciary Liability
Most excessive 401(k) fee lawsuits today relate to overpriced investment funds. To reduce their investment-related liability, 401(k) fiduciaries must do two things when choosing a fund lineup for their plan:
- Choose only “prudent” funds. Basically, a prudent fund is one that meets its investment objectives for a reasonable fee.
- Choose at least 3 funds that allow plan participants to sufficiently diversify their account – and minimize their risk of large participant investment losses. In other words, meet ERISA section 404(c) diversification requirements.
Unfortunately, most 401(k) fiduciaries don’t know how to choose a prudent fund lineup from the tens of thousands of funds available. This issue is exacerbated by the fact that most financial advisors are not subject to a fiduciary standard today - which means they can recommend funds based on commissions, not prudence.
401(k) Index Funds Make Prudent Fund Selection Simple
The beauty of index funds from a 401(k) fiduciary perspective is that most are inherently more prudent than comparable actively-managed funds, making prudent fund selection dead simple. This is true for the following reasons:
- Lower fees. Most index funds are cheaper than comparable actively-managed funds due to their passive investing approach.
- Reliable returns. Most index funds deliver highly-correlated benchmark returns. This is contrast to actively-managed funds, whose returns can differ dramatically from their benchmark.
Paying more for uncertain returns is a risky bet for 401(k) fiduciaries. When 401(k) fiduciaries lose this bet – which the Morningstar study shows is likely – they increase their liability.
Picking the Best 401(k) Index Funds
Generally speaking, comparable index funds from any of the largest providers – including Vanguard, Blackrock, Schwab, and Fidelity – offer similar (if not identical) returns and fees. In other words, it’s tough to pick a bad one.
That said, 401(k) fiduciaries should be able to confirm an index fund’s market-correlation and low fees. This is not hard.
To confirm an index fund’s market correlation, a fiduciary just needs to look up the fund’s Beta and R-Squared statistics – which can be found in fund fact sheets.
- Beta is a measure of sensitivity to the correlated moves of a benchmark, a fund or asset. A beta of 1 indicates that the fund's price will move with the market.
- A beta of less than 1 means that the fund will be less volatile than the market. A beta of greater than 1 indicates that the fund’s price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.
- R-squared measures the percentage of a fund’s movements that can be explained by movements in the benchmark index.
- R-squared values range from 0 to 1. An R-squared of 1 means that all movements of the fund are completely explained by movements in the index. Index funds should have a high R-squared vs. their benchmark.
- A higher R-squared will indicate a more useful beta figure. If the R-squared is lower, then the beta is less relevant to the fund's performance.
Index funds with highly correlated returns have a 0.95-1.05 beta and 0.95-1.00 R-squared, based on trailing 36-month returns vs. the benchmark.
A simple way to confirm an index fund’s low fee status is compare its expense ratio against its peer group. You want your fund to rank in the lowest quintile (20th percentile).
An example of an index fund lineup that delivers highly-correlated market returns with low fees can be found here.
Better Returns & Lower Fiduciary Liability. Sign Me Up!
In growing numbers, investors are flocking to passively-managed index funds. This success is hardly surprising when you consider these funds often outperform their higher-priced, actively-managed counterparts. This trend is great news for 401(k) fiduciaries because index funds can lower their investment-related liability.
That said, don’t take my word for it. Hire a fiduciary-grade financial advisor and see what funds they recommend for your 401k plan. My bet? You’ll end up with lots — if not all — index funds.