Investment portfolio construction is frequently debated specifically around utilizing active funds, index funds, or both. Within defined contribution employee-directed retirement plans, we believe it is not necessarily the purpose of a fiduciary advisor, consultant, or Plan Sponsor to determine which is “best” for their employees. Rather, the appropriate discussion to have should be how to offer investment choices in your Plan that make it equitable for both index and active investors to construct their portfolio, all while keeping costs low.
However, some Plan Sponsors are still constructing their core retirement plan investment lineups to ONLY include actively managed funds. Here are three reasons why Plan Sponsors should consider including index funds in their lineups.
When you invest in an index fund, you are selecting an investment that generally tracks a pre-set portfolio of securities. The investment is not trying to outperform the index. It is trying to track or replicate that indexes’ performance. As such, the difference in performance between that index and the index fund will be a function of its expense ratio. For example, the Vanguard 500 Index Adm fund’s expense ratio is 0.04% and it tracks the S&P 500 Index. As of May 31, 2018, the fund’s 5-year return was 12.94% versus the index return of 12.98%, a difference of 0.04%. The minimal difference in the percentages is actually one of the arguments against index funds. Index funds will always trail their index by approximately their expense ratio. One of the benefits however is that results will be in-line consistently with that index. The overall reason that there is such a strong argument for index funds is that the majority of active funds underperform (in some cases significantly) in the long run as they try to “beat” their respective index. For example, according to S&P Dow Jones Indices, LLC., over the most recent 5-year period 84.23% of all large-cap funds underperformed the S&P 500 Index. Over the 10-year period that number jumped to an astounding 89.51% of active funds underperforming. Selecting an active fund that potentially will outperform over the long-term can possibly add additional risk to your portfolio (risk defined as not being able to know whether your fund will outperform) and that can be a daunting task.
If you want to read more about successful investment menu design in retirement plans, download our free Fiduciary Best Practices for Retirement Plan Menu Design eBook from the button below.
2. Less Time Consuming
Most of the individuals we meet with and provide portfolio advice to lead busy lives. Their time constraints include their work, family, and hobbies. Knowing that their portfolios include positions where objectives are clearly stated and results intend to be aligned with a stated index reduces the stress of wondering what investment results will be. This is also true for Retirement Plan Committees that have the charge to select investments in the retirement plan investment menu. Instead of having to continually monitor any active investment choices to gauge whether the higher cost is commensurate to increased performance they can know that they will be paying a smaller cost for more consistent returns. (Review this SPIVA Report for more detail on Active Manager Persistence)
The cost of your investment has a significant impact on long-term performance. For every additional basis point (or 0.01%) that an investor pays through the expense ratio of their investment choice, an additional basis point needs to be gained to make up for the difference. According to Morningstar, the average expense ratio in 2017 for Large-Cap funds was 0.98%. If we continue our example with the Vanguard 500 Index fund, (expense ratio of 0.04%) that is a difference of 0.94%. A 94 basis point difference in cost over a 1-year period might not seem material but the compounding effect over a 40-year period is substantial.
There are strong arguments for investing in index funds. There are also strong arguments for active funds. This debate shows no sign of slowing and as such we believe offering index funds as a choice for investors to pursue is appropriate and prudent. As Warren Buffett said in his 2016 Annual Letter “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.” Disclaimer: This material is not to be taken as investment advice. Consult your fiduciary advisor on items including portfolio construction and whether or not to utilize index or active funds.
Other blogs to consider: