Passive investing has become popular with defined contribution (DC) plans due to its low costs and ease of use. In addition, many DC plan sponsors tend to view offering passive funds as a means of preventing participant lawsuits. But fiduciary responsibility doesn’t automatically equate to offering only the least expensive or most hands-off investment options.
So, what’s the ideal structure of a plan’s investment menu? In our view, it’s essential to ensure that participants have access to a variety of active funds--here are three reasons why.
1. Active funds provide participants the opportunity to achieve the best possible investment returns on their contributions
One of the most effective ways to simultaneously protect the plan from litigation and satisfy fiduciary obligation is to ensure that participants have a chance to seek the best possible returns on their contributions. Only active funds provide that opportunity. Passive funds, on the other hand, are designed to minimize investment losses by simply mirroring the performance of a particular benchmark, while active funds aim to beat their respective benchmarks.
2. Active funds deliver better risk management and greater diversification potential
Participants can benefit from the professional risk management that is baked into the active management approach, which aims to protect their principal. Passive funds offer no such oversight.
Participants who invest in passive funds may also face higher levels of concentration risk than those who choose active funds. For example, let’s take the S&P 500 Index, which is likely the most recognizable US stock index to participants. As of this writing, technology companies comprise about 25% of the index, while other sectors (such as communication services, financial services, and healthcare) are underrepresented. This overweight could benefit participants who invest in a passive S&P 500 Index fund when technology companies perform well. But history shows that today’s winners don’t remain in first place forever — and what will happen to participant account balances when technology eventually falls out of favor?
An active large-cap manager can manage this risk by either allocating to other companies within the index, to companies outside of the index altogether, or a combination of both.
3. Active funds offer more flexibility and control over the investment experience
An active investment approach offers more flexibility and control to the fund manager and participants. Active managers can take advantage of short-term market opportunities and make more informed decisions based on individual research and analysis. Participants who wish to take a more hands-on approach to their portfolio may also appreciate having active fund offerings in the plan.
Does this mean passive funds aren’t worth consideration?
We believe passive funds still have a place in the DC investment menu — and including them may especially benefit participants who aren’t comfortable researching, selecting, and monitoring the investments in their portfolios.