As a plan sponsor, one of your most important responsibilities is providing your employees with investment options that can help them reach their retirement goals. That’s why creating a diverse 401(k) investment lineup is among your core fiduciary duties.
In the last few years, index funds have become much more popular due to their lower fees. While evaluating fees is extremely important when selecting investments, it’s equally important to include actively managed funds as part of a diversified investment menu.
Here’s what you need to know about active management and why you should include an actively managed fund in your 401(k) plan.
Key Differences Between Passive and Actively Managed Funds
Passively managed funds track a market index with the goal of replicating its performance with minimum management and lower fees. The most common index funds in 401(k) plans are cap-weighted index funds that track well-known market indexes like the S&P 500 or the Russell 2000. These indexes provide investors with exposure to a broad market or sector. For example the S&P 500 provides investors with exposure to the 500 largest companies in the US. The securities included in index funds are weighed according to their market caps. This means that larger companies make up a larger portion of the index and have a greater impact on the overall returns.
Passive, or index funds, aim to replicate the performance of indexes by investing in the same securities as the index. They’re typically offered at lower expense ratios when compared to actively managed funds because the strategy requires less research and active decision-making and there’s typically less portfolio turnover.
Active management is when a professional portfolio manager selects securities with the goal of outperforming the index or providing additional risk protection. These portfolio managers develop an investment strategy using market research and analysis and use security selection, market timing, and risk management to try to improve performance outcomes.
Why You Should Add an Actively Managed Fund to a 401(k) Plan
Active managers have the potential for outperformance versus index funds. Skilled fund managers have outperformed their indexes benchmarks, especially in less efficient markets such as emerging markets or small cap. Within these markets there are different political and governance risks, unique growth trajectories, and limited coverage of the companies included in the index. Active managers can focus on specific stocks with counties or sectors with the strongest fundamentals and avoid regions or industries with heightened risks.
Active management can offer additional diversification when compared to the large cap weighted indexes. Index funds are heavily weighted toward the largest companies in the benchmark, which can often lead to concentration in specific sectors or stocks. In comparison, actively managed funds are not bound by these weightings and can diversify their investments to reduce risk.
One of the most important advantages of active management for 401(k) plan sponsors is the ability to protect assets during market downturns. Active managers can adjust their funds in response to market conditions, while index funds remain fully invested in their cap weighted benchmark. This flexibility can help protect against losses during market downturns.
What to Look for in an Active Manager
When selecting an active investment manager, there are several key factors to consider. Review the manager’s performance track record and focus on consistency, risk-adjusted returns, and benchmark comparisons. Reviewing investment fees is also critical. While active managers generally have higher fees than indexes, the fees should be reasonable compared to other active managers in their peer group.
While historical returns and fees are important, they are not a guarantee of future results. Plan sponsors should understand the manager’s investment philosophy and process and make sure they’re aligned with your goals.
You should also review the fund’s historic downside protection and volatility and compare the managers performance, risk-adjusted returns, and fees compared to peers managing similar funds.
The Blended Approach
While actively managed funds often come with higher fees than indexed options, cost should not be the sole consideration. And the debate between active and passive management doesn’t need to be either-or decision. Including both styles in your 401(k) plan can provide participants with the tools they need to build a diversified lineup. Actively managed funds can provide value to a plan through risk mitigation, diversification, and potential outperformance, especially in market segments where active funds have demonstrated success.
If you’re considering adding actively managed funds to your 401(k) plan, consult with your investment advisor to help identify funds that will meet your plan’s objectives, and your employee’s needs.
To learn how Sequoia can help, reach out to our team.
Disclaimer: This communication is intended for information purposes only and should not be construed as legal or tax advice. It provider general information and is not intended to encompass all compliance and legal obligations that may be applicable to your situation. This information and any questions as to your specific circumstances should be reviewed with legal counsel and /or a tax professional.
FOR PLAN SPONSOR USE ONLY. Pensionmark® Financial Group, LLC (“Pensionmark’) is an investment advisor registered under the Investment Advisors Act of 1940. Pensionmark is affiliated through common ownership with Pensionmark Securities, LLC (member SIPC). Pensionmark Financial Group, LLC/Pensionmark Securities LLC and Sequoia Consulting Group are non-affiliated entities.
