Nicholas Zaiko
Investment Consultant
Bridgebay Financial, Inc.
Many treasury professionals sit on their employer's
401(k) Retirement Plan Committee and share the responsibility of monitoring and
reviewing their plan's investments. Most plans have investment advisors that
provide the expertise in selecting, tracking, and replacing investment funds.
As a member of the Committee and a fiduciary, it is also important for you to
have a disciplined understanding of your advisor's due diligence and evaluation
process for recommending investment funds for your retirement plan.
The ever-expanding universe of available investment
funds is making the task of selecting the proper funds for retirement plans
increasingly difficult. With so many from which to choose, plan sponsors may be
making choices for the wrong reasons.
Evaluating performance is merely a first step in
selecting a mutual fund. Past performance is the primary basis of most fund
evaluations, but is insufficient as the sole means of measurement. Morningstar
and other third-party ratings rely heavily on historical performance against a
peer group when rating funds. Additionally, many sponsors make long-term
decisions based on short-term performance. While this is one important feature
to keep in mind, there are numerous other criteria to consider when building a
401(k) fund line-up.
As a quantitative measure, performance alone
ignores the many important qualitative factors that will impact your plan over
the long run. A fund's management team, investment style and risk level are
even more important than pure performance.
As a fiduciary, it is your responsibility to act as
a "prudent person" which means drilling down beyond superficial
performance measures when selecting funds. While there are many qualitative
factors to consider, we will discuss some of the most significant.
Manager Turnover
It is important to know that the people who were
making the investment decisions in the past will be the same people making the
decisions in the future. When participants invest in a fund they are actually
buying into the knowledge, experience and assumptions of the management team.
In many cases, a fund's track record may have been generated by a manager that
is no longer involved with the fund.
Knowing that investors are mindful of management
changes, firms will claim that key investment professionals were simply a small
part of a much larger team and attempt to reduce their perceived role in the
investment decisions.
A management change does not mean that a fund
should be automatically eliminated from consideration, it simply means that
further research is required. The new manager should ideally have a minimum of
three to five years of experience with expertise in the same asset class and
sector for which he or she is taking over.
Investment Style and Style Drift
While it may be hard to ignore the infatuation with
the high flyers, studies have shown that 95% of long-term performance is
attributable to asset allocation. Selecting a fund that stays true to its
intended style without migrating too far from its asset category is more
important to a participant's portfolio than peer ranking. Value and growth
styles shift in and out of favor over time.
Providing participants with a wide array of asset
classes to allow proper diversification is key to the long-term success of
their retirement strategy. As funds drift in style, their holdings may overlap
other funds in the line-up, reducing diversification through increased
correlation and effectively increasing risk. A 401(k) menu composed of funds
that have a lot of overlap won't allow participants to create well diversified
portfolios.
This makes monitoring style drift of paramount
importance to plan fiduciaries. It is relatively easy for a fund to slip out of
its style box and in most cases is unintentional. Style drift is most prevalent
with small cap stock funds because as small cap companies mature, they drift
into the mid-cap range and tend to move from growth to value.
A mid-cap value fund masquerading as a small cap
growth fund won't provide the proper risk-reducing benefits of diversification.
Risk and Volatility
Volatility is a roller coaster ride that most plan
sponsors and participants seek to avoid. The most common measure of volatility
and risk is standard deviation which describes the amount the performance of a
fund fluctuates in up and down markets. For the most part, participants are
willing to forgo some upside potential if they are also protected from
extremely poor results on the downside. Other statistics that measure risk
include Sharpe ratio, Beta, and R2. These figures describe the amount of risk
taken per unit of return, the degree to which the funds' performance is
correlated to the market and the rest of the plan line-up.
Fund concentration also plays an important role in
volatility. Diversification tends to reduce volatility but a large allocation
to a single stock or sector may deliver higher than average returns or larger
than expected losses.
Investment Manager Compensation
The incentives for a fund manager must be in line
with the strategy of the fund and the philosophy of the plan sponsor. Managers
can be compensated in various ways, encouraging different types of behavior.
Risk-taking to achieve high returns can lead to higher volatility than a
manager that is compensated for consistent, methodical returns.
The structure of a manager's compensation can lead
to style drift. A manager being compensated based on short-term results may
turn to aggressive risk-taking as a means of boosting performance. This means
that the fund may venture away from its stated style if that style is currently
out of favor.
Fees and Revenue-Sharing
A critical fiduciary responsibility in fund
selection is fully understanding the all-in fees and revenue-sharing
arrangements for each fund.
This task is complicated by the need for fees to be
"reasonable." Revenue-sharing arrangements are the primary components
of "hidden" fees. These arrangements are different from fund to fund
and impact participants directly. What might seem to be a "free" plan
to the plan sponsor may in fact include funds in the highest-cost share class,
shifting high costs of the plan and administration onto the participants.
Balancing the needs of the participants and the
needs of the plan sponsor are key to establishing and understanding reasonable
fees. Plan costs can be recaptured and used for the benefit of the plan
participants. A balance should be struck between high and low-cost funds to
deliver the appropriate services at a reasonable cost.
Delving Beneath Performance
It is clear that measuring performance is merely
one small part of the investment fund evaluation process. As a fiduciary, it is
imperative to perform both a quantitative and qualitative analysis.
Relying solely on historical performance is a
one-dimensional approach to solving a multi-dimensional problem. While still a
significant measure, style drift, manager compensation, risk and volatility,
manager turnover, and fees are often times much more impactful.
Properly evaluating these qualitative measures may
take additional time and resources, but is a critical component of the
fiduciary due diligence process. Evaluating performance is just the first step
in selecting a fund. Delving deeper, to discover how that performance was
achieved will provide the critical insight necessary to make the right
decisions for your plan and participants.
