Why your participants should avoid active trading of 401(k) investments

Passive investments, including target date funds can keep 401(k) participants on track

Research shows that the average equity fund investor earns below average returns. How can study after study show that the average investor earns below average returns?

Perhaps it’s best to present the results obtained by Dalbar, a financial data provider. For more than two decades, Dalbar has measured the effects of investor decisions to buy, sell and swap in out of mutual funds. Their data consistently shows that fund investors themselves typically earn less than the performance of the mutual funds they invest in.

Here’s what they mean:

For the year 2016, the S&P 500 produced a total return of 11.96% while the average mutual fund investor earned just 7.26%. The same was true in 2015 when the S&P 500 returned 1.38% compared to -2.28% for investors in equity funds. Dalbar’s calculations for investor returns account for changes in mutual fund assets. So if investors sell equity funds when the market dips and fail to reinvest as the market rebounds, the investor’s returns will lag those of a fund that earned those returns over the entire period.

The same pattern emerges over longer periods. The S&P 500 returned 8.19% annually for the 20 years ending 2015. Investor returns in equity funds as measured by Dalbar came to just 4.67%.

Part of the problem, according to Dalbar, is that equity mutual fund investors typically don’t stick with a fund for more than four years.

Why are investors so fickle when it comes to their funds? Dalbar points to nine distinct “behaviors” that lead investors to act against their own best interests. These include “herding,” or copying the behavior of others, and “loss aversion,” expecting high returns with little risk. Boiling it all down to a cliché may explain it just as well. It is difficult to buy “low” and sell “high.” In fact, investors often do the opposite, particularly as bear markets commence, and then eventually transform back into bull runs.

Minding the Gap

Morningstar regularly performs an analysis similar to Dalbar’s. The Morningstar approach is to compare the average return delivered by a segment of mutual funds to the return experienced by the investors in those particular funds. Morningstar takes into account money entering and leaving the mutual funds to calculate investor returns. Morningstar takes its analysis a step further by calculating an “investment gap,” or the difference between the fund returns and the return actually earned by investors in those very funds.

For the 10 years ending December 31, 2016, the annualized gap in active US Diversified Funds was -1.25% as calculated by Morningstar. Interestingly, passive US Diversified Stock Funds produced a positive gap of 0.59%. In other words, passive investors in US equity funds outperformed the underlying investments. This is probably more of a reflection of fund flows into passive vehicles than superior market timing by passive investors.

Nonetheless, Morningstar analyst Ben Johnson argues that the approach taken by passive investors could be working to their benefit. Such investors probably have expectations that differ from active investors. Passive investors expect to earn the market return less a fee. Active investors expect to earn a market beating return, perhaps by a wide margin. These high expectations can lead investors to abandon a fund when it disappoints or changes managers. When such buy and sell decisions are undertaken at inappropriate times, the “gap” widens.

Implications of the investor gap for 40(k) participants

If plan sponsors understand that investors often work against their own self-interests, how can they use this information when designing their 401(k) investment lineup? One way is to offer a fund lineup that includes low-cost, passive funds. The result can be a one-two punch for boosting participant performance.

First, low fee funds can effectively add 0.50% to 1.00% to returns each year compared to high cost active funds. After several years, what may seem like a small advantage with lower cost 401(k) expense ratios can result in significantly higher account balances.

Second, once investors understand the reasoning behind a passive approach they may be less prone to trade funds unnecessarily. As noted above, trading in and out of funds typically results in a drag on performance.

Target date funds can take this hands-off approach a step further. Because target date funds are designed with a “targeted” retirement date in mind, asset allocation shifts are handled automatically. The very nature of target date funds means that they are designed to be held, not actively traded. This shifts expectations far out into the future, reducing the incentive to trade the fund based on short term market movements.

Even investment advisors are not immune to trying to time the market to the detriment of their clients. One perhaps extreme example is cited by Jason Zweig, Wall Street Journal columnist and financial blogger. He notes that the Fidelity Advisor Biotechnology Fund I gained 13.6% over the past decade. But the typical investor in the fund captured a return of just 0.7%. And this is a fund geared toward financial advisors.