Frequently during employee seminars we get the question, should I invest in an actively managed fund or a passively managed fund? The answer is frequently two-fold: 1) You are making a decision regarding the amount you want in domestic equity, international equity, REIT, fixed income and cash. That in and of itself is going to be the biggest driver of your risk and your reward. That is always an active decisions.
2) You should focus on costs, but not above all else. Costs are frequently a determining factor of a manager’s ability to provide solid returns over a long time frame. The higher the cost, the higher that manager has to climb each year just to break even with his/her low cost peers. If you are selecting an S&P 500 Index fund, then yes, typically the lowest cost wins. But what if you are picking a domestic equity fund? What if you are using a target date fund (think Vanguard Target Retirement 2020, TIAA-Cref Lifecycle Index 2020, or TSP L fund 2020)?
Well what index does the fund track? Some are market cap weighted meaning the biggest companies make up the biggest share of the index. Some are equal weighted meaning each company within the index makes up a equal portion thus putting smaller firms in the index on par with larger firms. Other companies have introduced “factors” into their indexes to determine how much to weight each company based on some valuation metric. What this means to the end investor is anything but small. Even in the traditional index space there are many different providers including Russell, S&P, and MSCI and they all have their own subtle twists on the index.
In the target date fund space, these differences matter. In 2012 Vanguard switched providers of their indexes on many of their funds. They moved from the MSCI indexes to the CRSP indexes. Target date funds derive their performance in two ways: 1) The glide path (the gradual shift from a stock-centric allocation in early work years to a bond-centric allocations in later years and retirement) as well as, 2) The funds utilized to populate the glide path. When people discuss active versus passive they are talking about 2 even though 1 is extremely important. For a comparison, let’s look at three different target date funds that all use index funds to populate the glide path.
The Vanguard Target Retirement 2020 (ticker VTWNX), The TSP L Fund 2020 and the TIAA-Cref Lifecycle Index Institutional (ticker TLWIX). For the one year period ending 12/31/2016 their returns were 6.95% (Vanguard), 5.47% (TSP) and 6.65% (TIAA). For the five year period ending 12/31/2016 their returns were 8.17% (Vanguard), 7.55% (TSP) and 8.03% (TIAA). The TSP has by far the lowest expenses of all three of these so why would that be the least favorable fund to be in for each of these periods? The biggest driver is the TSP L fund 2020 has the most conservative glide path. It also has its largest allocation to Government Securities (conflict of interest anyone? This would be instant grounds for a class action lawsuit in the private sector).
As you can see, if you went with the cheapest fund, you earned the least amount of money during these time frames. While past performance is not indicative of future results, it does show that there is more to it then just picking the cheapest thing. As a Plan Sponsor you might want to focus on the translation from accumulation to income with your target date funds and there are providers that can do that. You might want to take an active but low cost approach while having the manager make the equity allocation more conservative in the glide path nearing retirement. There is a solution for that too. At the end of the day, an appropriate analysis of your employee demographics is key to determining the way forward for your employees.
And as always, remember the disclosures: Figures shown are past results and are not predictive of results in future periods. Current and future results may be lower or higher than those shown. Share prices and returns will vary, so investors may lose money. Investing for short periods makes losses more likely. Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.