Writing for the CBS News and MoneyWatch, Larry Swedroe shares a few classic findings from a recent study of mutual fund selection and replacement in 401(k) plans. If you're in the business of sponsoring or advising a defined-contribution retirement plan, you should give this a good, hard look (emphasis added):
As one would expect, when administrators change offerings, they choose funds that did well in the past. After all, who would choose a fund that had performed poorly? Funds that were added to plans had positive alphas for both one- and three-year periods prior to the change. And, unsurprisingly, managers fire poorly performing funds.
Funds that were dropped had negative alphas for both one- and three-year periods before they were dropped. The funds that were added had an alpha above those that were dropped of 2.8 percent per year for three years before the change and 2.3 percent in the year before the change (note the declining alpha). Unfortunately for investors, when a plan deleted a fund and replaced it with a fund with identical objectives, the deleted funds outperformed the ones they replaced by about 2.5 percent per annum over the next three years.
The authors also examined what happened when a plan replaced all of their offerings from one fund family and added funds from a new fund family. Not surprisingly, they found that the past Sharpe Ratios (a measure of return relative to risk) were higher for the portfolio of added funds than for the portfolio of dropped funds. After replacement, the future Sharpe Ratios were higher for the portfolio of dropped funds than for the funds that replaced them. Once again, inaction would have proved better for investors than action.
Swedroe also notes that individual plan participants tend to herd into prior-period top performers...just before those funds reconfirm one of the natural world's most reliable phenomena: reversion to the mean. To summarize, funds that have out-performed recently/relatively tend to underperform in the next period. Recent-period underperformance tends to be a little more durable than outperformance, but many funds that look like stinkers on a plan's typical chart of recent returns turn out to do better in subsequent quarters and years. Thus...mean-reversion for recent winners and recent losers alike.
Swedroe concludes with this:
These findings demonstrate that investors would be better served if plan administrators limited their offerings to low-cost index funds and if investors put their portfolios on autopilot--setting the portfolio to rebalance on a regular (e.g., quarterly or annual) basis.
Though we prefer market- rather than calendar-driven rebalancing, this is the general approach we take to our role as 3(38) fiduciaries. And it's the approach we recommend to everyone, everywhere. Why? Because we're all engaged in a probability-maximizing process, and chasing performance at the plan or individual level makes it less likely that participants and their beneficiaries enjoy the best outcomes possible under a given set of market conditions.
Larry Swedroe, "401(k) honchos could do better by doing less," CBS News MoneyWatch, August 29, 2013