The Float

BrightScope and Vanguard

Two weeks ago, Vanguard's Steve Utkus posted a thoughtful, if not quite fully informed, take on the work of our friends at BrightScope.*

We encourage you to read Steve's original post here.

Then take a look at Ryan Alfred's response at BrightScope's blog.

We're pleased to see these types of exchanges. They should help everyone who cares about the future of retirement security in this country understand what is being done well and what can be done more efficiently and effectively.

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* Full disclosure: Interlake has believed in BrightScope's basic approach from the outset and we subscribed to their Advisor Central service in October, 2009. We want them to succeed, we believe they will (more to the point, we see that they are succeeding), and we think their data and related services can help us bring a truly fiduciary approach to retirement plan participants at companies of any size and shape.

New DOL Proposal on Index Funds

We ran across an interesting piece in InvestmentNews on a recent DOL trial balloon concerning passive and active funds in ERISA plans. Here's the essence of the DOL proposal:

Specifically, financial advisers point to a recent proposal in which the Labor Department asked whether computer-based advice models should take into account only the fees and expenses of a mutual fund--and not its historical returns--since they aren't guaranteed. If fees and expenses are the primary factor when recommending funds for 401(k) plans, these advisers contend, index funds will win out over actively managed funds every time.

The next paragraph is classic industry stuff:

"I was absolutely shocked that they were asking questions about whether historical performance should be a factor," said Robert L. Francis, chief operating officer at broker-dealer National Retirement Partners. "It's like saying that you should buy a Volkswagen over a Rolls Royce just because it's cheaper."

It can be difficult to choose one's metaphors on the fly, so I don't want to make too much of this, but please...that Volkswagen can get people where they need to go just fine, thankyouverymuch. The reality is that the vast majority of investors should choose the metaphorical Volkswagen over the Rolls Royce. 

And then there's this deeply strange take:

A bias toward passively managed funds, leading to more 401(k) plan sponsors adding index funds to their lineups, would also have a negative impact on employee engagement in saving for retirement, said Paul R. D'Aiutolo, vice president of investments, advisory and brokerage services at UBS Institutional Consulting.

"The purpose is to keep people engaged in their plans," he said. While index funds may perform well over the long term, it's often the ups and downs of actively managed funds that keep plan participants paying attention, Mr. D'Aiutolo said.

Good grief. What a sad example of non-fiduciary thinking, as if participants' attention levels--as opposed to their future retirement security--were the objective. Engaged participation is fine, but only in the context of a sound portfolio strategy built on a foundation of best-available investment options. 

And this:

[If the agency does set a bias toward passively managed funds, it] could also mean increased costs to plan sponsors because index funds offer less in revenue-sharing dollars than actively managed funds, and thus there is less money to cover record-keeping expenses, [Thomas Clark Jr., vice president of retirement plan services at Lockton Financial Advisors LLC] said.

In the new, still-emerging ERISA world, transparency is a moral and practical imperative, and by definition transparency means less revenue-sharing (preferably none). Sponsors can still pass record-keeping and other administrative expenses along to participants, but not by burying them in the utterly opaque shell game known as revenue-sharing.

In our practice, we use index funds in all asset classes where they're available. On a portfolio-weighted basis, index-based vehicles constitute 8 to 23 percent of our holdings.* For us, the most important objective is to offer fully-/globally-diversified portfolios. Though we would prefer to do that using index-based vehicles only, fund providers haven't quite gotten us there just yet.

The point of which is that we're sympathetic to the DOL's implicit instincts here, but the real world is sufficiently complex and imperfect that it's difficult to write sweeping rules that don't create a few unintended consequences. So we'd like to see the DOL tread carefully here. But the old-school, non-fiduciary thinking on display in this InvestmentNews piece reminds us that there's still enormous room for improvement in the retirement plan marketplace. 

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* The asset classes in which we do not use--because we do not have access to--index-based vehicles are: non-U.S. REITs, non-U.S. fixed income (developed and emerging markets), and diversified commodities. Roughly a year ago, we replaced an actively-managed T. Rowe Price fund with a new Vanguard index-based option in the non-U.S. small-cap equity category.

Source

Jessica Toonkel Marquez, "DOL's 401(k) pitch strikes fear among financial advisers," InvestmentNews, March 28, 2010

The WSJ on ETFs in 401(k) Plans

This morning's Wall Street Journal includes an Ian Salisbury story on two of The Float's favorite subjects: exchange-traded funds and defined-contribution retirement plans. By our lights, Salisbury doesn't break much new ground, but he does a nice job of describing ETFs' small-but-growing share of the 401(k) market and the trade-offs involved in including ETFs in a plan's investment lineup. Here are a couple highlights:

According to estimates from BlackRock Inc., the largest sponsor of ETFs, investors hold at least $2 billion worth of its iShares ETFs in 401(k) plans after buying about $500 million in fund shares last year.

Since iShares controls about half the ETF market, the figure suggests that in total there may be something like $4 billion of ETF assets in 401(k)s.

That's just a tiny sliver of the more than $1 trillion in 401(k) assets invested in mutual funds, but it represents significant growth from several years ago, when ETFs were almost entirely absent from these plans.

...

Unlike other 401(k) options, ETFs don't accommodate "revenue-sharing," or using a portion of the fees investors pay to funds to support administrative costs of retirement plans.

Many financial advisers and consumer advocates think that's good news since it makes it easier to keep tabs on what investors are actually paying for.

That last point is especially important. We're no fans of revenue-sharing because of its inherent opacity. But there's another element in a plan's true-and-total cost structure that Salisbury doesn't mention: Bid-ask spreads paid in the trading of ETFs. Of course open-end mutual funds incur spread costs to trade positions in their portfolios as well, but that's exactly the point: The "trading costs" question doesn't resolve so clearly in favor of ETFs after all. When trading is frequent, as it is in the vast majority of 401(k) plans, spread costs add up, even when trades are aggregated within and across plans.

Salisbury mentions the ETF-based plans sponsored by BlackRock's iShares unit. We've looked into those options, and they might make sense for some plans. But we have to be honest: We have other programs at our disposal that impose lower total costs on sponsors and participants and provide easy access to complete portfolios that replicate (almost exactly) the best available ETF-based solutions.

We like ETFs. We use them extensively in our private client practice. We think they may well have a future in the defined-contribution world. But we haven't seen sufficient advantages in ETF-based options to make us abandon our current programs.

Source

Ian Salisbury, "ETFs Make Inroads with 401(k) Investors," Wall Street Journal, January 13, 2010

Target-Date Report from the Senate Special Committee on Aging

Back on Tuesday we mentioned that Herb Kohl's Senate Special Committee on Aging would hold a hearing on target-date funds, with special emphasis on their role in retirement plans. And hold that hearing they did.

The testimony the committee heard was all well and good, but the substantive issues are best captured in this staff report, revealingly subtitled "Lack of Clarity Among Structures and Fees Raises Concerns." If you're into this sort of thing, we recommend that you take a look.  The good stuff starts on page 8.

The Target-Date Debate...

...heads to Capitol Hill tomorrow, as the Senate Special Committee on Aging holds hearings on conflicts-of-interest in target-date vehicles. Here's a four-minute preview of some of the issues from CNBC, featuring Interlake's friend and colleague Mike Alfred of BrightScope:

In addition, Senator Herb Kohl of (the great state of) Wisconsin has just released a Government Accountability Office study of auto-enrollment in 401(k) plans. Here's GAO's overview:

Automatic enrollment appears to significantly increase participation in 401(k) plans according to existing studies, but may not be suitable for all plan sponsors. Some studies found that participation rates can reach as high as 95 percent under automatic enrollment. Available data indicate that the percentage of plans with automatic enrollment policies increased from about 1 percent in 2004 to more than 16 percent in 2009, with higher rates of adoption among larger plan sponsors. In most cases, these plans automatically enroll only new employees, rather than all employees. We also found that automatic enrollment may not be suitable for all plan sponsors, such as those with a high-turnover workforce. Further, some data show that while automatic escalation policies--which automatically increase saving rates over time--are increasingly common, they lag behind adoption of automatic enrollment. In combination with low initial contribution rates, this could depress savings for some workers. Also, the emergence of target-date funds--funds that allocate investments among various asset classes and shift to lower-risk investments as a "target" retirement date approaches--as the typical default investment raises questions in light of the substantial losses such funds experienced in the past year.

A New Slug of Active ETFs

This morning's Wall Street Journal features an Eleanor Laise article on a few new entrants in the category of actively-managed ETFs. We aren't crazy about the concept, largely because we think ETFs work best as part of a strategic asset allocation program with rock-bottom expenses. Here's a telling passage on that front:

Many investors are attracted to ETFs because of low costs. But the new Grail funds will each charge annual expenses of 0.89% of assets, making them pricier than three-fourths of the ETFs tracked by investment-research firm Morningstar. Grail American Beacon Large Cap Value charges 0.79%, only marginally cheaper than the 0.83% charge by investor shares of the nearly identical American Beacon Large Cap Value mutual fund. And the Dent Tactical ETF charges 1.56%. That is more than the average diversified U.S. stock mutual fund.

Roughly one quarter of ETFs have explicit annual expenses of more than 0.89%? Yikes. Then there's this:

Investors haven't flocked to actively managed ETFs. The Grail American Beacon Large Cap Value ETF has roughly $3 million in assets, and the five active PowerShares products have just over $24 million combined.

Brutal. If those numbers don't change soon, these little experiments won't last much longer. What about early returns from these things?

Performance that has lagged behind hasn't helped. PowerShares Active Alpha Multi-Cap Fund is down 21% in the year ending Monday, trailing the Standard & Poor's 500-stock index by 11 percentage points. PowerShares Active AlphaQ Fund is down 3.6% over that period, while its primary benchmark, the Nasdaq 100, gained nearly 4%.

Not a pretty picture. But some sponsors appear undaunted.

Despite the challenges, active ETF providers are aiming high. Grail aims to launch 24 to 30 new active ETFs over the next year or so, said Bill Thomas, the firm's chief executive. And over the past year, the firm has been talking to conventional actively managed mutual funds about converting to an ETF structure.

That's an interesting concept. Many of Vanguard's ETFs are simply different "share classes" of the firm's traditional mutual funds. We'll stay tuned to see if other open-end managers try to break in with ETF versions of their actively-managed funds.

UPDATE: ETFs are growing quickly, but they still occupy a small corner of the investment world. Here are a couple 2008 posts comparing ETFs and index-based vehicles to actively-managed, open-end funds:

• "ETF and Mutual Fund Data: A Reality Check"
• "ETFs and Index Funds: Still Modest in Most Categories"

Source

Eleanor Laise, "Grail's ETFs Take 'Active' Approach," Wall Street Journal, September 30^th, 2009

Agility Matters

We've long argued (here, here, and here, for example) that most big mutual funds are a rotten deal for individual investors. Due to their size, trading costs, and diversification, many of these funds end up behaving like very expensive index-trackers over full market cycles.

Most of the evidence we've pointed to has focused on big, lumbering laggards. Yesterday's Wall Street Journal featured a story on the best-performing funds in the first half of the year, and the upshot is clear: Small is beautiful.

While their names mightn't be familiar to many investors, there were some stock funds that delivered stellar returns over the past year.

Among the seven best-performing funds in the 12 months to July 31, none is from the 25 largest mutual-fund companies and none of the funds has more than $700 million in assets, according to data from Morningstar Inc.

Despite the market downturn that saw the Standard & Poor's 500 Index lose 22% during the 52-week period, the seven funds, all of which invest in long-only securities and are mostly invested in stocks, have seen double-digit returns.

Six of the funds use "value" strategies, while four have concentrated portfolios and held fewer than 40 stocks, according to the most recent data. The figures suggest investors should take note of smaller funds, if nothing else than for their ability to be more flexible in challenging markets.

Indeed.

Source

Sam Mamudi, "Top Funds' Traits: Strategy and Size," Wall Street Journal, August 6, 2009

More From Dalbar

Back in March, we posted a brief overview of Dalbar's most recent edition of its "Quantitative Analysis of Investor Behavior," an authoritative study of the perennial gaps between market returns and fund returns on the one one hand, and fund returns and investor returns on the other. Summary: The numbers get uglier with each step away from market returns--and (stock) market returns haven't been especially thrilling in the first place!

Via Mebane Faber, we found Dalbar's fuller treatment of its 2009 report (which is through year-end 2008). This is good, important stuff. Take a look.

Target-Date Funds and Portfolio Completion

On Friday, Investment News reported findings from a Janus Capital survey of retirement plan participants and sponsors. The focus: Target-date funds in defined-contribution plans.

Two-thirds of investors believe that target date funds need to be combined with other funds to achieve a proper mix for their retirement portfolios, a white paper released yesterday by Janus Capital Group Inc. of Denver suggests.
...

The study also found that some plan sponsors did not apply the same level of due diligence to target date funds as other funds.

While 60% of plan sponsors said they evaluated individual target date funds and their underlying holdings when selecting a series of funds, 40% said they did not.

Now, that first set of findings--that many rank-and-file investors use target-date funds "off-label," by combining them with other investment options--typically unleashes a lot of tut-tutting from the financial services crowd. Having seen the composition of a lot of target-date funds, we reckon many of those investors are right...they aren't complete solutions.

Unfortunately, however, many retirement plans that include mediocre target-date funds will lack the complete investment lineup participants want (and need, whether they want it or not).

Now, it's certainly true that a large number of participants aren't clear on the all-in-one concept of target-date funds. And where participants find themselves trading investment vehicles around their target-date funds, they're likely to create more problems than they solve.

The important point here is that some participants have very good reason to view their plans' target-date funds as incomplete. Whether they can round out their portfolios effectively...well, that's another story.

On the question of plan sponsors and their due diligence, this is clearly problematic, and it's symptomatic of a larger shortcoming in the retirement plan marketplace: the informational asymmetry between busy, non-expert plan sponsors (i.e., buyers) on the one hand and financial services firms (i.e., sellers) on the other.

But let's stipulate that a given sponsor wants to perform the same due diligence on those target-date offerings. What are the appropriate criteria? In the fund-selection game, that question isn't any easier to answer in the target-date space as it is in the mutual fund space in general. What are the criteria? Past performance? Doesn't tell us much, and chasing the leaders tends to be a losing strategy. Expenses? That's a good place to start, but don't forget the hidden ones. Asset-class exposure? Sure, but isn't that a problem for investment professionals?*

Apparently Morningstar is going to take a swing at this by publishing ratings on target-date funds. Using an alliterative set of criteria--people, parent, performance, portfolio and price--Morningstar will try to help sponsors and participants make sense of the target-date universe. We'll reserve judgment on these ratings until we see them.

As always, however, there will be no substitute for dispassionate guidance, for sponsors and participants alike, from truly independent fiduciaries.

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* Indeed it is, which is why the hiring of truly disinterested, fully independent, product-agnostic fiduciaries is so immensely important.

Source

Sue Asci, "Target date funds shouldn't stand alone, most investors believe," Investment News, May 29, 2009

Caitlin Mollison, "Morningstar to introduce ratings on target date funds in 3Q," Investment News, May 28, 2009

New Findings on Mutual Fund Trading Costs

Given recent discussions of implicit fund costs and their effects on retirement plan participants (see this for our latest take on the topic), this report from last week's Morningstar conference is very timely indeed:

Often-ignored trading costs for mutual funds add an average of 1.64%, making positive returns even more difficult to achieve, said Arijit Dutta, associate director of fund analysis at Morningstar Inc. in Chicago.

He and Roger Edelen, assistant professor at the University of California, Davis Graduate School of Management, spoke today at Morningstar's annual investment conference in Chicago.

...

"Some funds have a high hurdle to overcome because of the costs," Mr. Edelen said. "This doesn’t mean that active management is dead; it just means that they have a [high] hurdle to overcome."

Mr. Edelen said commission costs pale in comparison with the costs that are added by trading, particularly when fund managers buy stocks because they have an added supply of cash.

He said trading costs add up because managers start to buy a stock one day and continue to buy that same stock for several days.

By the time they've finished purchasing the stock, they have driven up the price of the stock, and it is much more expensive than it was when they first bought it, Mr. Edelen said.

We don't know what to make of Lisa Shidler's use of "commission costs" here. Is she referring to sales loads? Expense ratios? Either way, the basic truth remains: Implicit costs affect investors' returns, and understanding the factors that drive those costs higher--portfolio turnover, fund cashflow, asset-class liquidity, fund size--is an important part of establishing and maintaining an excellent investment program.

We'll look for more details on the Dutta-Edelen research and pass them along if we come up with anything.

Source

Lisa Shidler, "Trading costs on mutual funds outweigh commission fees for investors, experts say," Investment News, May 29, 2009