The Float

BrightScope Responds to the ICI

BrightScope's Ryan Alfred has posted the latest entry in the ongoing debate between leaders of the transparency movement (where BrightScope is at the head of the class) and the mutual fund industry's Investment Company Institute. For what it's worth, we've contributed our thoughts here, here, and here.

You should read Ryan's post in its entirety, but we think this is the most important thing he wrote:

The more we listen to both sides on this issue the more we realize that any single number used to describe 401k fees, be it asset-weighted, plan-weighted or participant-weighted is not all that useful in trying to help participants and plan sponsors understand what fees they are paying within their plan.

Exactly right. Though we'll always have a little uncertainty about plans' hidden expenses, it's perfectly straightforward to develop a general sense of which investment vehicles are likely to have higher and lower implicit costs. And it's even more straightforward to understand and disclose the full list of explicit costs facing a plan and its participants.

If we can get individual plans right, in the sense of both transparency and modest expenses, the average/aggregate numbers will take care of themselves. Those aggregate numbers are important, but only to the extent that they reflect the actual experiences of actual participants. And there's still so much variance across plans and participants that there's no substitute for calculating, disclosing, and, where necessary, reducing expenses at the level of individual plans.

Fun With Headlines

A telling pair, from this week's issue of Investment News:

• "Absolute-return trend inspires both optimism and caution"
• "Investors abandon 130/30 strategies"

Given the track record of the fund industry's faddish product roll-outs, we'd counsel more caution than optimism on those absolute-return funds (as we did a while back in this space).

Our Response to ICI's Response to BrightScope's Response to ICI's 401(k) Survey

Over the last two weeks, we've participated (marginally) in a discussion of the Investment Company Institute's recent survey of costs borne by 401(k) plans and participants. Elements of that discussion--including our initial post on the topic--have focused not just on the findings of the survey, but on ICI's descriptions thereof.

Writing at BrightScope's blog, Ryan Alfred advanced the debate by examining the ICI survey's sample. That sample leaned heavily on large plans, which tend to be less expensive than small plans, though there's enormous variance even among the biggest ones.

Yesterday, the ICI posted a comment on Ryan's response at BrightScope's blog and a longer response at its own website. We're pleased to see this discussion continue. It's important. And judging by the progress we've already made, it should help sponsors, participants, service providers, policy-makers, and reporters better understand the 401(k) marketplace.

Here are a few thoughts on the ICI's response to BrightScope...

Sampling. Here's ICI on this key factor:

The survey used a sampling technique known as nonproportional quotas. Knowing that the universe of 401(k) plans includes more than 450,000 plans, and that smaller plans are harder to find, the survey was specifically targeted across the spectrum of asset sizes and stayed in the field until specific quotas for plans of different sizes were filled. This survey design ensures that all segments of the population are included and resulted in the extensive, comprehensive data presented.

This is a perfectly reasonable approach. As we noted in our initial item on this topic, the biggest problem isn't with the sample per se; it's with the ICI's description of the report's findings. About those adjectives: We'll grant ICI "extensive," but we won't quite go for "comprehensive," and we certainly wouldn't grant them the most important descriptor (which they don't use)...representative.

What ICI Has Said About the Survey. ICI notes that in his description of the report's findings, ICI Chairman John Murphy said this (emphasis added in bold by ICI):

"The median all-in fee for these plans was 72 basis points. Less than three-quarters of 1 percent--quite a bargain compared to the 3 percent that some critics cite."

In fact, however, ICI's estimate isn't an "all-in" fee, at least if you consider "fee" and "expense" practical synonyms in this context. By excluding trading costs (more on that in a moment), ICI compares its incomplete picture of what participants pay with others' claims about plans' and participants' true and total costs. In addition, for all the reasons we cited back on May 8^th, ICI's "0.72%" excludes more than just implicit fund expenses. Bottom line: We need to get everyone on the same page, talking about the same elements of plan expenses in the same terms.

What Do 401(k) Participants Pay? The most important point made in ICI's response is that while most plans are small, most people participate in large plans. Weighting aggregate, system-wide estimates of expenses by assets or participants is fine. But it can't obscure the fact that, as an anonymous ICI employee posted at BrightScope's blog, "small and tiny plans" need help. And it shouldn't obscure the fact that a lot of non-small, non-tiny plans need help too.

Trading Costs. In a short summary of its response to BrightScope, posted at BrightScope's blog, ICI calls trading costs "a complicated issue." Indeed. But it's not so complicated that we can't get serious about understanding it and--just as important--including it in all discussions of plans' and participants' true and total costs. Here's what we know:

• Trading costs are, as ICI rightly points out, unavoidable.They can also be very substantial indeed.
  
• All else equal, they tend to be higher for funds in relatively illiquid asset classes (due to larger bid-ask spreads).
• All else equal, they tend to be higher for funds with more assets under management (due to larger market impact).
• All else equal, they tend to be higher for high-turnover funds (due to trading commissions and the fact that high turnover raises spread and impact costs).

To the extent that plan participants and fiduciaries care about implicit costs, as they should, they can compare investment options on the basis of asset class liquidity, fund size, and turnover. The point here isn't that big, high-turnover funds in less-liquid asset classes are always and everywhere bad choices. It's that sponsors and participants, guided by fiduciary service providers, should understand the nature and impact of these costs, and, armed with that knowledge, make prudent decisions about their investment options.

Big Ideas. The ongoing debate about expenses is important. The sooner we can establish a shared framework for comparing plans' and participants' true and total costs, the sooner we can agree on a new regulatory framework and industry standards to match. But we shouldn't let this talk about expenses and transparency distract us from the fundamental objective: to give participants and their beneficiaries a better shot at a decent retirement. Simply put, it's all about outcomes.

We care about expenses because, all else equal, lower expenses will produce better outcomes. We care about transparency because we think more and better information will help sponsors and participants correct the informational asymmetry that continues to plague the 401(k) marketplace. And we care about the 401(k) marketplace because it has profound implications for participants' economic outcomes.

So let's get disclosure right. Let's eliminate unnecessary expenses and shrink the rest. Let's replace the industry's selling machine with a thoroughly fiduciary model. Let's do all those things. But let's also remember that for the vast majority of participants, long-term outcomes are more a function of their investment programs--their original formulation, their ongoing maintenance, their periodic changes--than of the costs they pay to participate in these plans.

As we've noted in this space, a true fiduciary plan features low expenses and good decision-making. Unfortunately, the current model--in which participants (even those in the least expensive plans) are presented with a menu (which is often incomplete) of mutual funds (which are often mediocre) and left to fend for themselves--tends to produce all sorts of dysfunctional behavior and sub-optimal outcomes.*

So above all, let's organize the entire defined-contribution model around the inherently fiduciary concept of improving participants' long-term outcomes. That means modest expenses, full transparency, and easy access to superb, portfolio-centered (as opposed to fund-driven) investment programs.

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* See this post from late 2007, "Real Participants, Real Problems," for our take on The Uncertain 1/n Hedger, The Shameless Performance-Chaser, and other categories of participants behaving badly.

BrightScope Gets It

Last Friday, we posted an item on the Investment Company Institute's latest efforts to obscure the true costs of qualified retirement plans. We think we touched on a few important points, and that post generated quite a lot of traffic around here for a few days. But the more important contribution to this discussion--more important by far--is Ryan Alfred's latest post at BrightScope's blog. This is required reading, and it's required this very second.

If you're still reading this--and if you are we have to ask why, because you should be reading Ryan's explanation of what's wrong with the research on which ICI has hung its organizational hat--we'd like to note that when we called the ICI's survey "unserious" last week, we didn't expect that term to be among the more charitable adjectives applicable to this particular research product. (Or, more precisely, to ICI's presentation of the research, as they describe it as something it clearly isn't.)

Here's Ryan:

Due to the inadequacy of the sample in the two areas deemed most critical in driving fees by ICI/Deloitte--asset size and participant size--it is safe to say that the survey systematically underestimates median fees for the DC marketplace.

As it turns out, the ICI study oversamples the biggest plans (and thus wildly undersamples small ones) several times over. Because small plans tend to incur higher costs, this grossly unrepresentative sample can't help but understate mean and median plan costs (while excluding implicit costs entirely, which is another big problem).

Here are the key data from Ryan's post:

That pretty much says it all, doesn't it? Taken together, micro and small plans, which comprise fully 96% of the plan universe, are only 20% of the ICI survey. Mega plans, meanwhile, one of every thousand plans in the population, are one of every five in the ICI sample.

Memo to plan sponsors, reporters, and policy-makers: Don't believe the hype. Dig a little deeper. And, as always, follow the money.

The Cynicism of the ICI

In the investment biz, it's a tale of two meetings this week.

In Scottsdale, they're attending the annual Fiduciary360 confab, where fiduciary principles and practices form the programmatic core of the three-day event. Across the country, in Washington, D.C., we have the general meeting of the Investment Company Institute, the mutual fund industry's trade association.

Though the fi360 event is unlikely to make much news, the ICI meeting has made a few headlines already. Here's one that jumped off the screen at us: "401k fee critics overstate problem, ICI chairman says." From InvestmentNews (emphasis added in bold):

While supporting improved retirement plan fee disclosure, the head of the Investment Company Institute said yesterday that congressional criticism of 401(k) plan fees has been inflated by critics.

"What they don't mention is the long list of services that 401(k) plans provide," including investment management and record keeping as well as legal services, audits, websites, call centers and participant education, John Murphy, chairman of the Investment Company Institute, said in a speech to about 800 mutual fund executives at the group's general meeting in Washington.

Legislation introduced by House Education and Labor Committee Chairman George Miller, D-Calif., would require more disclosures of 401(k) fees.

In response to charges that plan fees are too high, Mr. Murphy cited a recent ICI-sponsored survey which showed that total fees for the plans were 0.72% of assets, "quite a bargain compared to the 3% that some critics cite."

He also said that "disclosure is not just about fees," adding that reports should include information on risks, performance and investment objectives. Disclosures, however, must be useful, and they should not overwhelm sponsors and participants "with data that they don't need," Mr. Murphy said.

Where to begin?

First, it's the very height of cynicism to list all the services "401(k) plans provide" in one breath, then cite a number (0.72%, which is the dubious number ICI claims is the average explicit expense--the expense ratio itself--of funds held in 401(k) plans) that not only excludes many of those services, but doesn't even reflect the true cost of mutual fund ownership.

As we've noted time and time again (here and here, for instance), mutual funds' implicit costs are difficult to pin down with absolute precision, and they don't show up in any prospectus (though trading commissions are reported in the Statement of Additional Information, always well-read by rank-and-file investors and their advisors, of course!), but they come out of investors' returns all the same.

We've heard that ICI personnel, when confronted by Capitol Hill over the incompleteness of "0.72%" (a number so thoroughly dubious as to deserve quotation marks every time it's cited, and we're happy to start that practice right here), respond by saying that they can't account for the services delivered and fees charged by professionals outside their own realm. True enough! But that means ICI can't cite a "long list of services 401(k) plans provide" that includes many services mutual fund companies don't provide. That seems pretty straightforward to us.

Second, that "average" cost of "0.72%" is misleading insofar as it's pulled lower by plans with truly rock-bottom investment expenses, and those plans are out there. Unfortunately, tens of millions of participants--and, by extension, their beneficiaries--are saddled with substantially higher explicit expenses, to say nothing of the fact that implicit costs tend to scale up in rough proportion to explicit costs.* So while the relative few might enjoy investment expenses of 20 or 30 basis points, the vast majority face true costs well in excess of "0.72%."

Third, "0.72%" doesn't include any annuity-related charges, which, alas, affect a shockingly large number of participants, many of whom are blissfully unaware of this particular problem.

Finally, while it's certainly possible to bury participants and sponsors under excessive information, the simple, obvious fact is that it's beyond easy to summarize and convey information on expenses and other plan characteristics to participants. The only question that matters is: Do you want to?

401(k) and other defined-contribution plans imply certain costs. But there's a blindingly clear divide between those meeting in Scottsdale this week, who want to reduce and disclose the true and total expenses investors incur, and those meeting in Washington, who commission unserious surveys, then spin the heck out of the place, in an effort to conceal the unpleasant realities of a defined-contribution system that's salvageable, and worth salvaging, but in need of bright light and serious reform.

The system is a lot like Steve Austin in the opening sequence of The Six Million Dollar Man. It's in pretty bad shape, but we have the technology. We can rebuild it. And rebuild it we must, with or without the ICI.**

UPDATE: Readers visiting from 401khelpcenter.com, please see this follow-up item, which draws on BrightScope's analysis of the ICI's claims.

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* This is true to the extent that the factors associated with high explicit costs, high-turnover funds in relatively illiquid asset classes, tend to correlate with high implicit costs, precisely because of turnover and relative illiquidity.

** A couple caveats: (1) Our problem here is with the ICI, not with all mutual fund companies, let alone everyone who works in the mutual fund business and (2) we use mutual funds in our 401(k) practice--inexpensive, index-based funds in every available asset class, but open-end funds nonetheless--so, again, our objections apply to ICI's political tactics, not all mutual funds.

Source

Sara Hansard, "401k fee critics overstate problem, ICI chairman says," Investment News, May 7, 2009

Still More on Target-Date Funds

Because we're in the business of providing asset management services to defined-contribution retirement plans, and because we care about the retirement security of our fellow citizens, we take a special interest in discussions of "target-date" mutual funds (see this, for example).

So we were delighted to see Tom Lauricella's semi-recent (and delightfully-titled) riff on target-date funds in The Wall Street Journal. Here's the bulk of Lauricella's short piece, with each excerpt (in blue) followed by our observations (in black):

With many target-date mutual funds inflicting big losses on investors nearing retirement, they've gone from hero to goat.

If history is any guide, these funds are still a better option in the long run than less-volatile alternatives like money-market funds -- a plus for Congress's decision to make it easier for employers to automatically direct employees' retirement money into target-date funds. But their poor performance is leading to scrutiny of how fund companies construct and market these portfolios.

Indeed. In the time-honored tradition of "follow the money," it's all about the construction and marketing of these things. More on these two factors below.

[M]any of the funds aimed at those in or near retirement suffered declines of 25% or more over the past year. Fund companies say the portfolios are designed for life spans that can last 30 years beyond retirement. That's cold comfort for those who need to start spending the money immediately upon retirement and will have less in play later on when, and if, the markets rebound.

As we've noted here before, the true finish line is one's life expectancy, not the day one retires. But the intervening moment of truth is the point at which an investor annuitizes a corpus of assets, turning that accumulated wealth into a stream of income (through an insurance product or a systematic withdrawal program).

Of course, the warnings that these funds may not be appropriate for every investor are spelled out in their prospectuses. But a 401(k) investor automatically placed into a fund by an employer is probably less likely to read a document that even engaged fund buyers rarely read.

Again, quite true. The clear imperative is to give participants (and other investors in these vehicles) plain-English versions of the relevant information, not thick prospectuses and statements of additional information.

Congress, somewhat belatedly, is looking more closely at target-date funds as default investments in retirement plans. One question is whether it should dictate investment-mix parameters -- or at least make it clearer that a 2010 "retirement" fund is actually a 2035 "death" fund.

This is why we favor a "target-risk" approach rather than a target-date model. We think the notion of risk-calibrated portfolios goes to the core of the problem, focusing on what really matters (expected risk and return parameters) rather than the wholly subjective premise of a future year when the difference between the "retirement fund" concept and the "death fund" concept can be very consequential...and totally opaque to most plan participants. If we're going to put rank-and-file participants in charge of their own investments, we simply must give them relevant information as straightforwardly as we can.*  

Some say there are more-fundamental issues to examine. Laws covering retirement plans were intended to ensure they are run in the sole interest of participants. There are prohibitions against "self dealing" by the fiduciaries. Mutual funds, however, are given a pass on these conflict-of-interest rules. That allows fund firms to build target-date portfolios with a tilt toward higher-fee stock funds, rather than low-fee bond funds. Even if that weren't a motive for asset allocation, in a bull market like the one through late 2007, the more stocks, the easier it is to attract clients.

This is really the central problem with proprietary target-date funds. Here, the construction and the marketing of these vehicles can produce some decidedly unhelpful cross-mojonation, contaminating the (legally/presumably) fiduciary function of portfolio assembly with the non-fiduciary imperatives of profit-making. Which is why Lauricella's last paragraph is his most important.

Another possibility is requiring 401(k) target-date funds to use asset-allocation models developed by a company not affiliated with the fund manager, in order to avoid conflicts of interest.

This is clearly the way to go, ensuring, when combined with rules governing advisors' compensation, a high degree of independence on the part of the professionals who assemble these portfolios.

One key, then, is to separate fund companies' profit-making imperatives from the process of portfolio construction. The easiest way to do that is precisely as Lauricella describes, using independent advisory firms to construct portfolios (preferably of the target-risk variety) using the best-available products from all fund companies, not just one.**

The second key is to communicate expected risk and return parameters to participants in simple, accessible terms, enabling them to make easy, informed decisions before returning to what they do best: working, deferring assets into the plan, and enjoying their lives without feeling the need to constantly monitor and tweak their 401(k) portfolios.

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* By "we," we mean plan sponsors and fiduciary service providers.

** For what it's worth, we use 15 funds in our 401(k) portfolios. Ten of those are Vanguard funds. Currently, the other five are Fidelity, T. Rowe Price (2), Alpine, and Pimco products. This list is always subject to change, but we'll only change it if we're convinced that some alternative vehicle would be better for plan participants and their beneficiaries.

Sources

Tom Lauricella, "Let's Set a Target, And Date, for Fixing Target-Date Funds," Wall Street Journal, April 6, 2009

Fred Reish, Bruce Ashton, and Jason Roberts, "Investment Advice for Participants: Prohibited Transactions and Level Fee Advice," Reish Luftman Reicher & Cohen, March, 2009

The Real Issues Underlying 401(k) Litigation

We attended a local law firm's annual employee benefits workshop this morning, where the first 90 minutes focused on retirement plans: Reductions in employer contributions, partial terminations, suspensions of RMDs for 2009, rollovers by non-spouse beneficiaries, DOL guidance on investment advice, and prototype 403(b) documents.

In addition to all that, there was one segment that had us listening very closely indeed: a discussion of Hecker v. Deere, the 7th Circuit's February disposition of which got some coverage from Stephen Rosenberg and our friends at BrightScope, among many others.

This morning, the discussion of Hecker got the crowd involved, producing several good questions and sensible observations (as well as a few curious ones), all of which led us to the following conclusions:

One of the fundamental shortcomings of the status quo in the 401(k) marketplace is the "bundled" approach itself, in which most plan expenses (i.e., the vast majority of costs borne by participants) are reflected in mutual fund expense ratios. We see two big problems with this practice.

First, the bundled approach is fundamentally non-transparent. Unfortuantely, wrapping everything up into one number (a number that's subject to change, and often at the most inopportune times) leaves sponsors and participants unable to know what they're paying for which services. Given ERISA's clear requirement that plan fiduciaries understand, monitor, and knowingly approve plan expenses, the bundled approach is a per se departure from ERISA's core principles. If you're a sponsor and the question is: What do your participants pay for recordkeeping services? The answer can't be "nothing" (because that isn't true, unless you're paying RK expenses with company funds, in which case you should know anyway) or "I don't know" (because the law requires you to know). The answer should be "20 basis points annually," or "$40 per person per year," or something concrete. (For most plans, we like the per capita approach, for reasons we'll explain in the next paragraph.) Bundled plans can be relatively expensive or relatively inexpensive. But because they aren't transparently priced, they're more likely to be more expensive for the simple reason that it's easier to roll a bunch of unnecessarily high fees into a number that doesn't itemize separate services and is paid entirely by (usually naive) participants. Transparency and low expenses aren't the same thing, but more of the former would be directly conducive to the latter.

Second, bundled plans don't share economies of scale with participants. If expenses scale up proportionately with assets (as they must when they're paid through the linear mechanism of mutual fund expenses), a $200 million plan will cost exactly 10 times as much as a $20 million plan, and 100 times as much as a $2 million plan. The simple truth, however, is that service providers' "cost of goods sold" doesn't come close to scaling up in such linear fashion. So a $20 million plan shouldn't cost exactly 10 times as much as that $2 million plan. There's no brightline formula for what that multiple should be, but it's perfectly clear--painfully obvious, even--that it should be less than 10.* The point here is that failing to share economies of scale with participants is inconsistent with ERISA's central concept, which states quite clearly that decisions made for the plan should serve the interests of participants and their beneficiaries.

To summarize: The absolute level of plan expenses (including, as always, the hidden costs of mutual fund ownership) should be reasonable, and the lower the better. But regardless of their level, expenses should be transparent, and should be structured in a way that shares economies of scale with the people who've earned them: rank-and-file participants.

No matter what happens with Hecker and its cousins, we need to get these things right: Less expensive, more transparent, easier access to high-quality investment disciplines. The destination is clear, but, alas, the path to get there is cluttered with entrenched interests. For conscientious sponsors, concerned participants, and fiduciary service providers, much work remains.

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* One complicating factor here is the number of participants, where plans with more participants (or, more precisely, lower average account sizes) imply a higher "cost of goods sold" for service providers. But the beauty of the per capita model is that it accommodates this in a perfectly straightforward, economically rational, and legally defensible way.

S&P Findings on Active Management

This isn't surprising, but it's important (emphasis added in bold):

Passively managed funds outperformed actively managed funds across all categories during the past five years according to [research from] Standard & Poor's Index Services, which was released today.

Between 2004 and 2008, the S&P 500 stock index outperformed 71.09% of actively managed large-cap funds, according to the year-end 2008 report from the New York-based research firm.

In addition, the S&P MidCap 400 Index outperformed 75.9% of mid-cap funds and the S&P SmallCap 600 Index outperformed 85.5% of small-cap funds.

"The belief that bear markets strongly favor active management is a myth," Srikant Dash, global head of research and design at Standard & Poor's, said in a statement. "The bear market of 2000 to 2002 showed similar outcomes."

Similar results were also reported for international-equity and fixed-income funds.

Among international-equity funds, the indexes outperformed a majority of actively managed non-U.S. equity funds.

For fixed income, the relative shortfall from the five-year benchmark ranged between 2% and 3% a year for municipal bond funds and 1% to 5% a year for investment grade bond funds, Standard & Poor's reported.

Here's a link to the S&P report itself. Especially impressive is the way S&P corrects for survivorship bias:

The Standard & Poor's Index Versus Active (SPIVA) methodology is designed to provide an accurate and objective apples-to-apples comparison of funds' performance versus their appropriate style indices, correcting for factors that have skewed results in previous index-versus-active analyses in the industry. SPIVA scorecards show both asset-weighted and equal-weighted averages, include survivorship bias correction to account for funds that may have merged or been liquidated during the period under study, and show style consistency for each style group across different time horizons.

As we've written over and over, some active funds do outperform the averages in given periods. (By definition!) The trick is to hire those funds before they win...and fire 'em before they lose. After all, hiring them after they've gone winning streaks raises the near-inevitable problem of mean reversion. And hiring them after they've gone on losing streaks isn't especially smart either, because the data show that under-performance is substantially more persistent than out-performance.

So what's the intelligent investor left to do? Favor passive over active vehicles, and ensure that any active vehicles are different enough from their passive counterparts to have a real shot at delivering positive alpha.

Source

Sue Asci, "S&P passive funds trumped active over past five years," Investment News, April 20, 200

60 Minutes on Retirement Plans

Last night's episode of 60 Minutes led with a report on problems in the 401(k) world, most notably the fact that many millions of plan participants have seen their account values fall substantially over the last year and a half.

Reporter Steve Kroft and 60 Minutes had a chance to educate viewers on the realities of the 401(k) marketplace. Unfortunately, they settled for the too-easy television trick of (over-)dramatizing on a personal level rather than educating on a systemic level.

Kroft and his guests made a few good points. Among them:

• The vast majority of participants are novice investors. Expecting them to serve as prudent investment managers is entirely nuts.
• Participants who can't roll with short-term risk (financially or emotionally) shouldn't be exposed to it in the first place.
• Many of the setbacks of the last several months aren't 401(k) problems per se. They reflect problems with the financial system and the financial markets. The 401(k) marketplace needs work, but we can't/shouldn't blame it for everything that ails us.

All that said, however, California Congressman George Miller is exactly right when he says that the financial services industry has skimmed untold wealth from rank-and-file participants in defined-contribution plans. We're service providers ourselves, so we're not opposed to reasonable profit-making. But we are opposed to excessive profits derived from services that don't add value...and to super-cynical sales tactics that mislead sponsors and participants about where value can be added...and to anyone who concocts lame objections to maximum transparency on fees and expenses.

David Wray's halting non-answer to Kroft's repeated questions about mutual fund (and other service) providers' opposition to greater transparency was revealing in the extreme. Sometimes a guy just doesn't have any answers. This was one of those times.

We have one more objection, which goes back to our original point about 60 Minutes' failure to educate. That on-screen graphic listing various types of hidden expenses was extremely weak. What they included didn't strike us as particularly accurate, and what they excluded was hugely important. The segment should have spent two minutes or more helping people understand the hidden costs of most plans, and the factors that drive plans' hidden costs higher. Getting this right wouldn't be difficult, but it would require a greater commitment to education, and less time spent on the personal drama television seems to need. Alas.

UPDATE: One other sequence that was entirely on point, featuring Brooks Hamilton:

"The fact is that the typical 401(k) investor is a financial novice. They don't know a stock from a bond. And we give 'em a list of 20 or 30 mutual funds with really, really powerful names, you know, they sound like, 'Gee, that's where I want to have my money,'" Hamilton said.

"What are the, generally, the quality of the mutual funds in 401(k) plans?" Kroft asked.

"Mediocre," Hamilton replied. "I'm being real honest with you, with half the funds on the list really dogs, what people would characterize as dogs shouldn't be on the list to start with."

Mean Reversion in Re-Opened Funds

This morning's Wall Street Journal contains a mildly interesting piece on mutual funds that have recently re-opened after closing to new investors at some point in the last few years.

"By closing a fund to new investors," writes the Journal's Shefali Anand, "management is in effect putting shareholder benefit above its near-term profits." That's true enough, and it's worth noting.

But there's another reality on display in this story, one that's more relevant to investor decision-making: The tendency for mutual funds to outperform in one period and underperform in the next. Here's Anand:

Four years ago, the top-performing Hotchkis & Wiley Large Cap Value fund shut its doors to new investors. The mutual fund had beaten at least 97% of its peers for three consecutive years through 2004.

Then last year, the fund collapsed, falling behind 95% of its peers. Its assets fell to a fourth of the fund's peak. Now, it's once again welcoming new investors.

...

Consistent management by itself is no guarantee. Consider Hotchkis & Wiley Large Cap Value, which closed in July 2005 and went into decline soon thereafter. One of the managers, Sheldon Lieberman, has been with the fund since 1997. Yet every calendar year since 2006, it has returned less than the Standard & Poor's 500-stock index and has been among the worst performers in its large-cap value category.

In 2008, it fell 47%, due to large stakes in financial stocks such as Freddie Mac and Washington Mutual Inc. The fund's 10-year return through Feb. 28 was an annualized negative 1.7%, lower than the category average. The fund's managers declined to comment.

This is just good old-fashioned mean-reversion, and it's one of the more reassuring regularities of our world.

The point here isn't about the opening and closing of funds. It's about the very bad practice of chasing performance, which often characterizes the "service" provided to individual investors and retirement plans by our industry's army of salespeople. It's a loser's game, one we'll decline to play as long as we're in the business.

Source

Shefali Anand, "Exclusive Funds Are Clamoring For Your Money," Wall Street Journal, March 31, 2009