A passive portfolio management approach is appropriate for many 401(k) plan participants. But indexing isn’t right for everyone. Many 401(k) plan investors are not satisfied with market average returns. Nor do they feel it makes sense to lock-in 100% of every market decline. Many 401(k) plan participants believe they can consistently outperform market averages by applying a little of the right knowledge. Think there is no point to active management? Consider the following to make active management work in your 401(k) plan account:
Eliminate closet indexers
Purge them from your 401(k) account. They never significantly beat their benchmarks and give active management a bad name. This is where excess cost resides in your 401(k). How do you identify a closet index fund? Generally, the higher a mutual fund’s correlation to its index, or R-squared, the more likely it is a closet indexer. Perfect correlation is defined at 100% or 1.0. Look to invest in actively managed funds that have correlations less than 90%.
Index efficient asset classes
Invest in index funds in those asset classes that are efficient — where it is hard for a mutual fund manager to significantly and consistently beat the benchmark. A nice listing of efficient and inefficient asset classes may be found here.
Active management for inefficient asset classes
Inefficient asset classes are those in which a skillful fund manager can generate positive alpha (excess returns above the benchmark) by identifying some criteria that the market is not efficiently pricing into the asset class or stock. Examples of these asset classes, where the returns of mutual fund managers can vary significantly, include small and mid-cap U.S. equities. Check this link to identify those asset classes which tend to be inefficient.
Defense is good
Consider that some active managers are really good defenders of your investment. They may not outperform significantly in up markets but may fall much less than market indexes in down markets. Choose to invest in actively managed mutual funds that have down market capture rates less than 100%.
Full market cycle
A major reason many investors abandon active management is they feel every actively managed fund should beat its benchmark every quarter. This is unrealistic. Review the performance of all your 401(k) mutual funds over a full market cycle, which generally lasts four to five years. How? Obtain the tickers for the funds you are interested in and input them into the Morningstar website to find out all of the information outlined above, and much more.
Use active management to allocate
Most investor’s portfolios will benefit from a blend of active and passive management. Talk with the investment adviser that works with your 401(k) plan. He/she can help you measure your risk tolerance so that you can allocate correctly between fixed income securities and equities. Use your risk tolerance level (aggressive, moderate, conservative) along with your age to generate appropriate allocations in your 401(k) account.
It is unlikely that the next five years in the equity markets will be anything similar to the last five, bull market years. The risk-on, risk-off market conditions we experienced for a number of years immediately after the crash favored an indexed approach. When all risk assets are highly correlated it is hard for active managers to distinguish themselves. Remember when investing we are always fighting the last war — looking back at what has done well, rather than what might work in the future. Will market conditions be as favorable to indexing in the near future? Probably not.