Plenty of data shows that passive management has largely outperformed its net-fee active counterpart for over a decade. This helped induce a massive transfer of assets from active funds to exchange-traded funds (ETFs) and other passive alternatives, and sparked considerable debate about the future of active management and what role it should play in investment portfolios. How, for example, should sponsors of defined contribution (DC) plans approach the issue?
A recent monograph from the CFA Institute Research Foundation explored that question, among many others important to DC plan sponsors. Media coverage of the book focused on the role of actively managed funds in aligning a DC plan’s potential investment and elicited responses from some influential investment industry voices. The authors of the monograph then address the criticisms..
Our recent post, Defined Contribution Plans: Challenges and Opportunities for Plan Sponsors, has generated considerable debate about a small segment of a very broad-based policy book. Some critics have misinterpreted our discussion of including actively managed investment options in defined contribution (DC) plan lineups. Much of this controversy was caused by an industry news article that incorrectly stated that we believed DC backers could be sued for hiring active managers.
We didn’t say anything like that.
Let’s be clear: we are skeptical of active management. It is difficult to recruit and retain active value-added managers, even when sponsoring investment committees are guided by professional assistance. Some plan sponsors have considered the issue and have chosen to offer only a set of passively managed investment options. On the other hand, many sponsors have included actively managed investment options and have suffered no legal consequences for those decisions.
We do not believe that sponsors who carry out adequate due diligence and choose to offer active investment strategies in their investment lines will expose themselves to legal risk. We argue that sponsors should do no harm in their selection of investment options. By that we mean that sponsors should carefully weigh the costs (fees, additional investment risks, participant communications, and investment committee time) associated with active manager selection and, through their documented considerations, convince themselves that the benefits outweigh the costs. That would seem obvious as a goal for choosing any investment option.
However, we want to emphasize that this statement is a policy guide, not a legal standard. What we proposed to sponsors is that they start with passive management as the basis for selecting investment options. Active management is based on deviations from a passive reference point. If active managers cannot add value, then the preferred position is passive, not the other way around.
That hardly seems controversial. We believe that many sponsors will and should reach this position. However, if a sponsor can convince itself through extensive research that the additional fees and additional active management risk of an actively managed strategy better serve the purposes of a segment of its plan participants, then the sponsor is justified in hiring the manager. There is no serious legal risk involved.
Different backers will reach different conclusions about the value of active management in different asset categories and investment strategies. That’s why the active versus passive debate has been going on for 50 years, and it’s not going away anytime soon.
We urge interested professionals to read our entire book. It is full of interesting observations and recommendations on the full range of responsibilities of DC plan sponsors. We expect readers to agree with us on some issues and (perhaps strongly) disagree on others. That is the nature of research and informed debate.
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All messages are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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