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3 Reasons Why the 401k Fiduciary Should Use Both Active and Passive Funds to Reduce Fiduciary Liability

October 28
09:30 2009

Much to the delight of the befuddled 401k fiduciary, the active investing vs. passive investing argument has become passé. Despite many purists still lauding one style over the other, (Managed Funds Offer Little Cover From the Bear, Wall Street Journal WSJ.com, April 5, 2009; Active Versus Passive Debate Rages OnInvestment News, July 2, 2009; Passive Investment May Beat Active Growth Management, But Value Beats Them Both, The Globe and Mail globefund.com, September 22, 2009), it appears the debate may have settled into a détente. In terms of reducing fiduciary liability, this uneasy harmony can offer an excellent guide to 401k fiduciaries for three important reasons:

  1. With all the studies, it’s clear any researcher can find data to support a hypothesis favors either active investing or passive investing. Perhaps we can attribute this to the “Snapshot-in-Time” anomaly first identified in a 2005 study. This common sense discovery simply states the ending date of the period chosen in any comparative of investment performance can overweight near term results. Known as “recency” in behavioral psychology, this phenomenon may also be responsible for the seemingly conflicting results pertaining to active and passive research.
  2. The “Snapshot-in-Time” effect that can create misleading studies might be a clue to both possibly increasing as well as avoiding fiduciary liability. If the superiority of passive or active depends on the time period chosen, this implies (as the evidence bears out) some periods exist when passive outperforms active while other periods exist when active outperforms passive. A 401k fiduciary who chooses only active or only passive options in the plan may assume an addition liability risk. On the other hand, fiduciaries who provide both active and passive options may delegate that risk to the plan’s participants.
  3. After all, picking an investment style should be the employee’s responsibility, not the plan sponsor’s. In the end, the best we can say about the active vs. passive debate is that it reflects differing investment styles, not any exclusive truth. So, in matters of faith, fiduciaries can best serve themselves by remaining agnostic and allowing participants the freedom to choose.

In the generation prior to the dominance of mutual funds as the preferred investment vehicle (i.e., when most folks invested directly in individual company stocks), sophisticated investors debated the merits of “growth” or “value” arguments. While remnants of that dispute persist (see The Globe and Mail article above), today most professionals understand it’s no longer a question of growth OR value, but of growth AND value. We now accept the likelihood diverse portfolios can, and maybe should, have both types of stocks. Perhaps we may be nearing a new consensus where it’s no longer active VERSUS passive, it’s active WITH passive. Most telling, according to the aforementioned Wall Street Journal article, even “Vanguard, a big seller and proponent of index funds, nonetheless sees a place for active funds, which the firm also offers.”

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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