Defined contribution plan executives are adding more passively managed equity investment options to their plans' lineups, moving beyond domestic large-capitalization equity index funds such as those that mirror the Standard & Poor's 500 stock index.
The motivation: Give participants greater choice and lower fees.
Among theadditions are domestic small-cap and midcap equity, along with international equity, according to interviews with consultants and results of recent consultant surveys.
“We think there's room for both active and passive,” said Winfield Evens, a partner at Aon Hewitt, Lincolnshire, Ill. “If sponsors say all passive is the way to go, then they will open a new asset class like small-cap equity or emerging markets equity. Likewise, if sponsors like an active approach, they will choose actively managed funds.”
Aon Hewitt's survey of clients and non-clients, conducted every other year, shows that large-cap domestic equity is the dominant passive equity strategy. Among plans offering such strategies, 95% were passively managed, the same as two years earlier.
Meanwhile, passively managed midcap equity options are becoming more popular, according to Aon Hewitt. Last year, 59% of DC plans with midcap equity strategies were passive, up from 42% in 2011 and 25% in 2007.
Among plans with an international equity option, 50% offered an indexed version last year vs. 31% in 2011 and only 16% in 2007.
“There's a heightened awareness that there are more variations in these categories for index investing,” Mr. Evens said. “It could be an index based on developed international equity and emerging markets or an emphasis on developed markets.”
For plans offering an emerging markets option, Aon Hewitt said 21% did so via an index fund last year, up from 12% in 20011.
Among clients of Callan Associates Inc., plan executives cite providing lower-fee choices to participants as the primary reason for offering indexed equity funds, said Lori Lucas, executive vice president and defined contribution practice leader based in Chicago.
Callan surveys of clients and non-clients conducted quarterly found 39.1% of all active large-cap domestic equity assets were in index funds by the third quarter of 2013, up from 30.1% in the first quarter of 2006, when Callan began the survey.
Callan also found:
- Among plans offering small- and midcap funds, 19.2% of assets were invested in passively managed funds in the third quarter of 2013 vs. 8.2% in the first quarter of 2006.
- Among plans offering developed market international funds, 16.3% of assets were invested in passively managed funds in the third quarter vs. 1.6% in the first quarter of 2006; and.
- Indexed target-date assets accounted for 18.2% of all target-date assets in the third quarter vs. zero in the first quarter of 2006.
Ms. Lucas said one reason plans are adding equity index funds is their use of an “active/passive mirror” strategy — offering active and passive management for the same asset class.
Another set of surveys by Callan, these conducted annually, show 21% of plans offered active/passive mirrors last year vs. 11.6% in 2012 and 8.9% in 2011. The annual surveys cover Callan clients and non-clients, and most have 401(k) plans.
But the percentage of plans with all-passive or all-active investment lineups remained very small, with 2.5% for all-passive and 1.2% for the all-active in 2013, said Ms. Lucas, though the survey doesn't distinguish among different strategies. Although the mirror approach adds choices, Ms. Lucas and other consultants question whether this approach could lead to confusion among participants.
Russell Investments detected an increased interest among some investment committees in evaluating mirror strategies for large-cap, small-cap, midcap and international equities, said Rod Bare, a Chicago-based defined contribution consultant for the firm. Offering low-cost options for do-it-yourself investors is the most commonly stated reason for this approach, he said.
“The rationale for adding passive options is not typically based on the notion that alpha opportunity is disappearing in other asset classes beyond large cap,” Mr. Bare said. “When these passive mirror options are added to a menu, they receive little usage and result in participants having to make additional choices relative to active and passive management.”
Too many choices can provoke two unwanted results. “We worry about naïve allocation errors,” said Mr. Bare, referring to participants receiving many choices and spreading out allocations among them. He also worries about participants becoming overwhelmed by too many choices.
Russell Investments advocates a multimanager approach combining active and passive management, Mr. Bare added, with index funds representing a small component that serves as a source of liquidity and benchmark-matching returns while plans rebalance their portfolios.
Clients of Towers Watson & Co. are increasing their offerings of index-based target-date funds and index equity funds, said Sue Walton, who works in Chicago.
“They see it as an opportunity (for) lower fees and to reduce volatility associated with active management,” she said.
A majority of Towers Watson's DC clients use a combination of active and passive. “We think there are opportunities across the board to have active management,” but success depends on the quality of managers and their strategies, she said.
Acknowledging that more DC plans are using more versions of passively managed equity options, Ms. Walton added that “it's fair to say there's been an evolution of index options available in the marketplace.”
More interest in passive investing appears likely. In the latest annual Callan survey published in January, 24.1% of plan executives said they would increase the proportion of passive equity and fixed-income options this year. n
