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Defined Contribution

Morningstar: ‘Significant evidence’ that replacement mutual funds outperform originals

When defined contribution plans replace investment choices in their lineups, there's "significant evidence" that the replacement mutual funds outperform the original funds over future one-year and three-year periods, according to research released Monday by Morningstar.

"Making decisions to replace funds has been incredibly beneficial to participants," David Blanchett, head of retirement research, Morningstar Investment Management, said in an interview. "There's strong evidence that suggests replacement funds create value for participants."

Mr. Blanchett cautioned that Morningstar's research doesn't predict when investment choices turn sour how fast sponsors should act to replace them, or what indicators are used to distinguish between a temporary blip in performance or an inexorable downward decline.

Instead, Mr. Blanchett emphasized, Morningstar's research demonstrates that sponsors must constantly monitor the investment lineups. Quarterly monitoring for larger plans and semiannual monitoring for smaller plans makes sense, he said.

The research results "reinforce common sense due diligence," Mr. Blanchett said. "You need to have a process in place and stick to it."

The Morningstar research looked at 3,478 mutual fund replacements among 678 defined contribution plans that were served by three record keepers from January 2010 through November 2018. He declined to name the record keepers or the DC plans.

The research found improvements in each of four types of mutual funds – equity, bond, asset allocation and the combination of all funds – with equity funds showing the biggest gains after replacement.

"We restricted our study to only look at instances where both funds – the replacement and replaced – were in the same Morningstar category—a system where funds are grouped together based on how they actually invest their money," said a report describing the survey results. "This helps to ensure we were comparing apples to apples when it came to performance of each fund after the replacement."

Replacement funds offered more "attractive" attributes, such as better historical performance, lower expense ratios and more-favorable Morningstar ratings, the report said.

However, Mr. Blanchett said more research is necessary to assess the process of how DC plans decide when and why to change investment options and what are the "primary drivers" of outperforming funds.

Until then, Mr. Blanchett referred to the "best practices" recommendations in the Morningstar research report, which include tailoring investment lineups to an employer's demographics; compiling information on participants' salary, education level and financial literacy; diversifying the types of investments; and simplifying investment menus.