Active or passive investing—choosing the right one for your retirement plan

As you’re constructing a retirement plan investment menu, you need to decide whether to include passive or active investment funds—or both. Here’s a brief look at both types of funds, as well as some of the factors to consider when deciding which ones are right for your plan and participants.

Offering appropriate investments is a 401(k) fiduciary duty

According to the Employee Retirement Income Security Act of 1974 (ERISA), selecting and monitoring retirement plan investments is one of the fiduciary plan duties you must perform with care and prudence.

ERISA clearly requires that plans offer a diverse investment lineup, but you also need to make thoughtful investment choices.

Compliance with ERISA may be your driving force or you may believe that setting up participants for success is the most powerful incentive for offering appropriate investments. Either way, one decision you’ll need to make is whether to include passively managed funds, actively managed funds, or both in your investment lineup.

What’s the difference between passive and active fund management? 

It all comes down to the amount of involvement the fund managers have in establishing and executing the fund strategy. To be fair, both types of funds call for diligent management and, presumably, plenty of action on the investment teams’ part. Here are a few basics you should know about each type of investment. 

About passively managed funds

Also known as passive funds or index funds, these vehicles allow plan participants and other customers to invest in a broad sector of the stock or bond market. In effect, the fund’s manager duplicates the makeup of a benchmark index, such as the Standard & Poor’s 500 Index or the NASDAQ Composite Index, by choosing the actual securities that are in that index and aiming to match its returns on an ongoing basis.

In fact, that’s where the term “passive” comes from—the manager simply seeks to track and match what’s going on with the index, rather than making active day-to-day decisions about selecting, buying, and selling stocks and bonds.    

The fees that investment firms charge on passive fund management can be considerably lower than those for active fund management. For this and other reasons, passive funds can be a good fit for investors who want to ride with the momentum of larger market sectors for longer periods.

While passive investments can help simplify and, potentially, limit the cost of retirement investing, like all investments, they have risks of their own. If an underlying index falls or a company that’s included in the index falters, then a participant feels the impact directly. 

About actively managed funds

Actively managed funds are run by managers who buy and sell stocks and bonds based on their fund’s strategy, performance expectations, and changes in economic and market conditions. In other words, they have the latitude to make choices.

The idea with actively managed funds is to seek to deliver additional value and exceed the returns of their stated benchmark. To pursue this goal, some active managers take a quantitative analysis approach, which means attempting to predict investment performance and making decisions based on data. Other managers lean more heavily on fundamental analysis, or the specifics of individual stocks and bonds, as well as the companies that issue them. Many active fund managers use both quantitative and fundamental analysis to run their funds.

The fees charged on actively managed funds can be higher than those on passive funds, due partly to the fact that actively managed funds call for more research and have more overhead to cover. Actively managed funds may also take on additional risk with the goal of beating their stated benchmark. 

Deciding between passive and active fund investments for your plan

While it could be argued that passive investments may be better for more cautious investors and active investments are best for those willing to take more risk, choosing investments for your plan calls for careful consideration.

To begin with, your lineup needs to offer participants a broad range of investment alternatives—so you need to pick your plan investments purposefully. While passive versus active investment decisions may be important, they’re secondary to offering an appropriate mix of stock, bond, short-term, and asset allocation investments.

Although past performance isn't a guarantee of future results, track records are crucial in selecting both passive and active investments. Although several funds may track the same index, there can be slight variations in their returns, especially after expenses. On the flip side, historical returns and fund manager tenure are especially important for active investments.

Not only is comparing track records necessary to fulfilling your fiduciary obligations, it’s the number one factor that plan participants and other mutual fund investors of all types use to inform their investment decisions.

How mutual fund owners evaluate their investment opportunities

Percentage of mutual-fund-owning households, 2019

Source: “ICI Research Perspective: What US Households Consider When They Select Mutual Funds,” Investment Company Institute, April 2020.

Target-date funds (TDFs) and managed accounts—both retirement plan staples—can offer a layer of active investment provided by the fund or portfolio manager. It’s also helpful and compelling to look inside the portfolio models to see if they call for passive investments, active investments, or a mix.

Finally, given recent history, it’s worth mentioning that active investment managers are free to take defensive measures with their investors’ assets during volatile times. This includes shifting to cash or other less volatile holdings—an option not available with passive funds.

So, is it active or passive investing—or both—for your participants?

In reality, the passive versus active debate may not be an argument at all.

Passively managed funds provide the ability to invest in large sectors of the market at a lower cost. Actively managed funds can provide strategic growth opportunities not available with passive funds. While there's no guarantee that any investment strategy will achieve its objectives, the bottom line for any retirement plan saver is risk-adjusted return: Will their portfolio generate enough money over time to help them achieve retirement readiness?

Knowing your participants’ needs and preferences will point the way to sound investment choices, whether that means passive or active investment management, or a combination of the two. Whichever you choose, as with all your ERISA duties, be sure to document the reasons for your decisions. And backing your choices with high-quality education and guidance will give your participants the best shot at success. 

For complete information about a particular investment option, please read the fund prospectus. You should carefully consider the objectives, risks, charges and expenses before investing. The prospectus contains this and other important information about the investment option and investment company.  Please read the prospectus carefully before you invest or send money. Prospectus may only be available in English.

There is no guarantee that any investment strategy will achieve its objectives.

It is not possible to invest directly in an index. The performance of an index is not an exact representation of any particular investment. Like all mutual funds, index funds are subject to market risks and will fluctuate in value. Index funds are designed to track the performance of their target index, but may underperform due to fees, expenses, or tracking errors. These investments are not actively managed and do not necessarily attempt to manage volatility or protect against losses in declining markets.

The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.

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