Close Close

Portfolio > Investment VIPs

Passive Funds Come With Own Fiduciary Risks

Your article was successfully shared with the contacts you provided.

Plan sponsors that rely on passively managed investment options as a hedge against fiduciary liability may be operating under false premises, according to analysts at Russell Investments.

In the wake of a decade’s worth of 401(k) class-action litigation, fee-conscious sponsors have outfitted investment lineups with passively managed mutual funds and target-date funds.

While awareness of fees is a welcomed development, the misperception that passive investments eliminate fiduciary obligations is dangerous, write Kevin Knowles, an analyst on Russell’s defined contribution team, and Josh Cohen, head of the institutional defined contribution team at Russell.

“If you decide to implement passively managed investments in your DC plan, your job as a fiduciary is not over,” write Knowles and Cohen.

“Every decision you and your hired managers make is an active decision that has implications and requires prudent review, even if implemented through passive investment vehicles,” they say.

In fact, some monitoring requirements are unique to passively managed investments.

Passive index funds are built on data from index providers—Russell is one, the Standards and Poor and Dow Jones indices are others.

Sponsors must consider the provider of that data when vetting funds, say the analysts.

Sponsors should also be aware that sometimes index fund managers will change their index provider, as Vanguard did in 2013 for several of its indexed equity funds.

Such changes could affect fees, the construction of funds and their ultimate performance.

Also, contrary to what the analysts imply is a common misperception, passive investments do have an underlying investment methodology that sponsors need to vet, just as they would the methodology of active investments.

They cite the example of in the difference between the Russell 1000 and the S&P 500 large cap equity indices. The Russell 1000 includes the largest 1,000 companies by market capitalization, while the S&P 500 selects that many securities from about 950 of the largest cap securities. That has meant different performance outcomes, say Knowles and Cohen.

Fixed income indices also have different methods of tracking investments, differences that have the potential to leave participants unguarded as interest rates rise, they say.

Passive fund managers also charge different fees, even for funds that track the same index.

“Are you paying the least you can pay, given your asset size? Are you in the cheapest share class you can get? Have you looked at collective trust funds?” ask the analysts.

They site the Supreme Court’s unanimous decision in Tibble v. Edison, which ruled against plan sponsor Edison for including more costly retail shares of investments when cheaper institutional shares were available.

Moreover, passive isn’t always better, say Knowles and Cohen.

“Going passive is an active decision,” they say. “While passive management is a good starting point, a prudent plan sponsor should consider active management as well, to ensure that the most appropriate management technique is selected.”

— Check out DOL Fiduciary Rule Could Complicate Rollovers for RIAs on ThinkAdvisor.