While that part of fiduciaries’ obligations is indisputable, a small body of academic research on what happens when an investment option is removed in favor of another has shown that the new funds fail to outperform, and sometimes underperform, the removed funds.
One paper, published in the Journal of Finance in 2016, found no evidence that consultants’ recommendations to replace investments resulted in added value to plan sponsors and investors in retirement plans.
Or in other words, action taken from the legal obligation to monitor fund lineups did not result in better savings outcomes.
But new research from Morningstar is pushing back on the idea that investment menus are best served with a set-it-and-forget-it design.
Like previous research, Morningstar found that the decision to replace a fund is largely based on comparisons of five-year historical performance.
But unlike previous research, Morningstar found that replacement funds go on to outperform the replaced funds over the ensuing one and three-year time periods after the switch.
Plan monitoring not a futile exercise
“We think the breadth of our analysis is unmatched compared to the other research,” said Jim Licato, vice president, product management for Morningstar Investment Management, which houses the firm’s advisory services unit.
Licato, David Blanchett, head of retirement research at Morningstar, and Michael Finke, a CFA with the American College of Financial Services, tapped Morningstar’s managed account platform to analyze nearly 3,500 fund replacements in 678 defined contribution plans over an eight-year period beginning in 2010.
Prior research was based on significantly smaller data sets; one 2007 study that found no performance improvement in replacement funds was based on a sample of 45 deleted investment options.
Morningstar’s analysis compared funds within the same investment style of three investment categories: equity, bond, and allocation funds that blend both.
Not surprisingly, the replacement funds tended to have lower expense ratios than the replaced funds, better historical returns, and overall higher ratings from Morningstar.
That much was expected, Licato told BenefitsPRO. But the subsequent outperformance of the replacement funds over one to three-year periods came as a notable surprise that supports the value in monitoring plan investments, he said.
“Plan sponsors, whether they use an outside fiduciary advisor or rely on internal investment committees, are being diligent in their monitoring,” said Licato of the new research. “You need to stay on top of your menu design, and make changes when necessary.”
Replacement equity funds had the highest rate of outperformance, but each of the three broad asset classes Morningstar reviewed outperformed the replaced funds. For all three fund groups, the median outperformance was 22 basis points after one year, 26 basis points after two years, and 52 basis points after three years.
What explains the outperformance?
Morningstar’s analysis establishes a correlation between replacement funds’ historical performance and their ability to outperform going forward, and underscores how lower-fee funds can contribute to better performance.
But the full explanation of why replacement funds do better going forward remains “elusive,” according to the report. Licato said Morningstar intends to conduct further analysis on more complete data.
Nevertheless, the research underscores the value of plan monitoring, and perhaps even the value third-party fiduciary advisors can bring to plans.
“If you don’t have strong monitoring, that opens up potential problems,” said Licato. “If you simply set it and forget it, you’re doing a disservice for the investor.”
Morningstar offers 3(21) and 3(38) fiduciary advisory services to 401(k) plan sponsors, along with its managed account platform, which touts a capability to design personalized investment strategies within a plan sponsor’s core investment offering.
Though still in its nascent stage, Licato thinks Morningstar’s new research proves the value of plan monitoring, irrespective of the firm’s business interest in facilitating plan sponsors’ legal obligations.
“Whether you are working with Morningstar, another fiduciary advisor, or your own investment committee, a sponsor needs people staying on top of their investment lineup,” he said.
While historical performance can and often does translate to improved future performance, other investment features, like management tenure and turnover, and style drift, need equal consideration.
And monitoring a plan can always prove a menu’s design is right where it needs to be.
“It all comes down to the funds being offered,” said Licato. “If a plan is working with representation from well-established asset managers, and there aren’t any red flags, then there’s not necessarily a need to replace funds.”