How I evaluate your 401(k)s fund line-up
As part of my role with Smart401k, I help small business owners evaluate and look for ways to improve the quality of their retirement plan. I try to ensure that they are fulfilling their fiduciary responsibility and meeting the requirements of their Investment Policy Statement. In the future I will cover several topics in this area. Today, I am going to focus on how I help employers build and/or improve their fund lineup.
When I evaluate a fund lineup there are several things that I like to look at, including:
- Does the plan provide options in all of the major asset classes?
- How high is the quality of the funds in the plan?
- Are the fund management fees too high relative to other funds in their peer group?
Asset Classes
The first check I do is to see whether a plan covers all major asset classes. These include Domestic Large Cap, Domestic Mid Cap, Domestic Small Cap, a Foreign Fund, at least one Bond Fund, and a Cash Equivalent Fund such as a Money Market or Stable Value Fund. A plan should cover all of the above at a minimum.
Preferably, I would like to see a company expand on these classes and include both a Value and Growth oriented fund for each stock focused asset class. In addition, I would consider including a Balanced, Risk Based or Target Date Fund option for those participants that want one fund that will give them both stock and bond exposure.
In an ideal situation, where an employer has the ability and desire, I like to expand on the options within the fixed income area by adding a Government, High Yield or a Multi-sector bond fund if one does not already exist.
Quality of funds
The quality of a fund is not based solely on returns. You must also consider factors such as manager tenure, risk adjusted performance and how diversified the fund is.
Relative performance - Refers to the how a fund performs relative to its peer group. During my analysis, I look at both year by year performance of the fund as well as annualized average performance. I like to look at the year over year performance to gauge the effectiveness or consistency of a manager. In other words I want to see if he or she consistently performs in the top half of their peer group or if they had one good year that is skewing their average annual return.
Manager tenure – I check to see how long a manager has been with not only the fund in question but also with his or her employer. I tend to put more weight in the returns of the fund if a manager has been with the fund for the entire period of time I am considering. The manager’s tenure at a particular employer helps me gauge the culture of the fund company. If a fund changes managers on a frequent basis there could be a problem with the culture of the firm. If that is the case then there is a chance we will see another manager change in the near future which will make it harder to analyze the fund’s returns.
Risk adjusted performance – The two main risk or technical ratios that I look at are the fund’s Sharpe Ratio and it’s Alpha. Sharpe Ratio measures risk adjusted performance by indicating whether the fund’s performance is due to a manager’s investment decisions or due to excess risk. Alpha compares the volatility of a fund and its risk adjusted performance relative to a benchmark index.
Diversification – The diversity of the portfolio can affect the volatility of a portfolio. If a fund is not properly diversified or holds a focused portfolio then the fund can have significant performance fluctuations.
Fees
The expense ratio of a fund is a measure of the costs associated with operating a mutual fund. The expense ratio is determined through an annual calculation, where a fund’s operating expenses are divided by the average dollar value of its assets under management. Operating expenses are taken out of a fund’s assets and lower the return to a fund’s investors. Similar to performance, I compare the expense ratio of a fund relative to its peer group. When comparing the expense ratio of fund relative to its peer group, you can use either the gross expense ratio or the net expense ratio. The gross expense ratio is the fund’s total operating expenses. I prefer to use the net expense ratio which is the actual expenses paid by mutual fund investors. It is found by taking the total expenses and subtracting any reimbursements made back to the fund from the management or fund company.
If you are a business owner or company decision maker and you would like me to evaluate your fund lineup, please feel free to contact me directly at 913.744.3376 or by email at bwendel@smart401k.com. If you are not a business owner but know of someone that this article may be helpful to, please click on the share button just below this article and use the email option to forward it.
Buck Wendel, Investment Advisor
