Choosing the “Best” Investments in your 401(k)
This is a question we are continuously asked, “how do I choose the best funds”.
Starting a new job, changing jobs, and/or getting a raise, are all great life events. These events also cause clients to take the time to log into their 401(k) and make some adjustments.
Hey! We heard you’re switching jobs, congratulations! When the dust settles, and you are ready to enroll in your new retirement plan, forward over the fund lineup and let’s plan to get together.
Which fund is the best?
The problem with choosing the “best” is that it is completely subjective.
Different investors have completely different investment objectives and their 401(k) generally makes up a relatively small piece of their investment portfolio. Also, consider that the average investment lineup in a retirement plan gives you 21 investment options. For comparison, there are over 600,000 companies that are publicly traded throughout the world.
There are of course reasons to think 401k administrators chose the best fund and reason for such a limited menu of investment options. For starters, it would be extremely expensive to have every investment choice be available in your 401(k). It would also put any investor in a paralysis by analysis situation and they’d never be able to pick from so many choices.
So, all this being said, how are the lineups selected?
For all of our corporate retirement plans, we use a 12 part evaluation criteria to narrow down a variety of best-in-class investment options to choose from:
Evaluation Criteria
Style Consistency (STYLE) <= 29
R-squared (5 YR R-SQ FIT) >= 80%
1-year annualized return vs. peers (1 YR PEER) > Median
3-year annualized return vs. peers (3 YR PEER) > Median
5-year annualized return vs. peers (5 YR PEER) > Median
5-year Up/Down Capture (UP/DN) Up > Down
5-year Information Ratio (5 YR INFO) > 0
3-year Information Ratio (3 YR INFO) > 0
5-year Beta (5 YR BETA) between 0.75-1.15
3-year Beta (3 YR BETA) between 0.75-1.15
Longest Tenured Manager (MGR TENURE) >=5yrs or >=Avg
Net Expense Ratio vs. peers (NET EXP) <= Morningstar Category Average
Minimum Score to meet criteria = 7 of 12
This is just a lot of investment lingo that gives us the ability to filter through all the investment options available to try and give participants the “best” options to choose.
Here’s what they always mean when they say “best”
Look at the 3 and 5 year past performance and choose the highest numbers!
This is what we call chasing returns. Linda Abu Mushrefova, CFA, wrote a great article in Morningstar titled “Buy the Unloved: 2021 Funds Edition” 1
Let’s look at the data she gathered:
The “Three-and-out” Phenomenon
In a 2015 research paper, “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies,” Jason Hsu, Brett W. Myers, and Ryan Whitby found that the average mutual fund investor earns 2% less than the mutual funds in which they invest.
Here is a great example of behavioral finance at work: it is not an easy task to be shown a list of 21 mutual funds and be expected to choose “the best”. The same way if a patient came in with chest pain and someone asked you to identify the best treatment plan. What if that patient didn’t accept your guidance when you updated the treatment plan based on additional health information? You certainly wouldn’t just blindly pick the same plan that you used for the last 3 or 5 patients.
So, what do you do?
The client who sends us their list of investment options will hear back within a week about which investment makes the most sense for them (at that given time). This depends largely on their risk tolerance, time horizon, other investments, and the investment choices available.
We want to make sure their entire financial plan is working in tandem. The same way you wouldn't want a pharmacist just slinging pills across a counter at your patient, we don’t want an internal benefits person or someone who works for the 401(k) company advising without knowing the entire picture.
https://www.morningstar.com/articles/1019863/buy-the-unloved-2021-funds-edition.