Index Funds Are Indisputably Prudent 401(k) Investments - How to Pick a Lineup

Inappropriate investment selection is one of the top three reasons why 401(k) fiduciaries are sued today. In my experience, employers can easily avoid these lawsuits by having a clear understanding of their investment-related 401(k) fiduciary responsibilities. These responsibilities are surprisingly basic. They boil down to selecting enough “prudent” investments to permit any plan participant to sufficiently diversify their account – to minimize their risk of unrecoverable losses. A prudent investment is simply one that meets its investment objective for reasonable fees. I’ve never seen a leading index fund from providers such as Vanguard, Fidelity, or Schwab fail to fit this bill. For that reason, I consider these funds to be indisputably prudent 401(k) investments.

My use of the word indisputably may seem overstated, but I don’t see a way around this conclusion for two reasons. One, good luck finding a leading index fund that doesn’t match the returns of its market benchmark – the primary investment objective of all index funds. I’m not aware of one. Second, because index funds that track the same market benchmark (e.g., the S&P 500 index) offer similar returns, their key differentiator is price. As such, leading index funds just keep getting cheaper and cheaper to gain a competitive edge. 

However, if you’re a business owner, you can’t just randomly choose leading index funds for your 401(k) plan to avoid fiduciary liability for inappropriate investment selection. You need a prudent process for selecting and monitoring these funds. This process can be completed in 3 steps.

Step 1 - Establish an investment policy

It’s a fiduciary best practice to have an investment policy for your 401(k) plan. While a formal written Investment Policy Statement (IPS) for 401(k) plans with actively-managed funds is recommended – because this documentation can help defend the selection of funds that underperform their respective market benchmark, net of fees, over time – I think a formal IPS may be overkill for 401(k) plans trying to earn market returns at a low cost with passively-managed index funds. Instead, I think a simple investment policy (written or not) with just 3 basic objectives will suffice:

1. Diversification – Plan investments must provide participants with different, internally diversified alternatives with materially different risk and return characteristics.
2. Market returns – Plan investments must offer returns that closely correlate to a target benchmark over time.
3. Efficiency – Plan investments must possess low expenses to reduce drag on participant returns.

Step 2 - Select funds that meet your policy

To meet each objective of your index fund investment policy, you should select funds that meet the following requirements:

Diversification

To meet this objective, I recommend you select index funds that meet the “Broad range of investment alternatives” requirement of ERISA section 404(c). Believe it or not, this requirement can be met by offering as few as three fund options that cover equity (stocks), fixed income (bonds), and capital preservation asset classes. Index funds that track a broad market are internally diversified.

Market Returns

To meet this objective, you want to select index funds that deliver market-correlated returns. To determine whether a fund meets this criteria, look at its Beta and R-Squared results – to ensure they are within reasonable tolerances. For leading index funds, these statistics are easy to find online. I recommend you select index funds with a beta between 0.90-1.10 and an R-squared between 0.90-1.00.

Efficiency 

To meet this objective, I recommend you select index funds that rank in the lowest quintile (20th percentile) of their peer group.

Step 3 – Ongoing monitoring

Once you’ve selected index funds for your 401(k) plan, you should “monitor” them regularly - to ensure they continue to meet your investment policy’s objectives. I recommend you do so no less than annually.

Below is a sample monitoring report for an index fund lineup that meets the three investment policy objectives for the quarter ending December 31, 2019:

(1) Risk measures are calculated from trailing 36-month fund returns relative to the associated benchmarks.

(2) This is a proprietary Morningstar data point. Morningstar evaluates a mutual fund share class's expense ratio relative to other funds that invest in a similar asset class and have similar distribution characteristics. Within each Comparison Group, a fund share class' expense ratio is ranked against peers using five quintiles. A "Low" rating means fund's expense ratio ranks in the lowest quintile (20th percentile).

Index funds often offer superior returns too!

Investment in index funds – and other passively-managed investments designed to track a market index – is exploding. According to Bloomberg, passive funds saw inflows of $88.9 billion while active funds saw outflows of $124.1 billion from January to August 2019.  The reason – when compared to their actively-managed counterparts, index funds that track the broad stock market indices are more likely to offer superior returns over time, net of fees charged.  Need proof?  Check out the latest SPIVA Scorecard from S&P Dow Jones Indices.

That’s not to say it’s impossible to find actively-managed funds that outperform their market benchmark – the odds just are not in your favor.  If you want to try, I strongly recommend you hire a fiduciary-grade financial advisor for unbiased (conflict-free) professional advice.

In short, I think leading index funds can be a win-win for you and your 401(k) participants. They don't just make it easy for you to avoid fiduciary liability - they also make it easy for you and other plan participants to earn enviable investment returns over the long-term.