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Guest Article

Index Funds: The Ridiculously Simple Solution To Finding Low-Cost Top Performing 401(k) Investments


Jane White, President
Retirement Solutions Foundation
225 Main St. #158
Madison, NJ 07940
973-769-7509

Are you ready for the latest mutual fund scandal? Federal and state investigators have begun to investigate whether mutual funds are being selected for 401(k) retirement plans because of *gasp* hidden financial incentives, according to a recent article in the New York Times entitled, A 401(k) Picks a Mutual Fund. Who Gets a Perk?

Called "revenue sharing," the practice is basically a kickback to a vendor for recommending a fund to a plan sponsor that ranges from a quarter of a percentage point to 1 percent of the assets in a worker's account. Incredibly, when account assets rise during a bull market, the payback goes up. According to Watson Wyatt, revenue sharing is used by roughly 90% of 401(k) plans.

Talk about paying something for nothing! Study after study has demonstrated that the best-performing investments are the ones that not only don't offer financial incentives but don't charge management fees because they are unmanaged: index funds, which seek to track the broad market or a segment of it rather than trying to beat the market averages. According to a 1998 study by Money magazine, of the 25 most popular mutual funds in 401(k) plans, only six kept pace with the three year return of the Standard & Poor's 500 index for 1995-98-- and three of the six were index funds!

Why do most managed funds under-perform the indexes? The conventional theory is that it's impossible to be a "star fund manager" because of the efficiency of the markets; everybody in the marketplace already knows which stocks are hot and which are not. My collorary to that theory is that even when they do find decent stocks, most fund managers don't have the good sense to hang on to them, averaging between 80% to 100% portfolio turnover annually. As legendary investment manager Warren Buffet put it, "Investment managers [make] whirling dervishes appear sedated by comparison. Indeed the term 'institutional investor' is becoming one of those self-contradictions ... comparable to 'jumbo shrimp,' 'lady mud wrestler' and 'inexpensive lawyer.'"

The only thing crazier than paying a broker to pitch a poorly-performing mutual fund is to pay a mutual fund manager a salary to choose poor investments. On top of the revenue-sharing kickback, right now, 401(k) investors and other mutual fund shareholders are forking over more than $100 billion a year to get their money managed. Annual expenses at the average large stock fund are 1.24% of assets; compared to as little as .12% at major index funds.

Let's get this straight. If, among other things, ERISA requires that 401(k) plan sponsors have a fiduciary duty to choose funds with a long-term track record and low fees, by Watson Wyatt's accounting 90% of plans aren't doing their fiduciary duties then by agreeing to revenue-sharing. From all appearances, vendors simply can't be bothered recommending the best investment choices for plans if they don't get the kickback. Just ask the Vanguard Group, apparently one of the few mutual fund companies that refuse to play the revenue sharing game. "When brokers realize they won't be compensated for placing our funds in a plan, they will typically hang up on us," Gerry Mullane, Vanguard's director of institutional sales told the Times.

The only thing more foolish than paying a fund manager to do a lousy job is to pay one to mimic the index. This practice is called closet indexing, in which a fund manager invests most of a fund's assets in stocks that comprise the bulk of a particular index. Despite the lack of significant stock-picking, the fund still charges fees that are 3 to 10 times as high as those of a basic index funds which simply tracks a benchmark. If your 401(k) plan features a large-cap stock fund, there's a good chance that you're paying a management fee for a fund that's essentially unmanaged. Morningstar Inc., the Chicago financial publishing firm, found that between 1996-1999, 86% of the performance of large-cap stock funds could be explained by the index it tracked-- the S&P 500.

Bottom line: Investing is not rocket science, it's common sense: the first rule is to pick the horses in the race that have the greatest chance of winning. The second rule-- at the risk of mixing metaphors-- is to refuse to switch horses in midstream. To quote Mr. Buffett again: "Inactivity strikes us an intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted... Why then should we behave differently with our minority position in wonderful businesses?"


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