Funds Flowing to Index Funds and ETF's Due to New 401(k) Regulations and Litigation

2011 was a year to forget for many active portfolio managers. Only 17% of active managers of large cap U. S. Stocks outperformed the S&P 500 last year, the worst showing for active management since 1997, when only 12% outperformed. This occurred in a year when most investors made virtually no money. CalPERS the largest pension fund in the U.S managed just a 1.1% return on its $229 Billion portfolio which includes exposure to every imaginable asset class and strategy. This lack of performance leaves investors frustrated and wondering if active management is worth the extra cost. Last year net inflows into passive index funds led actively managed funds by nearly $38 Billion and Exchange Traded Funds (ETF’s) led all fund types with a whopping $121 Billion in net inflows. If one considers that ETF’s are virtually all passive index funds, this makes the movement of funds from active to passive management even more stunning.


I believe this phenomenon is being driven by more than simple investor frustration with market conditions. In the mutual fund marketplace, the 600 pound gorilla is the 401(k) plan, containing $3 Trillion in assets, mostly invested in mutual funds. There are profound changes occurring in this space that are driving a movement towards passive index funds. These changes are being driven by a combination of a bevy of new regulations from the U.S. Department of Labor, which believes that 401(k) investors pay too much to invest in their retirement plans (they do, and small to midsize plan participants typically are hit the hardest) and by litigation whereby plan sponsors (employers) are being sued for breach of fiduciary duty by employees who believe their fund options are too expensive. All this is forcing employers to at least include some indexed options in their plans, and more than a few are replacing all actively managed options in their plans with index funds.

I will not go into the great passive versus active management debate here, as it is really immaterial. The shift to passive funds in 401(K) plans is being driven solely by the sharp reduction in fiduciary liability that it offers employers. Both regulators and courts adore passive management and that alone is sufficient to drive the fund movement being seen. The question I will address is, “Where does this leave the individual investor?” In short, I would not be so quick to dump active management from your portfolios.

Even the best active manager’s don’t outperform their benchmarks consistently. There are market conditions that make it difficult for them from time to time. This past year, particularly high market volatility and a late year flight to quality hurt active managers. Most active management philosophies are driven by rational thought. When fear rules the markets these strategies often lag. From what we’ve seen so far in the first quarter, many active managers have rebounded sharply, outperforming their indexes handily. We do see some opportunity for active managers in the mass movement of 401(k) funds to index funds. There are segments of the major market indexes that are under owned by institutional investors and may benefit by a strong flow of funds into the index, utilities and value stocks come to mind.

We have always viewed index funds and ETF’s as useful tools in our portfolios and use them in addition to our active managers depending on the objective that they address in a portfolio. As always, it is vital that you have an investment strategy that is appropriate to your risk tolerance and objectives. An independent, fee-only financial advisor can help, no matter what size your portfolio.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information is or was accurate. This blog represents opinion only and should not be construed as investment advice. Investors should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

Target Date Funds and Your 401(k) Part 2

A few weeks ago I commented on some of the issues we had with Target Date Funds (TDFs) http://oldperfessorsinvestmentblog.blogspot.com/2012/01/target-date-funds-and-your-401k-part-1.html  . This week I’ll share the protocol that I use to evaluate whether or not to recommend that clients use the target date funds available in their 401(k) plans.


1. Determine the clients risk tolerance

2. Develop an asset allocation based on risk tolerance

3. Develop a portfolio using the non-target date funds available in the plan. Note that I have run across plans that are so poorly designed that it is not possible to design a properly diversified portfolio.

4. If TDF’s are available in the plan, identify the fund whose asset allocation most closely matches the one developed from the client’s risk tolerance … not the one whose target retirement date most closely matches the client’s.

5. Compare the past performance of the TDF with the performance of the portfolio assembled from the non-target date funds in the plan.

6. If the TDF has consistently outperformed the portfolio put together using the non-target date funds or it is not possible to put together a decent portfolio using the non-target date funds then you should use the TDF. Note that past performance is no indication of future performance; it is, however, along with common sense, all we have to base decisions on.

7. If we identify a TDF that looks like it might be an effective investment tool for that client, then we look at the underlying fund investments and check for diversification and management quality. One issue with TDF’s is that some fund families have used them to gather assets for in-house funds that have performed poorly and have difficulty attracting assets on their own. This however will show up in poor performance relative to properly designed competing portfolio.

This is the only protocol that properly evaluates all of the options available to a 401(k) plan participant. The bad news is that it represents a fair amount of work, more that most 401(k) participants are willing to do. The above protocol takes me about 4-5 hours and I have been doing research like this for over 20 years. Further, I know of very few plan vendors that supply plan participants with the research tools to follow the above protocol to make a rational and informed decision about the use of a target date fund, while my practice spends a great deal of money annually on independent research so we can make effective, unbiased decisions for our clients.

One of my pet peeves is people who write lengthy criticisms but offer no solutions. So if you are a participant in a 401(k) plan that offers target date options or you already own one, here’s what you should do.:

1. Make the commitment to thoroughly understand the options in your plan. Use the protocol I have outlined above to evaluate the use of target date options in your plan.

2. If you are unwilling or unable to make the commitment, seek out an independent, fee-only financial planner in your area and hire them to evaluate your plan and make recommendations. A good place to start your search is The Paladin Registry, an independent evaluator of planners http://www.paladinregistry.com/ .

Merrill Lynch Spurns Small Investors

Merrill Lynch announced this week that it will eliminate or severely reduce compensation for its advisors on accounts under $250,000. The message to investors with accounts in this asset size range is pretty blunt, “Your account doesn’t interest us”. Other large brokerage firms are expected to follow suit shortly. Keep in mind that this is from the same folks (Big Brokerage, Inc.) who late last year spent hundreds of millions of dollars lobbing congress to successfully bury the effort to apply the same fiduciary standard that applies to investment advisors to brokerage firms. Their reasoning was that, if held to a fiduciary standard (putting their client’s interests ahead of their own), they could no longer afford to provide service to smaller investors. It appears that now their business model will not allow them to provide service to smaller investors even if they are allowed to ignore what’s best for the client.


Our firm is a small, fee-only financial planning and investment management practice. We do not sell financial products nor do we accept commissions on financial products. We readily acknowledge the fiduciary responsibility that the Investment Advisors Act of 1940 holds us to. We have found accounts of the size that the major brokerage firms are spurning to not only be profitable, but well supported by or fee- only business model. The question is, if we can do it why can’t they? We find the treatment of smaller investors by the major brokerage firms reprehensible and wonder why people continue to do business with companies so opposed to their best interest.

Target Date Funds And Your 401(k) - Part 1

Target Date Funds (TDF’s) have become a popular option in 401(k) and other defined contribution plans as they offer to simplify investor’s decision making. These offerings are typically “funds of funds” meaning that they are managed using other mutual funds, (usually from the fund family sponsoring the TDF) as the underlying fund investment holdings. For example, Vanguard target date funds are managed using other Vanguard funds as the underlying investment vehicles. TDF’s are managed to become more conservative (less stocks, more fixed income) as the holder approaches retirement. This relieves investors from having to make timing decisions regarding their portfolio.


Despite a great deal of regulatory scrutiny during the 2008 financial crisis, TDF’s have been adopted by many 401(k) plans as a default investment for plan participants who are auto enrolled (placed in the plan automatically when they become eligible). A practice endorsed by the U.S. Department of Labor. A recent article in the Huffington Post http://www.huffingtonpost.com/2011/12/30/no-lost-generation-for-ge_n_1176557.html indicated that despite opinion poll data that shows investors are less willing to take on risk by investing in stocks than in the past and that many are distrustful of the financial markets, more Americans than ever have some of their money in stocks. In fact, the number of retirement plan participants in their twenties who had 80 percent or more of their 401(k) funds in stocks grew to an all-time high of just over 60 percent. Since this is the age group most likely to have been auto enrolled, it makes sense that the increase is primarily due to the use of target date funds as the default investment option. The diversified nature of TDF’s would require stock content and the long time horizon of the funds used by younger participants would indicate a high stock allocation.

While I agree with the concept of TDF’s, I have often been critical of the execution. My criticism has centered on three key issues. The first and most critical is that there is no mechanism to match the investment allocation of a TDF to an individual investor’s risk tolerance. In other words, even though you and I may be planning on retiring around roughly the same time, we may not have the same tolerance for risk in our retirement investments. When investing in retirement date portfolios we are forced to accept what someone else dictates as an appropriate asset allocation and risk level for someone retiring within a certain date range. Which brings us to the second issue, opinions differ greatly on the appropriate risk level for any given time horizon. Hence, there is an incredible amount of variation in the amount of equity (stock) exposure between funds with the same target retirement date in portfolios run by different management groups. During our research for clients we have seen TDF’s from different vendors with the same target date differ in equity content by as much as 30%. The third problem is the fact that most individual investors really have very little idea of what they are buying when investing in target date funds or what’s in them. They simply fail to do the appropriate research.

If you are a 401(k) participant and you are using a Target Date Fund for some or all of your retirement investing, make a News Years resolution to find out exactly what you are investing in and if you are comfortable with the risk involved. Start with the information provided by the plan vendor. If you need help, determine if your plan offers the help of an investment advisor. If the plan fails to provide adequate advisory services (a not uncommon occurrence) find a fee-only investment advisor to guide you. Information on qualified fee-only investment professionals near you can be obtained at http://www.paladinregistry.com/. In our next post we’ll share the protocol that we use at Pilot Capital http://www.pilotcapitalmanagement.com/ to evaluate whether the target date funds available in your 401(k) plan offer a superior opportunity.



Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investors should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

The Failure of the Congressional "Super Committee" and Your Portfolio

Last week the failure of the congressional “super committee” to find ways to reduce the U.S. budget deficit by at least $1.2 trillion resulted in a sharp correction in the stock market. In short, we were not surprised by either the committee’s failure or the resulting market reaction. Congress basically set the committee up to fail by including automatic spending cuts of $1.2 Trillion beginning in 2012 in the same budget agreement reached in August of this year that created the “super committee”. This was the perfect out for congress as all areas of government will be affected and congress can respond to angry constituents by saying that they never really agreed to any specific cuts. This is Washington politics at it very best (gutless and cynical). We are assuming that congress does not repeal the automatic cuts or alter the sequestration process that implements the cuts.


Our investment outlook for 2012 remains unchanged. Most economic analysis we have seen of the automatic spending cuts show that the cuts, while effective in reducing the deficit, would have little impact on economic growth. The cuts are simply not big enough to make more than about a 0.5% dent in real GDP growth. We still see a prolonged recovery marked by painfully slow growth and high unemployment accompanied by higher than usual volatility in the financial markets.

We are more concerned with 2013 when the Bush era tax cuts will expire. The higher rates for higher income taxpayers coupled with higher taxes on investment income and capital gains and higher payroll taxes could have a serious negative effect on consumer spending in 2013.

In conclusion, we do not believe that the” super committee’s” failure in itself was a significant blow to the economy because the automatic spending cuts already in place will likely do much the same thing the committee was supposed to do. A much more serious threat in the form of higher taxes may be on the horizon for 2013. The situation in Europe is also likely to deteriorate further and could impact economic growth in this country if timely and constructive steps are not taken by European political leaders and central banks. We are monitoring this situation carefully and at this point are still optimistic that the European debt crisis will result in a moderate recession and not deteriorate into a prolonged and severe period of economic struggle.

We also remain concerned as to investor’s fortitude while working through this difficult time. We have often said in this blog that it takes both courage and patience to be good investor. The coming few years will test both. As always, if you are concerned about market volatility call an independent, fee-only financial advisor and schedule an appointment to review your portfolio and make sure it is appropriate for your risk tolerance.

The above commentary is the opinion of the author and should not be construed as investment or tax advice. Always consult a qualified investment and/or tax advisor before investing or changing investments.

Bad News for 401(k) Participants

On Monday the U.S. Department of Labor released a very disappointing ruling for 401(k) investors that withdrew a proposal to subject financial professionals who give investment advice to 401(k) plan participants to a fiduciary standard of conduct. This means that brokers and insurance agents who service investors in what has become our nation’s most important retirement savings vehicle would have had to put the investor’s interests ahead of their own. This would have meant no more selling outrageously priced investment products to plan participants, no more selling whatever fund pays them the highest commissions and no more placing poor performing funds in 401(k) plans whose only attraction was their willingness to pay the plan vendor to be in the plan. Needless to say the brokerage and insurance industries mounted an intense and heavily funded effort to defeat or delay this regulation.


Predictably, the political attack on DOL was lead by members of Congress hailing from states in the Northeast where the insurance and securities industry is concentrated. The main argument from these companies is that, if they have to place the plan participant’s interest above their own, then the small investor would actually suffer because they could no longer afford to give them advice. You can restate this more accurately as “if we are fiduciaries we can no longer get away with charging outrageous fees for selling products that mostly benefit our respective companies”. I find their (the brokerage and insurance industries) argument baseless as, my own firm, Pilot Capital Management, and many other fee-only, independent Registered Investment Advisors (RIA’s) have been successfully counseling small investors while being held to a fiduciary standard for a very long time. The stance taken by brokerage firms and insurers reflects their need to build and maintain large companies (and impressive buildings) that, in general, have not succeeded in producing better advice for investors. Fee-only RIA’s have found it very difficult to compete in the 401(k) arena because of the ease with which brokerage firms, insurance companies and banks have been able to hide the very high fees charged to plan participants, particularly in small to mid-sized plans. This regulation would have helped level the playing field. DOL did say that it plans to reissue the proposed regulation in early 2012.

Thankfully there is some good news for 401(k) plan participants. Beginning in 2012, 401(k) plan vendors will have to show every plan participant exactly how much they are paying in fees (in dollars) on each statement. Our guess is that this will be a very eye-opening experience for many plan participants. Examine your first statement in 2012 carefully for the fee disclosure. If your total fees are greater than 1% of your plan balance (for small company plans) or greater than 0.5% (for larger company plans), then you have a right to be concerned. Go to your employer and ask if the plan fees have been compared to similar plans to determine if the fees are reasonable and ask to see the data. Your employer is a fiduciary and is legally bound to place the interests of the plan participants above all others involved with the plan. Also, you are being charged these fees for “investment advice”. If you’ve never actually received any advice (this occurs more often than the industry cares to admit) then you have a right to question exactly what it is you are paying for.

Finally if you’re in the habit of writing to your elected representatives, write and tell them that you are outraged at Congress’s surrender to the lobbying efforts of the brokerage and insurance industries on this matter.

S&P Fires Warning Shot at Congress

Late Friday evening, well after the market close, Standard & Poor’s announced that it was lowering its credit rating on U.S. Government debt obligations to AA+ from AAA. This, not totally unexpected, move is the first such downgrade in the history of The U.S. It occurred after the other two leading credit rating agencies, Moody’s and Fitch reaffirmed their AAA rating but with a negative future outlook. S&P made it clear in their statement that the downgrade was based, not on a question of the ability of the U.S. to pay, but rather the amount of fiscal brinksmanship displayed during the disgraceful performance of our Congress. For an excellent commentary on this I urge you to read a timely post in The Economist http://econ.st/rr2d5X. I agree that this downgrade appears to be aimed squarely at the U.S. Congress and hence indirectly at ourselves. We must limit our long term obligations via entitlement programs (Medicare, Medicaid and Social Security) and we must address these issues now.

The downgrade tells us very little that we didn’t already know. S&P held true to its reputation for gleefully bayoneting the wounded after the battle. The downgrade may have negative credit implications for any entity public or private that depends heavily on U.S. Government spending. I will be writing more about this later as this works itself out. In the regular course of life this downgrade means very little as all credit ratings are relative. If you downgrade the cream of the crop, then everything below moves down a notch also. In fact, more than few respected analysts have noted that AA+ is becoming the new default rating for risk free. Despite S&P’s ongoing hissy -fit with Congress, the United States still enjoys a high credit rating (still AAA from two of the three agencies) and is not expected to have any trouble meeting its obligations in the short run and unlike the PIG countries in Europe controls its own currency.

The S&P downgrade of U.S. debt doesn’t change our investment thinking, mainly because our analysis and portfolio positioning already takes into account the serious domestic and global debt problems that influenced the downgrade. The significance of the global debt problem is that it will likely take many years to reduce this debt, and as it is being worked down it will hamper economic growth. The markets appear to be resetting to lower levels in broader reflection of this view that growth is likely to be slower than some were expecting.

Which brings us to the ultimate question, why, after the down grade did the prices for U.S. Treasury bonds actually go up? And why are foreign investors fleeing to the dollar and U.S Treasures as a safe haven? When you think about it, selling stock and buying Treasuries is very un-rational, not that markets are renowned for rationality. A more compelling consequence is that the downgrade scares U.S. consumers back into the recession hiding place from which they only recently exited. This has indeed stepped up my consideration of such a possibility which as late as early last Friday I considered as not very likely http://bit.ly/qjrJ99.

In the meantime, we expect a lot of turmoil in the markets and would be inclined to sit tight and watch for opportunities if stocks cheapen even more from where we are currently. I would reiterate that this is not 2008. The difficulties we face here in the U.S. are nowhere close to those we met at that awful time. I cannot say the same for our friends in Europe however, where it does look a lot like 2008. There are some very good U.S. companies that are not in any financial difficulty with generous yields that are looking very buyable. Morningstar published an excellent piece on what to do in a turbulent market. In Brief:

Step 1: Check adequacy of cash reserves.
Step 2: Check your long-term positioning.
Step 3: Initiate defensive hedges with care.
Step 4: Make sure you're taking advantage of "gimmes."
Step 5: Develop a strategy for deploying cash.

To read the full article click here: http://bit.ly/nHLpEd

The above commentary is the opinion of the author and should not be construed as investment or tax advice. Always consult a qualified investment and/or tax advisor before investing or changing investments.