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.