Why 401k Investors Chase Performance – and How to Prevent It

March 05
01:01 2013

This past January a fairly famous trio of investment researchers penned a brief for the Center for Retirement Research at Boston College. Entitled “How Do Employers’ 401k Mutual Fund Selections Affect Performance?” the paper, written by Edwin J. OLYMPUS DIGITAL CAMERAElton, Martin J. Gruber and Christopher R. Blake, is based on researched previously published by the same authors in 2007 (“Participant Reaction and the Performance of Funds offered by 401k Plans,” Journal of Financial Intermediation (16): 249-271). The authors conclude, “When making changes to a plan’s funds, administrators chase returns and do not end up improving investment performance. Like their employers, 401(k) plan participants also tend to chase returns, transferring assets into higher-performing funds, rather than rebalancing to restore their original asset allocations. And their investment performance is no better than they would have achieved using variations on the 1/N rule to allocate assets among funds.”

“It is natural to chase performance,” says Elle Kaplan, CEO & Founding Partner at Lexion Capital Management LLC in New York City, “but it’s what we call ‘rear view mirror investing.’ It’s as easy and inaccurate as naming the last 3 winners of the Super Bowl and trying to predict the next 3 winners based off that information. No one can foresee the future winners, and chasing after them is not a sound strategy.”

The dilemma of chasing performance has long plagued 401k plan sponsors. David Ott, a partner at Acropolis Investment Management, LLC. In Saint Louis, Missouri, tells, “Plan sponsors chase performance because that’s how the advisers often construct their value proposition – selecting funds, monitoring them and making changes when necessary. Usually past performance is a meaningful part of the selection criteria and probably the most important part of the monitoring process. When a fund underperforms – even if it’s just for a few quarters, the trustees feel as though they must make a change to fulfill their fiduciary duty. That means they sell the recent underperformer and likely buy the recent outperformer. Several studies have shown that this is a mistake since both funds tend to regress to the mean, the old fund comes back and the new fund falls down, compounding the original problem.”

Why do plan sponsors chase performance? “In my 13 years of working closely with 401k plan sponsors,” says Victor H. Hicks II, Managing Principal at Lumin Financial LLC in Southfield, Michigan, “I’ve found that plan fiduciaries choose investments in the same manner that participants do…based on the short-term performance of investments.  And, I’ve found this to be the case for all types of securities; whether it’s mutual funds, stocks, ETFs, or any other investment. The reason for performance-chasing can be easily summarized …‘lack of education and training.’ Managing investments is a complicated responsibility that requires dedicated training, with a vast amount of continuous learning. Add to that, there is limited formal investment training for plan sponsors. As a result, highly trained investment professionals (and the clients serviced by them), use past performance as a key criteria. There are many studies that show that as little as 2% of MFs maintain top-quartile performance over a 36-month period. Winners always rotate.”

But, as the Elton et al study suggests, this behavior isn’t limited just to plan sponsors, but to their investing employees as well. William Simon, Managing Director at Brinker Capital in Berwyn, Pennsylvania, says, “Very few plan participants understand the concept of a balanced portfolio, which by definition almost always means that one investment does not appear to be doing well.”

Ott blames the way the DOL requires data be disclosed to employees. He says, “Participants chase performance because the statements contain very little information except for the standardized performance disclosures (regardless of how long those funds have been in the lineup). Most plans don’t have sufficient education programs to help investors avoid these behaviors.”

In fact, this bad behavior isn’t limited to retirement investors. Ott says, “All investors, including many advisors, suffer from recency bias, the belief that what has happened recently will continue to happen in the future. This causes overinvestment in recently strong investments and underinvestment in recently weak investments. Advisers have mechanisms to help stem this bias, most notably, awareness of the problem.”

The twin evils of “snapshot-in-time” performance measurement and the recency bias can thwart investors. “I remember talking to a plan participant who was comparing 3-year annualized returns recently when deciding what options to ‘move around,’” says Adam D. Koos, President of Libertas Wealth Management Group, Inc. in Dublin, Ohio. “They hadn’t realized at the time (just last year) that 2008 had fallen off the conveyer belt, so the 3 year annualized returns for almost any asset looked good at that point!”

Besides awareness, what else can investors do to prevent the temptation to chase performance? Roger S. Balser, Managing Partner of Balser Wealth Management, LLC in Avon, Ohio, says, “I believe the authors’ are missing the point with respect to asset rebalancing. ‘Asset rebalancing’ may be the wackiest investment strategy ever perpetrated and created. Asset rebalancing relies on looking back in history to what asset classes returned. It does not tell you what is working today. An investor or plan sponsor would be better served by having a strategy, a game plan and the discipline to stick to it, these are three of the most important things that an investor or plan sponsor need to be a winner.”

Ryan Rink, Principal at Two West Capital Advisors located in Kansas City, says, “Investment options should be selected based on more metrics than just performance and plan sponsors should realize the benefit of encouraging participants to investment in ‘Do-It-For-Me’ allocation strategies. At the end of the day, the majority of plan sponsors and participants aren’t qualified to manage their investment portfolios and don’t have the available time and resources necessary to become qualified.”

Of course, “one size fits all” or the “one portfolio” approach may be good for some, but it represents only one option in plan’s menu of options. Steven W. Kaye, President & Founder of AEPG(r) Wealth Strategies in Warren, New Jersey, says, “As a plan sponsor, you need to provide tools which address the varying types of participants/investors within the plan and provide different solutions, education and communications. When addressing individual participants you need to target them towards the most suitable solution depending on their particular needs, wants, style and level,… and be realistic. Some people are validators, some are delegators and all with differing levels of understanding.”

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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