Administrative Choice: Mutual Funds and the Performance of 401(k) Plans Martin J. Gruber June 2012 Maier Plan We will first examine some facts about the performance of mutual funds We will examine how well plan administrators do in selecting mutual funds for their participants and how well participants do in allocating their pension assets among funds 1
Academic Credentials Professor of Finance at NYU since 1965 (Scholar in Residence since 2010) Past President of the American Finance Association Co-author of Modern Portfolio Theory and Investment Analysis (8 th edition 2009) Co-author of over 100 articles on Portfolio Management, Mutual Funds, and Pension Funds Professional Credentials Consultant on Mutual Funds Member of Board of Directors National Bureau of Economics Research (NBER) Daiwa Closed End Funds Member of the executive committee and the Investment Committee of the NBER Formerly Member of Board of TIAA Chairman of Board of CREF DWS (Chairman of Equity Committee) Member of Board of SG Cowen Funds 2
U.S. Retirement Market (2011) 17.5 Trillion Dollars 4.7 Trillion a 25% in Employee Sponsored Defined Contribution Plans DC plans had 2.5 trillion in mutual funds, 53% of their assets IRAs 48% in mutual funds 3
Growth of U.S. Mutual Funds by Type (Market Value) Year Money Market Bond & Income Equity Total 1975 4 5 38 47 1980 76 14 44 134 1985 244 135 117 496 1990 498 323 246 1067 1995 753 798 1269 2820 1997 1059 724 2685 4468 2009 1612 808 4423 6843 2000 1845 811 4363 7019 2001 2285 925 3765 6975 2002 2272 1125 2995 6392 2003 2053 1241 4119 7413 2004 1900 1300 4800 8000 2005 2040 1357 5507 8905 2006 2356 1495 6564 10415 2007 3117 1679 7242 12038 2008 3832 1567 4202 9601 2009 3319 2206 5606 11131 2010 2804 2605 6407 11816 2011 2691 2886 6044 11627 10000 Number of Mutual Funds 9000 8000 7000 6000 5000 4000 8662 8246 8307 8269 8126 8037 7977 8075 8029 7692 7569 7677 3000 5761 2000 1000 0 3105 1528 161 361 426 564 1960 1970 1975 1980 1985 1990 1995 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year 8 4
Number of Mutual Fund Complexes Over 650 in 2010 Top Ten Companies Hold 56% of Assets Top 25 Complexes 76% of Assets Percent of U.S. Households Owning Mutual Funds 60% 50% 40% 30% 20% 10% 6% 11% 12% 37% 20% 24% 25% 27% 31% 44% 49% 50% 48% 49% 46% 43% 0% 1980 1984 1988 1992 1996 2000 2004 2008 32% only invest in employee sponsored plan 37% both inward and outward 31% only outward employee invested plan 5
Channels Used for Mutual Fund Investments (Percent of Respondants) 40% 35% 30% 25% 20% 15% 10% 5% 0% Full Service Broker Discount Broker Insurance Agent Bank Representative Independent Direct Marketer Financial Planner 25% 13% 7% 15% 22% 19% *1/3 Online 2/3 Office # Funds Expense Ratio Total Load 12B-1 Fees All Equities No Load 4214 1.15 0.00 0.12 Front Load 2385 1.47 4.79 0.32 Deferred Load 2931 2.11 3.27 0.93 All Bonds No Load 1646 0.75 0.00 0.08 Front Load 1252 0.97 3.89 0.24 Deferred Load 1439 1.62 3.02 0.84 6
Performance of Mutual Funds Return Per Year Years Manager A Manager B Manager C 1971-75 3.2% 0.6% 0.8% 1976-80 13.9% 37.4% 36.1% 1981-85 14.7% 18.8% 19.2% 1986-90 13.1% 0.6% 1.0% 1991-95 14.8% 24.5% 24.4% 1996-2000 18.4% 10.9% 11.1% 2001-2005 0.5% 16.4% 16.2% 2006-2010 2.7% 3.6% 3.6% S&P 500 Index Small Stocks Index Small Stocks Manager 7
Morningstar Categories Investment Style Large Growth Medium Growth Small Growth Large Blend Medium Blend Small Blend Large Value Medium Value Small Value Morningstar Categories Investment Style Growth: (relative P/E + relative P/B) greater than 2.25 Blend: (relative P/E + relative P/B) greater than or equal to 1.75 but less than or equal to 2.25 Value: (relative P/E + relative P/B) less than 1.75 Large: geometric mean market capitalization of greater than $9.1 bln Medium: geometric mean market capitalization of greater than or equal to $1.6 bln but less than or equal to $9.1 bln Small: geometric mean market capitalization of less than $1.6 bln 8
α = average annual return above that of index funds with the same risk (of the same type) Average annual α = -.65% Average of expenses = 1.35% Average α for non-surviving funds= - 2.95% Future Performance Ranked By Previous Performance Alpha Decile Alpha Next Year Worst 10% -2.592 2-1.080 3-0.444 4-0.528 5-0.240 6-0.468 7 0.528 8 0.060 9-0.156 Best 10% 0.816 Spearman Rank 0.891 * * Top Bottom 3.408 * Alpha = average return above that of index funds with the same risk * Significant at 1% level ** Significant at 5% level 9
Ranked By Previous Expense Ratio Decile Alpha Next Year Highest 10% -1.716 2-0.948 3-0.828 4-0.012 5-0.024 6 0.120 7 0.564 8 0.156 9-0.216 Lowest 10% -0.096 Spearman Rank 0.552 Low High 1.620 * * Significant at 1% level Future Three Year Performance Predicted By Previous Three Years Decile Alpha Next 3 Years Worst 10% -2.676 2-0.528 3-0.312 4-0.684 5-0.156 6-0.372 7 0.132 8 0.060 9 0.696 Best 10% 0.876 Spearman Rank 0.903 * Top Bottom 3.564 * * Significant at 1% level 10
Annual Cash Flows for Deciles Formed on the Basis of Previous Years Performance in the Year Following Formation % Change in Cash Decile Flow next year Worst 10% -15.4 2-11.2 3-5.1 4-5.0 5-3.7 6-2.4 7 4.5 8 6.6 9 12.8 Best 10% 29.0 Spearman Rank 1.00 * Top Bottom 1.620 * * Significant at 1% level Annual Realized Cash Flow Weighted Alpha 1 Year Positive 0.2892 Negative 0.2244 Weighted Average 0.2652 22 11
1. Index funds outperform actively managed funds of the same risk Active funds 65b.p. below indexes. Charge fee of 130 b.p. Bring information worth 65b.p. but charge 130b.p. 2. Funds that charge higher fees tend to do worse that funds that charge lower fees 3. Funds that perform well have a slight tendency to continue to perform well Funds that perform really badly tend to continue to perform really badly 4. Investors seem to be aware of this. Funds that perform well have higher subsequent cash flows. Funds that perform badly have high cash out flows. 5. The cash flow in and out of funds has positive alpha greater than 20 b.p. 12
Pension Plans There has been a lot of research on how participants behave. Surprisingly, there has been almost no research on the actions of plan administrators on the choices given to plan participants. The action of a participant is a result of two decisions: the choice the participant is offered and how he or she allocates among these choices. This is the first set of research to examine the appropriateness of the choices given to the participant: an examination of the decisions of the plan administrators rather than the participant. Do administrators choose the right funds? 13
Return Based Style Analysis α = how much better did a manager due than holding a combination of indexes with the same risk 27 Methodology A. Alpha R it R rt = α i + β ij I jt + e it Stock Funds: S&P 500, Fama French Small-Large and high minus low, Lehman Gov/Credit, and MSCI Europe Bond Funds: Lehman Gov/Credit, Lehman Mortgage- Backed, Credit Suisse High-Yield Index, Salomon non-dollar World Gov. Bond Index International: S&P 500 and the three MSCI Indexes (Europe, Pacific, and Emerging Markets 28 14
B. Differential Alpha Mutual funds, in general, have negative alpha. We took the alpha for each mutual fund minus the average alpha for funds of the same general size from the same ICDI category. 29 Performance of Administrators α α = average annual return above that of index funds with the same risk Differential α = annual return above that of the average active manager Equal Wts. Alpha Diff. α Average -0.32 0.51 P-Value 0.161 0.009 Fee difference.019 15
Given the type of fund offered, administrators tend to hold better than random funds, but much of the difference is due to lower expense ratios. They do not do better than holding index funds Do participants allocate savings wisely given the choices they are offered? 16
Performance of Administrator and Participant α Equal Wts. Participant Wts. Alpha Diff. α Alpha Diff. α Average -0.32 0.51-0.56 P-Value 0.161 0.009 0.034 0.44 0.040 The choices of plan administrator is very important because participants destroy value rather than increases value by their decisions. 34 17
Does the past performance of administrators tell you anything about their future performance? Past Performance Quartiles Average Future Differential Alpha 1 (lowest) -0.024 2 0.040 3 0.063 4 (highest) 0.061 18
Plan administrators who outperform in the past have a tendency to outperform in the future. Plan administrators who underperform in the past have a strong tendency to underperform in the future. 37 Conclusions 1. Actions of plan administrators vitally important 2. Offer portfolios of better active funds 3. Nevertheless, don t outperform index funds 4. Additions and deletions not as skillful 5. Some do better than others over time 6. Participants don t add value to the decisions of the plan administrators 19
Performance of Added minus dropped funds - annual α Alpha Differential Alpha Before 3.36 2.304 P-Value 0.01 0.01 After -0.96-1.30 *not significant at 1% level 20