Q&A with IFA: How Well Have the Funds in My 401(k) Performed?

by Mark Hebner - Tuesday, 30 September, 2014

Question: I was recently informed by my company that the majority of the funds in our 401(k) plan have beaten their benchmarks as of 8/31/2014. I find myself somewhat skeptical. Can you please help me analyze the performance of these funds to determine if, going forward, they can be expected to beat their benchmarks?

When we get a question like this, the first thing we ask for is a history showing the dates that each fund was added to the plan as well as the funds that were terminated from the plan. It is easy to pick the winners at the end of a period. The real question is whether these funds were selected before they did well. Unfortunately, we can count on one hand the number of 401(k) plan sponsors or advisors who have been both willing and able to provide this data to us.

For this particular plan, there are seventeen funds, of which six are target date funds and one is an index fund. The index fund is an S&P 500 fund that carries a relatively high 0.25% annual expense ratio, instead of a more common expense of 0.10% or less.

Knowing that plan sponsors/advisors have a lot of leeway in choosing benchmarks, we compared the funds to the benchmarks assigned to them by the Morningstar analysts. Then we determined calendar year excess returns over (or under) the benchmark (i.e., alpha). For the fourteen funds that have ten years of data (excluding the index fund), only six (or 43%) were found to have a positive average alpha. Next, we ran a statistical test to determine if the manager had a long enough track record to determine if the excess return was due to luck or skill. We performed the test on their returns data as far back as possible, based on the inception dates of the funds and their benchmarks. The formula and entry form below indicates how this calculation works.

Of the sixteen funds analyzed, only two appeared to have statistically significant alpha (indicating a long enough track record to indicate skill). However, the first of these two funds, PIMCO Total Return, only recently obtained significant alpha when Morningstar changed its benchmark from Barclays U.S. Gov’t/Credit 5-10 Years to Barclays U.S. Aggregate Bond Index. Below is a reward vs. risk chart showing that PIMCO Total Return has taken on more volatility risk than its current benchmark, which is one explanation for the higher return. It appears that neither benchmark is appropriate for the fund.  


It is important to note that PIMCO Total Return has a large exposure to derivatives, which makes it difficult to benchmark. As a result of the complexity of its holdings, Morningstar does not assign an average bond quality rating to the fund, which is a fundamental indication of bond risk. Below are the two Alpha Charts for PIMCO Total Return against its previous and current benchmarks. Against the previous benchmark, it did not have significant alpha, but against it's new benchmark it does. Either way, since Bill Gross is no longer at PIMCO, the past risk and returns should have little to do with the future.


Since risk and return are inseparable, we evaluated the risk level of PIMCO Total Return and found it to be higher than the bond funds that IFA advises investors to hold. If an IFA client were to use PIMCO Total Return in their portfolios for their bond holdings, then they would have to reduce their equity holdings to keep their overall portfolio risk level constant. This would then lower the return from the previous equities allocation and the portfolio would be back to a similar risk and return. The chart below shows PIMCO Total Return vs bond indexes that IFA advises it's clients to invest in and the scatter plot reminds us of the strong relationship between risk and return.

The investment consulting firm of Ennis Knupp evaluated PIMCO Total Return for Milwaukee County in 2009. Here is a link to their report in which they discussed issues such as the complexity of its derivative holdings and its use of leverage which makes this fund very different from a traditional bond fund. While they stated that overall they were comfortable with PIMCO Total Return, their conclusion raised some important points, particularly for a 401(k) plan sponsor.

"But we acknowledge that this complex strategy relies heavily on derivatives and may not be ideal for all investors, particularly those investors that view their fixed income portfolio as an anchor to windward as opposed to a source of total return. Investors relying on PIMCO as their only bond manager may want to consider diversifying into more traditional fixed income managers or consider an index fund for a portion of their fixed income allocation. For a plan sponsor of a DC plan this presents a unique challenge as participants may not appreciate the complexities in the PIMCO Total Return Fund." The plan consultant concluded the report by stating, "Regardless, we believe that discussing merits of adding a bond index fund would be an appropriate action for an investment committee." 

We concurred with Ennis Knupp, but would go further and replace the PIMCO fund with a passively managed bond fund. As mentioned above, the news just broke that Bill Gross has left PIMCO. This comes on the heels of sixteen months of straight redemptions by shareholders. These redemptions can force the fund to sell assets in unfavorable conditions, thus harming the remaining shareholders. It is likely that these redemptions will accelerate with Gross's departure. This is yet another reason to consider replacing PIMCO Total Return with a passively managed bond fund.  

The other fund that appeared to have significant alpha was American Funds New Perspective, as shown in the chart below. 

American Funds New Perspective is a global stock fund (U.S. plus foreign) that is strongly tilted towards large cap growth companies. Since large cap growth is a sub-optimal asset class (see the high risk and low return here), we would not recommend holding this fund. One problem with actively managed global stock funds is that the manager can substantially change the geographic allocation over time, which again, makes it very difficult to benchmark and therefore the excess return is not meaningful. The style attribution chart below shows how this occurred for the New Perspective fund and indicates that a moving or blended benchmark would be more appropriate. This is a case of style drift and the drift explains why the fund had different returns than the benchmark.


Of the fourteen remaining funds, none had a statistically significant alpha, and six actually had negative alpha. The alpha charts are shown below:

To summarize, we see nothing in the fund choices for this 401(k) to indicate that the plan participants can have an expectation of outperforming a portfolio of low-cost passively managed funds.

We would expect to find similar results in all 401(k) plans that do not ultilize a menu limited to passive or index funds. To better understand why, please see this video.

If you would like us to evaluate your 401(k) plan, please contact us through the comments section below or call us at 888-643-3133.