The Ten Commandments of Selecting a Mutual Fund as a 401k Option

By Christopher Carosa, CTFA | April 4, 2012

(This is the second installment of a special three-part series)

While the four steps to a well-documented 401k investment due diligence process just fell in our laps, getting into the nitty-gritty of the first two steps – the identifying the selection and monitoring processes – might prove a tad bit morelaborious. There’s another thing about this particular portion of the due diligence process you must be warned about. It’s the part where the arguments start.

If you take any two investment advisers and ask them which specific characteristics one should focus on when selecting a mutual fund to be included among a 401k plan’s investment options, you’re likely to get vastly different answers. Fortunately, in speaking to different advisers, we’ve been able to whittle down their recommendations to very broad areas – wide enough for most advisers to swim comfortably within. So, if you’re looking for a fight, you won’t find one here.

I.        Company’s Custom Statistics – It all starts here, with specific data pertaining to the company’s demographics. This data set will produce the major criteria 401k plan sponsors – or their advisers – will later use when determining appropriate fund options. Todd Reid, General Agent for Intermountain Financial Group in Salt Lake City, Utah says this will indicate the “time horizon, liquidity, and true risk tolerance” of the plan’s investors; hence, act as a great starting point towards selecting funds. II.      Company’s Goal-Oriented Target Analysis – While company demographics are generic, it’s important to recognize that even employees of the same age may have difference return requirements. In order to best select relevant funds for the plan option, it’s critical to know the range of target returns. This will come in handy during the later performance analysis of each candidate fund. III.    Key Characteristics of the Fund – Before even getting into performance and costs, it’s important to identify a set of key differentiators you’ll review among all funds, whatever the investment objective. Boyd Wagstaff, 401k and Qualified Plan Specialist for Intermountain Financial Group, likes to focus in on the fund managers. He looks at years of tenure and style. “We want to make sure that fund or investment is true to its value,” he says. “For example, if we are looking for a large-cap value stock, we want to make sure it does not change to some other style, but that it remains consistent with its original design.” IV.     Peer Group Performance – Manny Schiffres, Executive Editor, Kiplinger’s Personal Finance in Washington, D.C. says, “We look at performance, specifically the consistency of performance. How has a fund done year by year against its peer group and an appropriate benchmark is far more important than cumulative results, which can be swayed by one outstanding year.” V.       Rolling Long-Term Performance – This approach to performance measurement is more consistent with the results of studies in behavioral finance as it dodges the dangers of short-term volatility and avoids the “snapshot-in-time” phenomenon Schiffres refers to. He says, “Analysis of the sort that says this or that fund has beaten its peers or an index over the past 1, 3, 5 and 10 years is bogus. As mentioned earlier, one outstanding (or awful) year totally distorts the numbers. Plus, because this sort of analysis can change depending on whether a fund is strong at the beginning or the end of the period, even if the results are essentially the same in either case, it is obviously a flawed approach to analyzing performance.” VI.     Generic Fund Statistics – All funds share common traits. Some of them may reveal characteristics the plan sponsor will want to shun or emphasize. Among these can include the number of holdings (addressed previously in “Overdiversification and the 401k Investor – Too Many Stocks Spoil the Portfolio”), the concentration of holdings, the fund’s size and any unique costs associated with the fund. When it comes to a fund’s size, Schiffres says “The bigger the fund, the harder it is to manage. This is especially true when the fund focuses on less-liquid investments, stuff other than big-cap stocks and Treasury bonds. When you buy in big quantities, you tend to force up the price of the security you’re buying. When you dump large quantities, you help push down the price. Neither is helpful to the manager.” Regarding costs, besides the usual expense ratio, Reid also looks at the “sales charge in relation to the fund class, and available break points purchased. The different fund fees vary by Class A, B, and C. Some classes have front-end fees, while others do not. Service fees are also a piece of the fees needing to be considered and vary by manager, and length of deferred sales charge.” VII.   Proprietary written description of Fund’s Investment Objective – These next four Commandments have one thing in common. They all rely on written documentation beyond the fund’s prospectus. While plan sponsors must read the prospectus, they must also remember the prospectus is inherently a sales tool. Getting a third party’s opinion can often help the plan elude the seemingly attractive pitch of an inappropriate fund. Sometimes this third party view comes from an adviser, sometimes it comes from a publisher. Ideally, it will be proprietary in nature, aimed at the specific needs of the plan and not for the general mass market. The first detail the 401k plan sponsor will want to see is an objective description of the fund’s investment objective. That’s the basis of each of the next three items. VIII. Proprietary written analysis of Fund’s ability to meet its objective – Did the fund meet its objective? Plan sponsors should not count on the fund to tell them. Select an unbiased party. Reid uses these sources to “review the history, performance of sector, and scrutinize any drifting that may have occurred.” He says, “It is my duty to my clients to ensure them the funds stay true to their sector and that the allocations are relevant.” IX.    Proprietary written commentary on Fund management – According to Schiffres, “the manager is the person responsible for the record.” He matter-of-factly says “past performance is not guaranteed. Expenses pretty much are baked into the cake. In other words, expenses are something you know in advance, so you want to keep them as low as possible. Of course, super-low expenses are the main justification for going with index funds. To recommend actively managed funds, you have to feel confident that you can identify managers you think are good enough to overcome their expense disadvantage.” X.      Proprietary written recommendation of relative appropriateness – When all is said and done, a plan sponsor must always ask “Is it time to replace this fund?” Here it’s vitally important to have a wide variety of choice, since any limitations may expose the plan sponsor to greater fiduciary liability. Wagstaff says, “We use a variety of sources to compare and contrast. We use third-party resources and we look for balance. We don’t want to load the platform up with one type of fund. We prefer a large number of funds to cherry pick and collect a platform for our clients that we believe is cost appropriate, diversified, and with excellent returns.”

We trust this represents a Decalogue possessing both credence and compatibility. Not only does it make sense to use, but the vast majority of plan sponsors can easily adopt each category of scrutiny.

We end this series next with a summation of the ideal 401k investment due diligence process.

Part I: 4 Easy Steps 401k Plan Sponsors Can Take to Insure a Well-Documented Investment Due Diligence Process Part II: The Ten Commandments of Selecting a Mutual Fund as a 401k Option Part III: 10 Point Checklist for the Ideal 401k Investment Due Diligence Process

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Christopher Carosa, CTFA


About Intermountain Financial Group, LLC
Our company is built on a solid foundation of excellent client service and in-depth industry knowledge. Our focus is helping you improve your quality of life through financial peace of mind. We offer a wide variety of products and services to help you solve today’s personal and business financial problems and to prepare for the future. For more than a century, the Intermountain Financial Group/MassMutual (IFG) has provided a comprehensive offering of a diverse array of products, including life insurance, annuities, disability income insurance, long term care insurance, retirement planning products, mutual funds, and access to money management to individuals and businesses in Utah and most of United States. IFG currently has offices in Salt Lake City, Provo, and St. George, Utah. IFG has also been recognized as one of the best places to work in Utah by the Work/Life Awards Committee for 2011, 2010, 2008, and 2007 and the national Sloan When Work Works award in 2012, 2011, 2010, 2009, and 2008.

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