A new research paper investigates whether mutual fund families acting as service providers in 401(k) plans display favoritism toward their own affiliated funds.
The title of the paper — “It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans” — gives away the conclusion. The researchers conclude that “affiliated” mutual funds are less likely to be removed from, and more likely to be added to, a 401(k) menu, and that those additions and deletions of affiliated funds are less sensitive to prior performance than for other funds.
The researchers found that if a plan deletes one or more affiliated funds, there is a 95.7% probability that at least one new affiliated fund is added during the same year. On the other hand, if one or more unaffiliated funds are deleted, there is only a 43.2% probability that at least one other fund is added from the deleted fund's family.
‘Passed’ Performance?
Refuting the possibility that the record keeper might have superior knowledge about its own funds, the researchers noted that “…the subsequent performance of poorly-performing affiliated funds indicates that this favoritism is not information driven.” Additionally, they noted that the di?erence in deletion propensities between a?liated and una?liated funds is largest among the worst performing funds, with similar results for mutual fund additions. They further noted that affiliated funds that rank poorly based on past performance but are not deleted from the menu do not perform well in the subsequent year. Indeed, they estimated that, on average, they underperform by approximately 3.96% annually on a risk- and style-adjusted basis.
While participants could counter these perceived menu biases with their own choices, the researchers found no evidence that they did so. In fact, they noted that the “reluctance to remove poorly-performing a?liated funds from the menu generates a signi?cant subsequent negative abnormal return for participants investing in those funds.”
Not surprisingly then, the researchers noted that the “…decisions of plan sponsors and service providers have a substantial impact on flows to mutual funds.”
Aside from the obvious financial incentives associated with fund representation on the 401(k) menus, the researchers noted that non-401(k) investors were more likely to move money from poorly performing funds — and that by keeping those funds on 401(k) menus, “affiliated mutual funds can benefit by obtaining higher money flows and by avoiding large out flows from their poorly-performing funds.”
The study was based on data from approximately 2,500 401(k) plans for the period 1998 to 2009 from annual flings of Form 11-K with the SEC. In that sampling, the average plan size was approximately $324 million and the median $61 million.
A couple of cautionary notes: The SEC filing sampling would tend toward firms that included company stock on their menu. Additionally, the researchers note that the affiliated funds in their sampling tended to have lower expense ratios, lower turnover and lower standard deviations of monthly returns because they were more likely to be indexed funds, whereas unaffiliated funds were more likely to be specialized funds (such as international or sector funds).
