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Morningstar: DC Investment Menu Moves Matter

Industry Trends and Research

It’s said that change is good – and, according to new research, that also applies to 401(k) investment menus.

A new report from Morningstar Research finds “evidence that fund replacements provide significantly higher risk-adjusted returns than the funds that were replaced,” going on to state that the results “…provide evidence that monitoring plan menus to identify underperforming funds and replace them with more attractive funds provides value to plan participants.”

Ironically, the report – unabashedly titled “Change is a Great Thing” – begins by stating: “There is little evidence to suggest that monitoring defined-contribution menus adds value, despite the time, effort, and resources spent by plan sponsors on such activities.” 

But these researchers found what they termed “significant evidence” that replacement funds outperformed the replaced fund over both future one-year and three-year periods. This the researchers noted as the “most surprising” finding, more specifically “unexpected in the context of past research, which has generally noted that replacement funds do no better (or worse) than the funds being replaced.” Moreover, they conclude that the outperformance remains even after controlling for various fund attributes and risk factors (expense ratios, momentum, style exposures, and other metrics commonly used by plan sponsors to evaluate funds such as the star rating and quantitative rating).

The analysis was performed on a “unique longitudinal data set of plan menus from January 2010 to November 2018” that included 3,478 fund replacements across 678 DC plans on three different recordkeeping platforms. They employed a “matching criterion to determine when a fund is replaced within the same investment factor style based on its Morningstar Category over time.” 

The paper acknowledges that prior studies of plan sponsor replacement decisions suggest that replacements may be motivated by historical performance data relative to a benchmark that does not predict future performance, and cited studies that suggest that: (a) institutional investment managers hired to replace terminated underperforming managers perform much better before they are hired, but this outperformance disappears after they are selected; and (b) plan sponsors often favor investments that have recently outperformed, and subsequently underperform – resulting in a loss of value for participants.

That said, in the database they considered, the researchers found that, on average, the replacement funds had better historical performance and lower expense ratios, along with more-favorable comprehensive metrics such as the Morningstar Rating for funds and the Morningstar Quantitative Rating for funds, than the funds they replaced. 

However, the largest performance difference in the replacement and replaced funds turns out to be the five-year historical returns, which the researchers conclude suggests that this historical reference period is “the one that carries the most weight among plan sponsors.”

There were differences in asset class; equity funds tended to have the highest relative outperformance, followed by allocation and bond funds. The researchers note that for each broad style group the relative performance of the replacement fund to the replaced fund improves over longer out-of-sample periods. For example, for all funds, they note that the median performance difference is 22 basis points after one year, 26 basis points after two years, and 52 basis points after three years.

The researchers write that their analysis “demonstrates that the historical performance of replacement funds is significantly higher than that of replaced funds,” and that, they write “…suggests historical performance is an important component of the replacement decision.” And that, they write, suggests that it’s worth exploring the relation between historical performance and future performance for these replaced funds.

But if the report is unequivocal in concluding the success of replacement funds, the big question remains unanswered – why? “While we can analyze certain factors related to the outperformance, such as the type of fund (equity or bond), lower expense ratios, higher recent historical performance, and various Pillar ratings, the primary drivers of the outperformance remain elusive,” they acknowledge. And while “we can make generalized statements (e.g., replaced funds tend to have lower performance), there are clearly exceptions to the rule,” lacking information on the relative importance of the fund being replaced (proxied by plan assets), how long the fund has been in the plan, and so on, they hope that “future research will explore this relation more, using a more-complete data set.”

NOTE: As the researchers acknowledge, there are certain unique aspects to this database in that it relies on historical fund menus provided by three recordkeepers who use Morningstar’s managed accounts services. The managed accounts provider, Morningstar Investment Management LLC, is an investment manager and the fiduciary responsible for determining the appropriate portfolio for participants who use the service. However, the researchers note that for these plans Morningstar Investment Management is not responsible for the creation or selection of the menu of investments, rather that the creation and selection (and monitoring) of the investment menu is the responsibility of the plan sponsor (although they may work with an investment advisor who helps select the plan menu in a “co-fiduciary” capacity). That said, the extent to which each plan sponsor uses an investment advisor, and the scope of the potential relationship, was not available.