401(k) Investment Menus: Sans Small-Cap Value, EM and REITs
In a MarketWatch post, “The No. 1 Flaw in America’s Biggest 401(k) Plans,” author Paul Merriman makes three observations concerning the investment lineups of the 100 largest U.S. companies’ 401(k) plans:
- U.S. small-cap value stocks over the past 50 years returned more than five percentage points than the S&P 500. But only a third of the 100 plans give participants that choice.
- Fewer than 40% of plans offer an emerging markets fund, even though many believe this asset class will have the best future long-term returns.
- Only about one-third of these plans offer a real-estate investment trust (REIT) option. That’s too bad because REITs have outperformed the S&P by 0.5% while moving up and down at different times, giving investors more return with less volatility.
One way to model the impact of including these asset classes — which apparently are underrepresented in the investment menus of the largest 401(k) plans — is to consider the impact of having access to these asset classes during the tech bubble between 1995 through the bursting of the bubble in 2000/2001, as well as the subsequent years leading up to the Great Recession.
The annual performance numbers for most of these asset classes can be found at Callan Associates. Since the Callan chart does not track REITs, the J.P. Morgan chart of annual asset returns, which includes REITs, serves as a reference as well.
The large-cap growth asset class was the best performing category between 1995 and 1998, with annual returns of 38% (’95), 23% (’96), 36% (’97) and 42% (’98). In 1999, large-cap growth dropped to third place. Beginning in 2000 it had negative returns for three years, with an average decline of 20% each year. After the tech bubble burst in 2000, the asset classes which had the highest returns were small-cap value (2000 and 2001), intermediate term bonds (2002) and emerging markets (2003-2007, a period in which EM averaged over 37% a year). However, if REIT funds are included, real estate was the top performer in 2004 (31%) and 2006 (35%), outperforming EM in both of these years. It should also be noted that REITs have been the number one performing asset class in 2010, 2011 and 2012, as well as year-to-date.
Considering this sequence of asset class returns from 1995 through 2006 in the context of the MarketWatch article, Merriman is clearly correct in pointing out the significance of including small-cap value, emerging markets and real estate as distinct asset classes in an investment lineup. The obvious value of having access to these asset classes after the tech bubble burst is that they blunted the impact of the precipitous drop in the large- and small-cap growth sectors, an event that came after four years of rapid (and as it turned out, unsustainable) appreciation.
If the asset allocation program had had a policy to rebalance periodically (as it should), all the better. During the four years that growth equity funds outperformed (’95-’98), gains would have been captured at the time of each rebalancing event (e.g., quarterly) and redistributed to asset classes that had been underperforming.
Given the fact that the beneficiaries of the flows from the funds being rebalanced would have been the out-of-favor asset classes, DC investors would have had their assets periodically repositioned to take advantage of the future period of outperformance. This is what occurred with small-cap value, emerging markets and real estate in the years following the bursting of the bubble in 2000. Unfortunately, the reality is that many DC investors had become overweighted in growth-oriented equities during the tech bubble and only a minority of DC investors had access to the subsequent top-performing asset classes (small-cap value, emerging markets and real estate).
The same few reasons are typically given for why asset classes (in this case, small-cap value, EM and REITs) are left off investment menus:
- These asset classes are already imbedded in existing funds (e.g., S&P 500 — a blend of value and growth).
- These asset classes are too risky to be offered as a standalone fund.
- DC investors should be using asset allocation funds (e.g., TDFs) versus building asset allocation programs on their own.
- These asset classes do not offer any significant diversification benefits (reducing risk while increasing return).
One major shortcoming with blended funds such as the S&P 500 is that they limit the asset allocator’s ability to finely tune the asset allocation mix and manage it over time. It also diminishes the positive impact of periodic fund rebalancing within blended categories.
The concern that such funds are too risky to offer on a standalone basis is often overblown. One asset class that one consistently hears about as being “too aggressive” to offer to DC Investors is emerging markets. EM has been the best long-term performing asset class since MSCI introduced the first comprehensive EM index in 1988, making it an important asset class to include in any investment lineup. Proper diversification will significantly reduce the volatility of EM experienced at the portfolio level. Additionally, EM exposure can be constrained by placing a limit on the amount that DC investors are allowed to invest in this asset class, as well as other asset classes that are important diversifiers but create concern when offered as a standalone option.
The argument that DC investors should be invested in asset allocation programs (e.g., TDFs) as opposed to building their own programs rings true for close to 80% of DC investors. However, if a plan sponsor offers a core menu of funds representing individual asset classes, then the most important asset classes should all be included for those participants who choose to manage (or outsource to a managed account service) their own asset allocation models.
Finally, determining the benefits of diversification is a straightforward process. Historical returns of each major asset class are regressed over time (i.e., via regression analysis) in order to model the past behavior of different constructs and the impact on investor outcomes. In the case of small-cap value, emerging markets and REITs, such an analysis will demonstrate the value of adding these asset classes in terms of lowering volatility while increasing returns. Despite this, however, these same funds seem to be missing from the majority of the 401(k) plans offered in the top 100 companies.