5 Star Euphoria

When you look at investment options inside of a 401(k) plan you almost always find options that have received 5 stars and have an excellent performance history. Sounds great right? It would be if the plan participants actually had been able to participate in these returns, but here is what happens in reality:

The “dog” fund underperforms its benchmark and plan fiduciaries add it to a watch list. The “dog” fund continues to underperform meanwhile the “rocket” fund has outperformed on a 3, 5, and 10 year basis and has excellent risk-adjusted returns. The plan fiduciaries replace the “dog” fund with the “rocket” fund and map assets to the new fund. Over the next three years the “rocket” fund underperforms and the process repeats…

Not only do participants fail to participate in the exceptional returns of the plan’s investment choices, but quite often they select their investments and base contribution amounts on past performance. Why is this a problem? Study after study shows that past performance does not predict future performance.

Dimensional Fund Advisors tracked US Mutual Funds based on 5 year performance and separated them into quartiles. Of the funds that were in the top 25% based on relative performance to their benchmark in 2002-2006 only 8% of those funds stayed in the top quartile from 2007-2011. Only 10% were in the second quartile, 21% in the third, 46% in the bottom quartile, and 15% of the top performers didn’t even survive. See graphic below.

Source: CRSP Survivor-Bias-Free US Mutual Fund Database

The left column represents US equity funds in the CRSP Mutual Fund Database with a complete return history for 2002-2006. The funds are sorted by performance relative to their benchmarks. Funds in the top quartile are then tracked and directed to their subsequent performance qualities in the following 5-year period (2007-2011), or to the “Did Not Survive” category. Quartiles in the following period reflect all funds with a complete retun history. Percentages may not total 100% due to rounding.

The root of the problem is that trying to pick investment options based on manager selection, past performance, alpha, beta, Treynor Ratio, Sharpe Ratio, and standard deviation doesn’t work because they are all based in the past.

At Financial Plan, Inc. we help participants capture market returns through selection criteria that are within our control such as:

Our mission is to give plan participants the best chance for success by reducing participant costs, educating participants how to select a diversified investment portfolio, and maintain a disciplined investment strategy based on their goals.