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A passive portfolio management approach is appropriate for many 401k plan participants. But indexing isn’t right for everyone. Many 401k plan investors are not satisfied with market average returns. Nor do they feel it makes sense to lock-in 100% of every market decline. Many 401k plan participants believe they can consistently outperform market averages by applying a little of the right knowledge. Think there is no point to active management? Consider the following to make active management work in your 401k plan account:

Eliminate closet indexers

Purge them from your 401k account. They never significantly beat their benchmarks and give active management a bad name. This is where excess cost resides in your 401k. How do you identify a closet index fund? Generally, the higher a mutual fund’s correlation to its index, or R-squared, the more likely it is a closet indexer. Perfect correlation is defined at 100% or 1.0. Look to invest in actively managed funds that have correlations less than 90%.

Index efficient asset classes

Invest in index funds in those asset classes that are efficient — where it is hard for a mutual fund manager to significantly and consistently beat the benchmark. A nice listing of efficient and inefficient asset classes may be found here.

Active management for inefficient asset classes

Inefficient asset classes are those in which a skillful fund manager can generate positive alpha (excess returns above the benchmark) by identifying some criteria that the market is not efficiently pricing into the asset class or stock. Examples of these asset classes, where the returns of mutual fund managers can vary significantly, include small and mid-cap U.S. equities. Check this link to identify those asset classes which tend to be inefficient.

Defense is good

Consider that some active managers are really good defenders of your investment. They may not outperform significantly in up markets but may fall much less than market indexes in down markets. Choose to invest in actively managed mutual funds that have down market capture rates less than 100%.

Full market cycle

A major reason many investors abandon active management is they feel every actively managed fund should beat its benchmark every quarter. This is unrealistic. Review the performance of all your 401k mutual funds over a full market cycle, which generally lasts four to five years. How? Obtain the tickers for the funds you are interested in and input them into the Morningstar website to find out all of the information outlined above, and much more.

Use active management to allocate

Most investor’s portfolios will benefit from a blend of active and passive management. Talk with the investment adviser that works with your 401k plan. He/she can help you measure your risk tolerance so that you can allocate correctly between fixed income securities and equities. Use your risk tolerance level (aggressive, moderate, conservative) along with your age to generate appropriate allocations in your 401k account.

It is unlikely that the next five years in the equity markets will be anything similar to the last five, bull market years. The risk-on, risk-off market conditions we experienced for a number of years immediately after the crash favored an indexed approach. When all risk assets are highly correlated it is hard for active managers to distinguish themselves. Remember when investing we are always fighting the last war — looking back at what has done well, rather than what might work in the future. Will market conditions be as favorable to indexing in the near future? Probably not.

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About the Author

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple Inc., AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Car Company, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or bob@lawtonrpc.com.

About Lawton Retirement Plan Consultants, LLC

Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com or visit the firm’s website at: http://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.