Are 401(k) participants putting their money into the best funds? Probably not, says Mike Alfred, CEO of BrightScope, a data firm that tracks 401(k) plans.
After analyzing 50,000 retirement plans, Brightscope identified the 10 most popular funds chosen by participants.
The list includes giant funds, such as
American Funds Growth Fund of America
, which has $151 billion in assets,
, $68 billion, and
Dodge & Cox Stock
, $40 billion.
These funds gained wide followings because they delivered solid performance but Alfred says the success may not last. "When funds become big, it is difficult for them to continue outperforming," he said.
All too often, growing funds follow a disappointing pattern. In a typical scenario, a fledgling fund starts by delivering strong performance that attracts a big inflow of assets as investors discover the hot manager.
As the fund expands, the portfolio manager must work harder to employ the assets. Instead of just taking a limited number of attractive stocks, the manager may be forced to sop up cash by buying some less appealing shares.
With more assets in the fund, trading becomes more difficult and expensive. A manager who wants to buy $1 million worth of shares in
may complete the trade in seconds.
By contrast, Fidelity Contrafund, which owns $1.6 billion worth of McDonald's, faces a monumental task. Buying billions of dollars worth of shares can take weeks or months. When the manager buys so much, the trading is likely to push up the share prices, making the transactions more expensive. All that drags down returns, as the nimble star fund turns into an unwieldy also-ran.
Alfred would like to see the employers who sponsor 401(k) plans begin to select more small funds. But he said that isn't likely to happen any time soon.
To pick funds, employers typically hire consultants who favor winning funds from big companies. The employers select a menu of funds, and participants tend to gravitate to those with the best track records.
Lately some of the most popular 401(k) funds have shown signs of slowing down. After performing brilliantly in the early part of the decade, Dodge & Cox Stock has delivered uninspiring results in recent years. During the past three years, the fund has lost 10.3% annually, lagging the S&P 500 by 3 percentage points and trailing 79% of its large value peers, according to Morningstar.
American Funds Growth Fund of America has lost 6.7% annually for the past three years, lagging 57% of large growth funds.
While such results are troubling, proponents of the big funds argue that the situation is far from dire. None of the top 10 funds blew up during the credit crisis. That was not surprising because the top funds are run by big companies that work hard to avoid disaster with their 401(K) funds. Without exception, these popular funds are broadly diversified and take limited risks. Such cautious choices may not lead the pack, but they are unlikely to finish last either.
Besides being steady, the funds that perform well tend to charge modest fees. That helps to explain why the funds outperformed during their best days. These low fees should continue providing an important edge in the future.
Among the most popular funds, a few still make sensible choices. Consider
American Funds EuroPacific Growth
. Although the portfolio is large, the performance has not shown signs of slowing down. During the past three years, the fund lost 4.7% annually, outdoing 93% of its foreign large blend competitors. Because they can invest in markets around the world, the portfolio managers should be able to find enough top stocks to fill the portfolio. The expense ratio is 0.85%, compared to an average figure for the category of 1.51%.
Another safe selection is the
Fidelity Spartan 500 Index
, which tracks the
Because they simply mimic the benchmark, giant index funds deliver the same results as small ones. Fidelity only charges an expense ratio of 0.10%, one of the lowest fees available among 401(k) choices.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.