NEW YORK (FMD Capital Management) -- Often I am asked by clients what the best options are to choose in their 401(k) when they are limited to a small subset of mutual funds.
They want to participate in a similar investment strategy as the exchange-traded funds that we have selected for them, but don't want to be saddled with the high fees and limited transparency that traditional mutual funds impose.
The bad news is that you don't have a choice. You are going to have to deal with the restrictions that your 401(k) provider has chosen as part of their guidelines.
The good news is that you can still implement a similar asset allocation strategy and steer your portfolio towards areas that mimic low-cost ETFs. Even though a 401(k) is more restrictive, it is still a vastly better retirement savings vehicle than a taxable account.
The first step towards positioning your employer-sponsored retirement account for success is determining what your asset allocation will look like. Everyone will likely have a different split between equities and bonds based on their risk tolerance, time horizon and a host of other factors.
My only recommendation in this area is to strategize on a longer timeline than you would a more liquid investment account. People often think that they can time the market with their 401(k) and are surprised to find that the number of trades in a year is limited or the funds may impose penalties for short-term redemptions. You want to be conscious of your penalty fees and trading restrictions.
Once you have your asset allocation targets, you should screen the list of available funds for passive index strategies. Often times these will have similar names to major stock indices such as: S&P 500, Midcap 400, Russell 2000, or International EAFE index. These funds are going to be excellent core holdings that will most likely have the fewest limitations and lowest management fees when compared to their actively managed peers. You will also be able to find out exactly what the underlying stocks are because they are based on well-established indexes that don't change frequently.
Actively managed equity mutual funds are often loaded with higher fees and only report their underlying holdings on a quarterly basis. In addition, it has been proven in many studies that the majority of actively managed funds are not able to successfully beat their benchmark index. This is one of the reasons why so many people have flocked to passive ETFs in the first place.
For the fixed-income side of your portfolio you may actually benefit by choosing an actively managed holding such as the Pimco Total Return Fund (PTTRX) - Get Report. Many fixed-income managers such as Pimco have been able to successfully beat their benchmarks over the last decade by strategically allocating to sectors that offer superior returns. In the event that the quality of your fixed-income selections is poor or fees are too high, it may make sense to turn to an index fund as a suitable alternative.
When you come to the crossroads of not being able to substitute an area of the market where you want exposure because you don't have a suitable candidate in your 401(k) menu, consider making some compromises. You may have to adjust your asset allocation to increase exposure to stocks or bonds that you normally wouldn't own in your other investment accounts. However, that can sometimes lead to better diversification and enhance your returns in other areas.
The Bottom Line
My preference is to use ETFs whenever possible to increase trading flexibility, lower fees and enhance transparency. However, there are going to be situations where they just aren't offered or a better alternative presents itself. In that instance, you need to be prepared with a game plan to select the best fund to meet your needs.
You should also review your 401(k) at least quarterly to ensure that it is performing in line with your expectations and consider making changes when opportunities present themselves. The end game is to have a large nest egg when you are ready to retire that you can roll over into an IRA and manage with as few restrictions as possible.
At the time of publication the author had no position in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.