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Index Funds May Gain Edge in 401(k) Plans

Lawmakers are discussing a proposal to force 401(k) providers to offer index funds.

BOSTON (TheStreet) -- It's the investment world's version of the Hatfields and McCoys -- perhaps better described as the Vanguard versus the Fidelity clan.

Sticking with passively managed index funds (Vanguard) or actively managed mutual funds (Fidelity) has been a decades-long debate among financial advisers. (Vanguard and Fidelity offer a mix of both.) The arguments are likely to intensify in the coming months.

Congress and the Department of Labor are considering regulations that would limit how brokers offer advice to 401(k) plans. Intended to rein in conflicts of interest, the law could also shift some fund strategies into legally prudent passivity. There's also discussion in Washington on requiring 401(k) plans to include at least one index fund in investment lineups. Currently, 90% of defined-contribution assets in mutual funds are actively managed.

Proponents of those moves cite the fact that very few actively managed funds beat their correlating indices over the long term. In any given year, only about 50% beat an index. These funds have lower fees, less risk and more stability, they say.

Don Humphreys, president of New Jersey-based Voyager Wealth Management, is on the side of passive proponents, especially when it comes to retirement plans.

"The 401(k) is meant to be a long-term investment vehicle," he says. "Most of the studies and academic research clearly show that over time, you are better off in a passively managed portfolio with lower fees."

Some funds may be worth the higher fees they command, says Cameron Short, senior vice president for the wealth-management division of Stifel Nicolaus.

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"You can do due diligence and go out there and find the managers" that beat benchmarks, he says. "It doesn't always mean the manager is always going to outpace the index in up markets, but if I can get what the index can supply to me with a little less risk over time, that is an important part of my decision making."

Short says funds that focus on small or mid-cap companies have an easier time beating indices. It's more difficult for managers to outperform the

S&P 500 Index


He also points out a danger inherent to index funds: bubbles. Active-fund managers can potentially avoid bubbles, as they have choices on allocating money. Index managers don't.

Short sees the ongoing debate as becoming less clear-cut as more investment options take on a hybrid character.

-- Reported by Joe Mont in Boston.