Can Advisors Add Value Through Fund Selection?

Low-cost index funds will beat the average actively managed fund after expenses. But can advisors identify superior active funds to overcome this disadvantage?

Advisors who believe they can choose those funds will be challenged by the results of two studies from the defined-contribution industry.

Comparing advisors to plan sponsors

Unfortunately, there are no comprehensive performance studies of funds chosen by advisors. But there are studies that examine choices for 401(k) plans. With defined-contribution plans, like 401(k)s, the plan sponsor decides which funds to offer to participants. Such funds typically span a range of fixed-income and equity offerings and may also include alternative asset classes.

Plan sponsors may assign this selection responsibility to a single individual, use an internal committee or rely on outside consultants. Many advisors face similar decisions in choosing, and periodically updating, the stable of funds to recommend to clients. Similar to plan sponsors, advisory firms may rely on individuals, committees or outside consultants.

Although there are certainly differences between plan sponsors and advisors, there are enough similarities in the processes they use and the skills they possess that plan sponsor results give an indication of how advisors fare with fund selection.

The Elton, Gruber and Blake study

I'll discuss two studies carried out in different timeframes. The first is the Elton, Gruber and Blake (EGB) study based on 1994-1999 data. Their study, which was published in 2007, received recent recognition in a January 2013 briefpublished by the Center for Retirement Research at Boston College.

These researchers examined the month-by-month performance of 43 separate 401(k) plans and compared risk-adjusted returns for each plan against two separate measures: a passive portfolio of indexes and a random selection of similar funds. To compare, the researchers calculated the contribution to overall return from systematic market factors (such as large-capitalization or small-capitalization index performance), which they called beta. Alpha represented the positive or negative value added by investment management skills like security selection and market timing. In the second comparison to similar funds, the researchers calculated a differential alpha equal to the alpha for the selected funds minus the alpha for the similar non-selected funds.

This study showed that the average differential alpha for the 43 plans was 0.52% per year — plan sponsors selecting funds for the 401(k) plans were able to add value, on average, compared to random fund selection. Additional analysis showed that average fees in the funds selected by plan sponsors were 0.23% per year lower than in the random set of funds. Plan sponsors offered roughly equal value in their ability to choose funds with lower expenses and choose managers who performed better.