The Capital Advantage℠ Participant Case Study
Screening for the Right Core Retirement Plan Lineup
Financial professionals generally agree that when choosing core investments for a retirement plan, it’s important to look for funds sharing certain qualities. These could include lower expense ratios, lower portfolio turnover, higher manager tenure, higher firm-level manager ownership and long-term manager incentive programs.
Although past results aren’t predictive of results in future periods, our research indicates that funds sharing the following two characteristics tended to outpace market indexes:
- Lower expenses
- High firm-level manager ownership
Furthermore, while it may well be true that the “average” investment manager can’t beat the indexes, it stands to reason that not all managers are “average.” In fact, as our research also proves, some equity investment managers — American Funds among them — have distinguished themselves by a proven record of consistently outpacing broad market returns.
As this case study will demonstrate, selecting the right equity funds for a retirement plan “core” lineup can, over the long term, help participants pursue their long-term investment objectives.
“Asset managers with better stewardship practices reward investors with better results.”
— 2015 Morningstar U.S. Mutual Fund Industry Stewardship Survey
Low Cost, High Ownership Has Led to Better Results
Since a majority of assets typically go to plan core funds, it only makes sense that selection of the core funds — typically comprising U.S. and international large-cap equity funds — should be based on prudent quantitative and qualitative criteria.
To test different approaches to core investment selection (see chart below), we considered three hypothetical portfolios:
Portfolio 1: Index Portfolio
Portfolio 2: Select Equity Core
An equal mix of all actively managed mutual funds in both the lowest cost and highest firm-level ownership quartiles
Portfolio 3: Select American Funds Core
Seven equally weighted U.S.-focused American Funds for half the portfolio, and two equally weighted international-focused American Funds for the other half of the portfolio, all of which are also found in the Select Equity Core funds (low-cost and high-ownership quartiles):
- U.S.-focused American Funds:
A select equity core would have made a meaningful difference
“[American Funds] very visibly accomplishes what index-fund proponents claim cannot be done: outperform year after year, decade after decade.”
— Morningstar, January 2014
The Potential for Greater Accumulation and Income
Accumulation Phase: Ages 45–65
To illustrate our research, consider a hypothetical employee who, at age 45, rolls over $85,0001 into a new employer’s plan and then invests $500 each month for the 20 years ended December 31, 2016, in each of the three portfolios, as described on the previous page.
As the chart below illustrates:
- Both actively managed portfolios (Select Equity Core and Select American Funds Core) would have accumulated more than the Index portfolio over this 20-year period.
- The Select American Funds Core portfolio would have accumulated 14% more than the Select Equity Core and 25% more than the Index portfolio.
Participant accumulation phase Portfolio growth from January 1, 1997 through December 31, 2016
Participants who invested in the select equity portfolios could have retired earlier or benefited from greater accumulation.
Retirement Income Phase: Ages 65–85
Let’s also assume that this same hypothetical participant retires at age 65 and elects to take an annual withdrawal of 5% in the first year and increases that resulting distribution by 3% annually, as a cost-of-living adjustment, in each of the subsequent 19 years through December 31, 2016.2
- To compare the results of each portfolio, we started with the ending accumulation balances from the accumulation phase chart on the previous page.
- As the chart below demonstrates, the Select Equity and Select American Funds core portfolios would have delivered more retirement income than the Index portfolio.
- By 2016, the annual withdrawal from the Select American Funds Core would have risen to $56,019. This portfolio would have distributed $6,681 more than the Select Equity Core and $11,119 more than the Index portfolio in 2016.
- This translates into a substantial difference over 20 years. Cumulative withdrawals from the Select American Funds Core would have exceeded $858,000, as compared to the $688,035 from the Index portfolio.
Participant retirement income phase Annual withdrawals in Year 1 (1997) vs. Year 20 (2016)
After 20 Years of Withdrawals, Account Continued to Grow
Although past results aren’t predictive of results in future periods, the chart below illustrates what would have been left in each portfolio after 20 years of withdrawals.
The Select American Funds Core portfolio would have $1.2 million left — 60% more than in the Select Equity Core portfolio and more than twice than in the Index portfolio.
At this point, the retiree could continue making the scheduled withdrawals for the rest of his/her life and, beyond that, leave a legacy for beneficiaries. If withdrawals had not been taken, the Select American Funds Core account value would have been over $2.9 million.
Participant account remainder What’s left in the account after 20 years of withdrawals. Balance remaining in account on January 1, 2017
For more information about how to put American Funds and our retirement plan solutions and services to work, call (800) 421-9900.
Assumes all dividends were reinvested.
Compiling the fund universe
The database built to represent the universe of both large-cap domestic and large-cap foreign funds drew from Morningstar’s U.S. Open-End Large Value, Large Blend and Large Growth U.S. and Foreign categories, with live and dead funds combined to eliminate survivorship bias. For live funds, only the oldest share class was used. For dead funds with multiple share classes, the median monthly returns were used. This screening resulted in seven qualifying domestic American Funds (AMCAP Fund, The Growth Fund of America, The New Economy Fund, American Mutual Fund, Fundamental Investors, The Investment Company of America and Washington Mutual Investors Fund) and two qualifying foreign American Funds (EuroPacific Growth Fund and International Growth and Income Fund). Funds are identified as domestic or foreign based on Morningstar categories. A number of the U.S.-focused American Funds can invest some assets in non-U.S. securities; likewise, the two foreign-focused American Funds can invest some assets in U.S.-issued securities.
Tracking least expensive quartile and highest manager ownership quartile
In conducting our research, we searched Morningstar’s database for large-cap actively managed funds that were in both the lowest quartile ranked by expense ratio and the highest quartile ranked by manager ownership at the firm level. For this analysis we relied on Morningstar Direct data analysis software. Least expensive quartile was calculated using annual report Net Expense Ratio (NER) for all observed Morningstar categories for the 20-year period indicated. For funds with missing expense ratios, gaps between two available data points were filled in using linear interpolation. Highest manager ownership quartile was calculated using weighted averages of Morningstar screens of manager holdings at the firm level. Each fund was assigned the weighted average of its firm manager holding. Funds without values were excluded from the quartile rankings. The combination of least expensive NER and highest manager ownership quartiles (the select equity core) was the result of a cross-section of the two screens. Only those funds with both the lowest expense ratios and the highest manager ownership were included. Investors who wish to identify funds that ranked in the least expensive quartile by NER can rely on the following rule of thumb: The least expensive quartile of funds ranked by net expense ratio for Class A shares roughly corresponded with those reporting expenses below 0.98% for large-cap domestic funds and below 1.08% for large-cap foreign funds. Expense ratios for institutional and advisory share classes would be approximately 25 basis points lower, or below 0.73% for large-cap domestic funds and below 0.83% for large-cap foreign funds. Investors who wish to identify funds that ranked in the top quartile by manager ownership can rely on the following rule of thumb: The top quartile of funds ranked by manager ownership roughly corresponded with firms that had 55% or more assets in the fund family complex in which at least one fund manager had invested a minimum of $1 million. The Securities and Exchange Commission requires that mutual funds disclose all fees and expenses in a standardized table published in the front portion of the fund prospectus. The SEC also requires that a fund disclose in its statements of additional information (SAI) certain information about its portfolio managers, including ownership of securities in the fund. Ownership disclosure is made using the following seven ranges: none; $1 to $10,000; $10,001 to $50,000; $50,001 to $100,000; $100,001 to $500,000; $500,001 to $1 million; and over $1 million.
Morningstar tracks manager ownership as a percentage of assets at the firm level. This information can be found using Morningstar Direct software, which can be downloaded by visiting global.morningstar.com/direct and clicking “Download Morningstar Direct.” Advisors seeking to incorporate manager ownership as part of their fund screening criteria can take the following steps using Morningstar Direct. Start by creating a new open-end fund advanced search and defining a universe. For example, for the broad large-cap domestic fund universe, select U.S., then Large Value, Large Blend and Large Growth; to avoid duplication, screen for the oldest share class available. With the universe selected, the snapshot page will show a set of default screens, including “Annual Report Net Expense Ratio.” It is necessary to manually add a field for manager ownership. Under Available Data Points, select “Firm % Assets Manager Investment Over $1 million.” This selection will allow you to sort the chosen fund universe by both the expense ratio and manager ownership fields. Due to the dynamic nature of the Morningstar database, results for the Morningstar Large US and International universes may change.
Working with indexes
Market indexes referenced in this brochure are defined as follows:
- MSCI All Country World ex USA Index is a free float-adjusted market capitalization-weighted index that is designed to measure results of more than 40 developed and emerging equity markets, excluding the United States. Results reflect dividends gross of withholding taxes through December 31, 2000, and dividends net of withholding taxes thereafter.
- Standard & Poor’s 500 Composite Index is a market capitalization-weighted index based on the average weighted results of 500 widely held common stocks.
The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. There have been periods when funds have lagged the index. Past results are not predictive of results in future periods.
Alpha is a measure of the difference between a portfolio’s actual returns and its expected results, given its level of risk as measured by beta. A positive alpha figure indicates the portfolio has generated better results than its beta would predict. In contrast, a negative alpha indicates the portfolio has lagged, given the expectations established by beta.
Capture ratio reflects the annualized product of fund versus index returns for all months in which the index had a positive return (upside capture) or negative return (downside capture).
Standard deviation (annualized, based on monthly returns) is a common measure of absolute volatility that tells how returns over time have varied from the mean. A lower number signifies lower volatility.