Tuesday, March 15, 2005

Dow Jones 401(k) Plan

Timothy Middleton provided a review of the Dow Jones 401(k) Plan on MSN. For 401K plan sponsors this provides some valuable insight into one of Fidelity's large cases.

The major issue I see with this plan is the exclusive use of Fidelity actively managed funds. This is always a sign that the sponsor could be more engaged and could be leaving some value on the table. In addition, one primary lesson that should have been learned over the last few years is to diversify by manager in case of past or present indiscretions. It is probably not surprising to find that many vendors with proprietary funds serve up the “dogs” of the industry in their ‘alliance programs”. The worse they look the better the vendor’s funds look. Fidelity has a limited menu of alliance alternatives in the smaller market but at this plan size virtually any other outside fund should be available to the Plan. There should be better or at least very different alternatives in some of the larger categories like Large Cap Value or Growth. While Fidelity has some top choices in certain asset classes and styles (i.e. Fidelity Diversified International), they don’t offer outstanding active management or diversifying alternatives in all areas.

Some of Fidelity’s best actively managed funds are not in the lineup. If you are going to pay for active management and stay with Fidelity funds …get their best! Fidelity Blue Chip and Equity Income, though they provide core exposures, are expensive index funds with very high correlations to their bench-marks as you noted. Where is Fidelity Low Priced, Capital Appreciation or Contrafund? These funds at least offer some hope of paying their way and adding some extra value in the end.

Since hard dollar administrative fees can’t go below zero, the more proprietary and actively managed funds in a lineup, the more participants will be padding Fidelity’s bottom line. Economic leverage in the asset management business is huge. It costs virtually nothing to add a marginal dollar to an existing portfolio strategy. This lineup looks like it could be a financial bust or bonanza for Fidelity depending on how participants use the funds. A typical diversified 60% equity all indexed portfolio would cost about .25% in this Plan while an estimate for an all actively managed portfolio using the same asset allocation would be more like .66%. Let’s say a provider like Fidelity could do quite well by providing services to a $1billion dollar plan for .20% ($1,732,000), that leaves anywhere from $433,000 to almost $4,000,000 left over depending on the funds utilized.

Despite some of these deficiencies, the DJ Plan looks superior in some important respects to many Plans I see.

The DJ plan has very good index coverage of the core capital markets – This alone should help Plan investors avoid lots of unnecessary expense and allow them to build a good core portfolio. Many plans and providers either don’t provide indexation alternatives at all or only provide an S&P 500 index. In my opinion, the availability of index alternatives in US Equity/Int’l Equity/Bonds is far more valuable than having additional marginal asset classes like high yield and emerging markets available. Institutional investors wouldn’t strategically allocate more than 10-15% of a total portfolio to these asset classes while the remaining 85% of the portfolio could be positively impacted by index exposure. The issue here lies with the participants. They should be heavily indexing given many of the actively managed Fidelity proprietary funds.

Uninvolved participants can get diversified portfolio coverage in either active or index flavors with the alternatives provided in the Plan. While I am not a big fan of the Freedom funds I do acknowledge that the asset allocation value of these funds probably out-weight any negative product characteristics when the alternative for many uninvolved investors is to let their balances sit in money market funds or worse.

The 401K industry needs major revamping to allow participants better access. I think the cost bundling paradigm is one of the largest obstacles to more rational Plan management. Plan sponsors and participants alike should demand that administrative and recordkeeping expenses be unbundled from investment expenses. This would take some of the economic incentive out of pushing active management to subsidize plan costs. It would also create more robust competition by making the market easier to understand and negotiate in for plan sponsors.

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