Practical Applications of How Long Is Long Enough?

Abstract

In How Long Is Long Enough? from the Fall 2020 issue of The Journal of Retirement, authors Gerald W. Buetow (of BFRC Services) and Bernd Hanke (of Global Systematic Investors) introduce an easy-to-use system to help defined-contribution plan (DCP) fiduciaries decide when to replace underperforming actively managed mutual funds. Many active funds underperform their benchmark indexes, especially net of fees. This raises two questions: How long should fiduciaries wait to replace an underperforming fund, and should they replace it with another active fund or a lower-cost passive fund?

Buetow and Hanke examine historical performance data to calculate the differences between two investment strategies: one that keeps all assets in active funds, and another that switches assets from underperforming active funds to passive funds. They find that switching to passive funds after three years of underperformance generates higher long-term returns than leaving assets in active funds, waiting five years to make the switch, or switching only if underperformance is statistically significant (5% or more). Therefore, the authors say, DCP fiduciaries can better serve plan participants by monitoring active funds and replacing underperformers with passive funds in a timely manner.