Once we begin believing performance laggardsare “inappropriate investment choices,” we step onto the slipperyslope of never-ending investment cycles. (Photo:Shutterstock)

The great thing about being a reporter on a regular beat meansbuilding strong relationships with insiders and thought leaders.Not only is it intellectually stimulating, but readers enjoydiscovering what's behind the curtain.

I had a chance to peek behind that curtain last week (see“Exclusive Interview: Blaine Aikin says DOLFiduciary Rule's 'Lasting Impact Lives On',” FiduciaryNews.com,April 30, 2019). When I asked Aikin about the greatest litigationrisk facing 401(k) plan sponsors and fiduciaries right now, hementioned some of the research he was doing. (He'll be issuing awhite paper on it soon. I look forward to reading it.)

Among the studies he cited was a May 2018 paper from the Centerfor Retirement Research at Boston College entitled “401(k)Lawsuits: What are the Causes and Consequences?”.

That got me thinking.

The paper, by George S. Mellman and Geoffrey T. Sanzenbacher,named “inappropriate investment choices” as one of the three majorareas fiduciary lawsuits fall into. Lest you think “inappropriate”refers to “excessive fees” or “self-dealing,” it doesn't.Those were the other two major areas mentioned by Messrs. Mellmanand Sanzenbacher.

So, if “inappropriate” doesn't mean high fees or conflicts ofinterest, that leaves only one other interpretation: performance.

Ouch!

That's one greasy oinker to catch.

As the CRR study points out, the DOL (and the SEC, for thatmatter), never use results (i.e., performance) as a litmus test.Rather, regulators focus on the process. If the selection processis diligent, deliberate, and documented, regulators will generallybe satisfied.

Of course, plan sponsors and fiduciaries aren't worried aboutregulators. They fear the tort bar. And when you're a big fat juicy$5+ trillion target, there's justification in that anxiety.

Why? The DOL trusts the process may be forgiving when it comesto poor performance. Plan participants generally only complainbecause of poor performance. And when enough plan participantscomplain, the trial attorneys come calling (or is it the other wayaround?).

In either case, for every action there's an equal and oppositereaction. Mellman and Sanzenbacher write “Passive investments –assuming they are reasonably managed and priced – do not pose arisk of significantly underperforming other index funds onperformance and fee benchmarks.”

Umm… last I checked, they were the performance benchmark. Notthat that means they represent an appropriate benchmark.

See how this game is played? It's the ol' “one man's treasure isanother man's garbage” thing.

What is appropriate and what is inappropriate? And therein liesthe problem: What's appropriate today may be deemed inappropriatetomorrow. (Just ask Kate Smith.)

If Mellman and Sanzenbacher are correct, and plan sponsors seekto replace “inappropriate” funds with index funds, what happenswhen we experience a decade similar to the 2000s, when the majorindices (and presumably their associated index funds) laggedactively managed funds? In such a circumstance, a preponderance ofdata would suggest passive investments are not appropriate giventhe market and economic conditions then existing.

Markets go in cycles. Investment styles go in cycles. Once webegin believing performance laggards are “inappropriate investmentchoices,” we step onto the slippery slope of the vicious circle ofnever-ending investment cycles.

Is your head spinning yet?

Welcome to life behind the curtain.

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