Clients often ask me what they should choose in their 401k when they are limited to a small subset of mutual funds. They often want to participate in an investment strategy similar to the ETFs we have selected for them, but they don’t want to be saddled with the high fees and limited transparency you can get through traditional mutual funds.
But I’ve got some good news and bad news for you.
The bad news is that you don’t have a choice — for now, you have to deal with the restrictions that your 401k provider has chosen as part of their guidelines.
The good news is that you can still implement a similar asset allocation strategy and steer your portfolio toward areas that mimic low-cost ETFs. Even though a 401k is more restrictive, it is still a vastly better retirement savings vehicle than a taxable account.
401k Mutual Funds: Form Your Strategy
The first step toward positioning your employer-sponsored retirement account for success is determining what your asset allocation will look like. Everyone typically has their own split between equities and bonds based on risk tolerance, time horizon and a host of other factors.
My only recommendation in this area is to invest with a longer timeline in mind than you would with a more liquid investment account. People often think that they can time the market with their 401k, but are surprised to find that the number of trades in a year is limited or the funds may impose penalties for short-term redemptions. In short, always know what kinds of penalty fees and trading restrictions you could face.
Once you have your asset allocation targets, you should screen the list of available funds for passive index strategies. Often times these will have similar names to major stock indices such as the S&P 500, S&P Midcap 400, Russell 2000 or MSCI EAFE (international) index. These funds will be excellent core holdings that most likely will have the fewest limitations and lowest management fees when compared to their actively managed peers.
You also can find out exactly what the underlying stocks are because they’re based on well-established indexes that don’t change frequently. Actively managed equity mutual funds often are loaded with higher fees and only report their underlying holdings on a quarterly basis.
In addition, it has been proven in many studies that the majority of actively managed funds are not able to successfully beat their benchmark index — one reason why investors began a mass exodus to passive ETFs to begin with.
For the fixed-income side of your portfolio, you might actually benefit by choosing an actively managed holding such as the PIMCO Total Return Fund (PTTAX). Many fixed-income managers such as PIMCO have been able to successfully beat their benchmarks over the last decade by strategically allocating to sectors that offer superior returns. But in the event that the quality of your fixed-income selections is poor or fees are too high, it might make sense to turn to an index fund as a suitable alternative.
When you find yourself unable to substitute an area of the market in which you want exposure because your 401k menu isn’t up to par, consider compromising. You might have to adjust your asset allocation to increase exposure to stocks or bonds that you normally wouldn’t own in your other investment accounts. However, that can sometimes lead to better diversification and enhance your returns in other areas.
The Bottom Line
My preference is to use ETFs whenever possible to increase trading flexibility, lower fees and enhance transparency. However, sometimes they aren’t offered (such as in 401ks), and occasionally a better alternative to a mutual fund simply doesn’t exist.
Also, review your 401k at least quarterly to ensure that it is performing in line with your expectations and consider making changes when opportunities present themselves. The end game is to have a large nest egg when you are ready to retire that you can roll over into an IRA and manage with as few restrictions as possible.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. Want to learn more about ETF investing? Visit our special report section with a variety of detailed strategies to get you on the right track.
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