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Doug Meeks, Pier LLC (15 clicks)
Dividend growth investing, registered investment advisor, portfolio strategy
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The chances are that if you are reading this then you are unhappy with your current 401(k) plan. I want to look at a few reasons why these plans are not working for most people in this market.

Mutual funds make up the majority of all investments in 401(k) plans. According to a study by Deloitte in 2010, 92% of plan assets are held in mutual funds (Deloitte study can be seen here) and the median number of fund options in a 401(k) plan is sixteen. So let's take a look at what this bias to mutual funds means to plan participants.

What about the Fees?

Fees surrounding 401(k) plans have been a hot topic lately and they should be. Mutual funds, even today, are often structured to share fee revenue with record keepers and advisors. Record keepers and advisors have nothing to do with the investments in the fund and all fees collected by these two groups are basically overhead costs to the investors.

Read below a description of a "front load" fee assessed by one of the top three most popular mutual funds in all 401(k) plans, American Funds - Growth Fund of America (AGTHX). Keep in mind that this fee is added to the ongoing annual management fee of 0.68% charged by the fund. Article shown here from InvestPlan.

"Class A share mutual funds generally have a high front load or commission, and a lower ongoing management fee. For example, the American Funds Growth Fund of America Class A share (ticker AGTHX) has a 5.75% front load commission. For every $1,000 you put into this fund, you get $942.50 invested. That fee or commission represents the amount paid to the financial advisor and investment company for you to invest in the fund."

Why would a plan sponsor put front loaded fees in your plan?

These fees are paid to the advisor(s) that set up the 401k plan at the beginning. There is little doubt that the advisor's financial motivation is involved if you have class A shares. Please make sure you or your plan sponsor are avoiding these fees by not purchasing class A shares. Fees vary widely on the 12 classes of AGTHX shares.

Yes, you read that correctly, 12 classes of shares. That type of 'entry' diversity is very common in mutual funds. See American Funds web site here. All share types lead to the same investment vehicle these are just different ways to extract the fees from the clients.

Other Fees Apply: Companies also pay administration fees to start and maintain these plans, the assets are held in custody with limited access and no control over 'transfer' and fund 'dropping' fees. It's just a known fact that 401k plans can be expensive.

Fund Bloating

Mutual funds are bloated and not able to respond quickly enough to market conditions and news. According to Investment News, the most popular funds are oversized and not able to sell positions fast enough to get the best pricing. These over-sized funds, such as the before mentioned, Growth Fund of America (AGTHX) are among the largest and most popular holdings of all 401(k) plans. AGTHX has $116 billion in assets according to Morningstar.

A specific example of bloating would be the $2.6 billion of Home Depot (HD) stock in Growth Fund (AGTHX).

In order to sell this position, the fund would have to sell roughly five times the average daily volume of Home Depot stock. That type of sell order would push the stock price down in the open market. This severely limits the Growth Fund from being able to collect or even value all of the gains in their Home Depot Investment, especially in the case of some very bad news.

Most individual investors could simply add a limit order to the position and protect all the gains, you just can not do that with a position that is so much larger than the market average volume.

Over exposure to under performing assets

Again let's look at the very popular mutual fund, the Growth Fund of America (AGTHX). It yields a very disappointing 0.65% (details from Yahoo finance). It's too big and exposes its owners to too many low performing stocks. In support of this point please look at the following three charts.

Growth Fund of America (AGTHX) 10 year chart vs. its own top 5 holdings.

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Growth Fund of America (AGTHX) 5 year chart vs. its own top 5 holdings.

(click to enlarge)

Growth Fund of America (AGTHX) 3 year chart vs. its own top 5 holdings.

(click to enlarge)

Yes, the dark blue line, at the bottom, is the Growth Fund on all three charts. In all three time frames, the top five holdings have outperformed the fund. This is an example of over-diversity and bloat in a larger fund. The managers are unable to move fast enough or be focused enough to perform as well as the holdings that even their own analysts think are most important.

Re-investment, What re-investment?

Over exposure to underperformance is also costly to an investor in the loss of dividend re-investments. Dividends collected by these mutual funds are re-invested back into the entire fund (or distributed). The misapplication of this cash flow can be the highest fee of all.

Conclusions

This article had some focus on a single, very popular fund. However, I ran this same chart set for Vanguard Total Stock Market Fund (VTSMX) and State Street Global Advisors S&P 500 Index Fund (SVSPX). The results were very much the same.

In fact Apple (AAPL) is the largest holding in all three mutual funds mentioned in this article and Exxon (XOM) at the second position in the last two funds. An investor would be better served by owning Apple and Exxon stock directly.

Overall, this market is best left to actively managed portfolios of individual stocks. Your portfolio can have both income and growth with very few, if any fees. If you do not want to handle it yourself then the income from dividends can easily outpace the reasonable management fees charged by independent advisors.

If you have changed jobs or retired and find that you have 401(k) plans 'orphaned' in the market, then please get them transferred to an IRA and get focused on better returns for now and over the longer term.

Source: Why 401(K) Plans Don't Work In This Market