by: Bruce Shutan
from:  Employee Benefit News
August 1999

Holding some of the best performing blue-chip offerings that 401(k) money can buy may seem like a slam-dunk move, but it could spell doom on diversification.

Just ask Roxanne Fleszar, the principal of Financial Resources Management Corp., a registered investment advisory firm in Peabody, Mass.

After reviewing the holdings of equity offerings from three top mutual fund 401(k) providers, she uncovered results that "were at times both surprising and unnerving."  In a nutshell: blatant securities overlap involving many of the usual suspects - from Microsoft on down to Philip Morris.

Without naming vendor names, her intention isn't to "besmirch any reputations" but rather "alert both employers and employees to an unknown variable in their portfolios."

During nearly 16 years of work on 401(k) and profit-sharing plans, Fleszar noticed that many plan sponsors were repeating the practice of choosing only one fund family.

One explanation was that allowing participants access to outside funds came at a price:   higher recordkeeping or management fees that, in many cases, would be passed along to participants.

She finally decided to research the issue last fall as part of a review of 11 requests for a proposal for a particular client.  The analysis confirmed what she suspected all along.

One service provider held General Electric as a top five holding in 12 of 15 reviewed funds, while Microsoft and Merck & Company appeared in the top 10 holdings of 10 and nine of the 15 funds, respectively.

That meant participants who selected among the plan's nine investment options, only one of which was outside the provider's fund family, would encounter an overlap as high as six stocks in the top 10 holdings, depending upon their choices.

Another provider she examined fared slightly better, though the fund family was partial to Microsoft, which appeared in the top 10 holdings of seven of the firm's 11 most popular equity choices.  Runners-up for this category were BMC Software and Computer Associates International, appearing in the top 10 holdings of six and five of the 11 funds, respectively.

The third vendor proved to be another big offender, holding both Exxon and Philip Morris Companies in the top five holdings of four of its six equity offerings.

Noting that plan sponsors have a fiduciary responsibility to carefully select - as well as monitor - funds, Fleszar calls the potential for securities overlap "a major issue.  This kind of stuff goes on all the time.  But what people don't do is connect the dots."

Employers simply cannot overlook their mission to "provide employees with the necessary base from which to create an effective retirement portfolio," she says.

With more plans increasing investment options in an effort to boost participation, Fleszar suggests that sponsors carefully choose investments that will offer their employees "true" diversification.

Offering four large cap growth funds will only serve to confuse participants, she says.   "If your mid-cap blend option suddenly becomes a large cap value, seek to replace it.  Also beware of  mutual funds that hold a major share of your company stock if this is also a plan option."

Emphasizing categories instead of fund names will help participants focus on the type of investment that's best for their portfolio and decrease confusion if a specific fund is performing poorly and needs to be changed, according to Fleszar.

A good rule of thumb, she says, is for plans to offer up to a dozen investment options, including three managed funds, a stable fund, bond fund and series of equity funds ranging from domestic to international, small capitalization to large capitalization.  Her point:  Responsibly limiting plan options to a diverse group of investments will greatly help employees choose the right retirement allocation mix.

"If you hire a bundled provider and don't do your homework and get beyond the names of the funds, then you run the risk of picking funds that have a lot of similarities," adds Jeff Van Orden of Milliman & Robertson.  "If a fund family if principally on the equity side, them you're much more likely to allow this to happen."

'The most important  factor that divides the offerings in a 401(k) plan is the asset allocation in each fund:  Is it a bond fund, stock fund, balanced fund or international fund versus growth fund, aggressive growth fund and income fund?"

Van Orden also notes that mixing international and domestic securities would minimize the number of funds held in common.