In designing a 401(k) lineup, empirical research favors passive index funds for core exposure, complemented by a few targeted active funds where managers have historically added value. Studies show that index funds generally outperform active peers in most asset classes (Morningstar, 2023)[1]. Meanwhile, certain market segments (international equity, fixed income, small-cap value, large-cap growth) exhibit inefficiencies that skilled active managers can exploit. The resulting hybrid strategy combines a passive core with selected active satellites to improve net outcomes.
Passive Style-Box Coverage
Passive core funds should cover all nine equity style boxes (large/mid/small crossed with value/blend/growth) at low cost. This broad coverage ensures participants receive market-like exposure without stock-picking risk. Passive funds have low fees, minimal turnover, and reduce behavioral risk.
- Passive core funds span the full style-box grid, giving exposure to value, blend, and growth stocks in each size tier.
- Low fees mean higher net returns: even small expense differences compound into large performance advantages.
- Research shows passive funds dominate core equity: over long horizons, most active large- and mid-cap funds underperform.
Rationale for Active International Equity
- Market Inefficiencies: Non-U.S. markets exhibit more complexity — including variable accounting standards, political risks, and currency volatility — which can create opportunities for skilled managers.
- Long-Term Evidence: Morningstar’s 2023 Active/Passive Barometer shows that approximately 40% of active international large-blend managers outperformed their average passive peers (Morningstar, 2023)[1] over the past 10 years. While not a majority, this is notably higher than the 10-year success rate for U.S. large-blend managers, which is closer to 10%. This relative improvement highlights that international equity markets may offer more opportunity for skilled active management due to greater inefficiencies and dispersion. (Source: Morningstar Active/Passive Barometer, 2023)
Rationale for Active Fixed Income
- Market Structure: The bond market is less efficient than equity markets. There are thousands of issuers and individual securities, most of which are not traded daily and have no centralized exchange. Bonds differ by coupon, maturity, credit rating, and call provisions — making analysis and pricing less transparent.
- Manager Flexibility: Active bond funds can shift credit exposure, shorten or lengthen duration, and overweight undervalued sectors (e.g., MBS, corporates) based on macro trends. Indexes cannot.
- Long-Term Evidence: Over the 10 years ending 2023, nearly 40% of active intermediate core bond funds beat their average passive peer (Morningstar, 2024). While not a majority, this rate is substantially higher than for active equity.
Rationale for Active Small-Cap Value
- Market Inefficiency: Small companies often lack analyst coverage and trade with wider spreads. Many are mispriced or have volatile fundamentals that require deeper research.
- Style Advantage: Value-oriented small caps can offer better entry points for active managers. Broad small-cap indexes tend to hold speculative or unprofitable firms — skilled managers can avoid these and target quality.
- Empirical Support: Morningstar’s long-term data (2023) shows that over a 10-year horizon, ~36% of active small-cap value funds outperformed — significantly higher than in large-cap. This provides a more favorable landscape for active strategies.
Rationale for Active Large-Cap Growth
- Concentration Risk: Growth indexes like the Russell 1000 Growth are highly concentrated in a few mega-cap tech names. As of mid-2024, over 50% of the index’s weight is in the top 10 holdings, creating a portfolio that behaves more like a concentrated fund than a diversified strategy.
- Cyclical Opportunity: In years when leadership broadens or top names falter, active managers can outperform. For example, during the 2022–2023 cycle, many active large-growth managers beat their benchmarks by reallocating away from overvalued mega-cap names.
- Risk Management Benefit: While long-term evidence of outperformance is weaker in this category, the case for active large-cap growth lies in mitigating concentration risk. Active managers may not consistently generate alpha, but they can reduce single-stock exposure and better manage downside volatility. This is particularly important given that large-cap growth is often one of the highest allocations among participants, driven by the familiarity and popularity of big-name tech stocks.
Cost and Fiduciary Considerations
- Fee Discipline: A small annual fee gap — such as between a 0.05% passive index fund and a 0.60% active alternative — can reduce terminal wealth by around 13% over 20 years due to compounding.
- Fiduciary Process: ERISA requires that fiduciaries act prudently and in participants’ best interests. “A fully passive lineup can meet this standard by offering broad diversification at low cost. However, offering evidence-backed active options in areas with higher inefficiencies can also be prudent—especially when it gives participants an opportunity to enhance returns or offset plan-related fees.
Conclusion
A 401(k) lineup built on passive index funds for full style-box coverage plus a targeted set of active funds in inefficient asset classes offers the best of both worlds: cost efficiency, fiduciary alignment, potential for excess return, and improved risk management.
By combining the reliability of passive investing with selective active management in four time tested categories — international equity, fixed income, small-cap value, and large-cap growth — sponsors can create a modern, research-backed lineup that supports participant success over time.
Are you reviewing your plan’s investment lineup? At Gatewood, we help plan sponsors apply fiduciary standards while building smart, efficient lineups that support long-term participant success.
Sources:
Morningstar. Active/Passive Barometer: U.S. Fund Landscape. July 2023.
https://www.morningstar.com/lp/active-passive-barometer
S&P Dow Jones Indices. SPIVA® U.S. Scorecard – Year-End 2023.
https://www.spglobal.com/spdji/en/research-insights/spiva/
U.S. Department of Labor. Employee Retirement Income Security Act of 1974 (ERISA), Section 404(a)(1)(B).
https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/publications/understanding-retirement-plan-fees-and-expenses
Vanguard Research. The Case for Active Management in International Markets. 2022.
https://advisors.vanguard.com/insights/article/the-case-for-active-management-in-international-markets
Morningstar. Why Indexing Works. Morningstar Research Article. 2023.
https://www.morningstar.com/articles/1132679/why-indexing-works
Vanguard. Vanguard Large-Cap Value Index Fund (VVIAX) Prospectus and Fact Sheet. 2024.
https://investor.vanguard.com/investment-products/mutual-funds/profile/vvifax
Morningstar Direct. Intermediate Core Bond Fund Category Performance. Accessed 2024.
FTSE Russell. Russell 1000 Growth Index Fact Sheet. 2024.
https://www.ftserussell.com/products/indices/russell-us
Important Disclosures:
This information was developed as a general guide to educate plan sponsors but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations..
Investing involves risk including loss of principal. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets
Bonds are subject to credit, market, and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The prices of small cap stocks are generally more volatile than large cap stocks.
