With 401(k) allocation, performance is relative

Question: In reviewing the mutual funds in the 401(k) plan that I established for my medical practice, I noticed that some funds performed well last year while others did not. As the plan sponsor, should I look to replace those underperforming funds in my company's plan?

Answer: The answer to this question is not easy. The ultimate decision to replace a fund depends upon many factors.

First of all, it is important to ensure that your fund options cover most major asset classes. Your investment choices should include large-cap, mid-cap and small-cap equity covering growth, value and core investment styles. It also should include international equity and more conservative choices, such as fixed-income and stable-value funds.

Asset classes tend to come in and out of style over different market cycles. For example, the S&P 500 BARRA Growth index was the best performing major asset class for years 1995 through 1998 and came in second-best in year 1999 (behind small-cap growth -- Russell 2000 Growth index).

Then the tides turned as the technology bubble burst and, subsequently, from 2000 through 2004, the S&P 500 BARRA Growth was the second-worst performing asset category. After five consecutive years of underperformance, investors might be ready to throw in the towel, but it might very well be the exact time they should not.

When reviewing your 401(k) options, it is important to review performance on a relative basis. That is, review fund performance versus an appropriate benchmark and peer group rather than on an absolute return basis.

Take the Growth Fund of America, for example. This large-cap growth fund reported an annualized five-year return of 1.32% through Jan. 31, a fairly disappointing return on an absolute basis.

But the category average for large-cap growth funds, according to Morningstar, reported an average negative 7.54% annualized five-year return. Thus, on a relative basis, Growth Fund of America exhibited significant outperformance during that same period.

Once you have reviewed the funds on a quantitative level, you may consider a qualitative review. Has the fund experienced a change in management? Has there been a shift in investment philosophy? Qualitative review might not lead to necessarily terminating the fund from the investment line-up. But it could make you monitor the fund more closely.