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April 26, 2010 

Office of Regulations and Interpretations 

Employee Benefits Security Administration 

Attn: 2010 Investment Advice Proposed Rule 

Room N–5655 

U.S. Department of Labor 

200 Constitution Avenue, NW. 

Washington, DC 20210 

Submitted via email to e-ORI@dol.gov 

Re: Investment Advice – Participants and Beneficiaries: RIN 1210-AB35

Dear Ladies and Gentlemen: 

We appreciate the opportunity to provide comments on the U.S. Department of Labor's 

proposed regulation regarding investment advice to defined contribution participants and 

beneficiaries. 

Callan Associates Inc. is one of the largest privately owned company engaged primarily 

in asset management consulting with more than 300 large fund sponsor clients who are 

responsible for more than $840 billion in assets. Callan clients include defined 

contribution plans, multi-employer plans, corporate and public pension plans, and 

endowments and foundations. 

Callan has been conducting investment manager searches on behalf of fund sponsors for 

more than three decades, since the founding of our organization in 1973. On average, we 

conduct over 150 active and passive investment manager searches a year. 

We support the Department of Labor’s efforts to increase the availability of investment 

advice to defined contribution plan participants. At the same time, we believe that the 

regulation should clarify language around the need for computer-based models to refrain 

from “distinguishing among investment options within a single asset class on the basis of 

a factor [such as historical performance] that cannot confidently be expected to persist in 

the future.” 

The number of investment funds that are offered in 401(k) plans run the gamut from just 

a few to hundreds of funds. A plan may offer a stock, bond, and capital preservation fund. 

Or a plan may offer large-cap equity, small-cap equity, international-equity, emerging 

markets-equity, etc. among stock funds; intermediate-term fixed income, high-yield fixed 

income, global fixed income, etc. among fixed income funds. Some plans distinguish 

SAN FRANCISCO 

NEW JERSEY 

CHICAGO 

ATLANTA 

DENVER 
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between growth and value funds; others offer single-sector funds (such as REIT funds). 

The Department seems to suggest in its guidance that while it might be appropriate to use 

factors such as historical performance in distinguishing between asset classes, within 

asset classes, such factors may not be appropriate. However, how does the Department 

define asset classes? 

Any rules-based approach to defining asset class is likely to fall short, either by being too 

vague or too restrictive. Indeed, that can also be said of any rules-based approach that 

attempts to define which factors (e.g., historical performance versus fees) impacting 

investment performance can confidently be expected to persist into the future. 

Callan believes that the Department should remove this language from the regulation. It 

should be left to an eligible investment expert, as described in the regulation, to 

ultimately determine the efficacy of the advice model, based on the process Callan 

describes below.

Response to the Department’s Solicitation for Comments 

The Department has solicited comments on a number of topics related to the use of 

historical performance in computer-based models. Callan would like to take the 

opportunity to address these topics. 

1. Is a fund’s past performance relative to the average for its asset class an 

appropriate criterion for allocating assets to the fund? 

It is generally accepted investment theory that prudent fund selection is made with 

attention to many quantitative factors—including both past investment performance and 

fees—but also with attention to qualitative factors such as consistency of investment 

philosophy, strength of investment process, and depth of organizational structure. Such 

are the factors that can lead a prudent expert to conclude with a reasonable level of 

confidence that a strategy will continue to outperform lower-fee strategies over time, 

after fees. 

It is not typical that historical investment performance alone is used in investment 

selection. Nor is it typical that fees alone should inform the investment selection decision. 

This is evidenced by the prevalence of active management within DC plans. If fees alone 

informed investment decision-making, one would expect passive investments to dominate 

DC investment fund line-ups. 

Instead, according to Callan’s DC IndexTM, 83% of DC assets were in active strategies 

(which typically have higher fees than passive strategies) as of December 31, 2009. 

Within strategies such as emerging markets equities, active management accounts for 

100% of assets. On the other hand, according to a recent survey by Callan Associates, the 

vast majority (87.7%) of plan sponsors describe their fund menu as a mix of active and 
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passive options, with 4.1% of plans offering passive-only and 8.2% offering active-only 

menus. 

In Callan’s 2010 DC Trends Survey, plan sponsors cited portfolio construction, 

performance, and then fees as the top three criteria by which they selected target date 

funds. 

Plan sponsors typically follow two approaches in determining when to use active and 

when to use passive investments within the plan: 1) Passive and active fund menus that 

mirror each other across asset classes within the plan, for example an active and passive 

large-cap fund; passive and active small-cap fund, etc. 2) Active funds offered in asset 

classes where there is evidence that active management has been able to add value over 

time; passive funds offered in assets classes where active management has not clearly 

been demonstrated to add value over time. Following is a sample of the type of analysis 

that plan sponsors engage in to determine the appropriateness of active versus passive 

investments. 

The following charts provide rolling three-year analyses showing the frequency of 

periods that active managers outperform/underperform their benchmarks, considering 

various fee level assumptions, and assumed “manager-picking” skill (percentile of peer 

group). It covers 20 3-year periods, thereby showing return consistency over a very long 

time frame relevant to a DC participant investing for retirement. The average annual 

excess return shows the significance of the average annual outperformance. 
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International Equity – 20 Years Ended December 31, 2009 

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

(12.0)

(8.0)

(4.0)

0.0

4.0

8.0

12.0

16.0

20.0

for 20 Years Ended December 31, 2009

Rolling 12 Quarter Excess Return Relative To MSCI:EAFE US$

Excess Return

CAI:Intl Eq Core Broad Style

MSCI:EAFE US$

Percent of Three-Year Periods where Manager Beat Benchmark by More than Hurdle - by Percentile

Hurdle 0.45% 0.50% 0.55% 0.60% 0.65% 0.70% 0.75% 0.80% 0.85% 0.90%

Median 88% 88% 85% 84% 79% 79% 78% 76% 75% 74%

45th Percentile 95% 93% 93% 93% 91% 89% 88% 88% 86% 85%

40th Percentile 98% 98% 98% 98% 96% 96% 95% 95% 94% 91%

35th Percentile 98% 98% 98% 98% 98% 98% 98% 96% 96% 96%

30th Percentile 98% 98% 98% 98% 98% 98% 98% 98% 98% 98%

25th Percentile 100% 99% 98% 98% 98% 98% 98% 98% 98% 98%

Average Annualized Excess Return - Median Manager: 2.91%
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Large Cap Core – 20 Years Ended December 31, 2009

The first set of charts above show that the average annualized excess return of the median 

international equity manager over the past twenty years has been 2.91%, and that the 

median international equity manager has outperformed the benchmark 88% of three-year 

periods during that time, with assumed expenses of 45 basis points, and median fund 

selection skill (random). 

In contrast, the second set of charts show that large cap core managers provided no 

excess return relative to the S&P 500 Index over the period cited, and that the median 

manager was only able to beat the benchmark 46% of three-year periods during that time 

with median fund selection skill (random), even with a lower assumed expense level of 

0.25%. 

From this analysis, a plan sponsor might determine that an actively-managed 

international equity option may be appropriate within the plan, while a passivelymanaged large-cap core fund may be appropriate. 

According to Callan’s DC Index, 42% of plans offer passive large-cap funds, while 90% 

of plans offer active international equity funds. This implies that many plan sponsors 

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

(8.0)

(6.0)

(4.0)

(2.0)

0.0

2.0

4.0

6.0

8.0

for 20 Years Ended December 31, 2009

Rolling 12 Quarter Excess Return Relative To S&P:500

Excess Return

CAI:Lg Cap Core Style

S&P:500

Percent of Three-Year Periods where Manager Beat Benchmark by More than Hurdle - by Percentile

Hurdle 0.25% 0.30% 0.35% 0.40% 0.45% 0.50% 0.55% 0.60% 0.65% 0.70%

Median 46% 43% 40% 36% 33% 33% 31% 30% 29% 29%

45th Percentile 51% 51% 51% 50% 50% 48% 45% 43% 38% 35%

40th Percentile 60% 59% 56% 56% 55% 55% 54% 53% 51% 51%

35th Percentile 78% 78% 73% 68% 68% 66% 64% 63% 58% 56%

30th Percentile 84% 83% 83% 79% 79% 79% 78% 78% 74% 71%

25th Percentile 91% 89% 86% 85% 85% 85% 81% 81% 80% 80%

Average Annualized Excess Return - Median Manager: 0.00%
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understand these dynamics and are already choosing active management more often 

where appropriate. 

As mentioned above, once the plan sponsor opts for an active investment approach within 

an asset class, the next step is to select an active manager that is likely to outperform its 

benchmark over time, after fees. This is done first by using multiple periods in evaluating 

historical performance to eliminate time period bias and to measure the consistency of 

outperforming benchmarks and peers over time. Other critical factors to be evaluated are 

the appropriateness of the levels and types of risk taken in the pursuit of return, as well as 

the reasonableness of the fees involved. As mentioned, qualitative screening is then used 

to assess the likelihood that performance strength will persist into the future. Qualitative 

factors include: manager type, organizational history, depth and experience of investment 

personnel, investment process and style, and resource allocation. 

2. Under what if any conditions would it be consistent with generally accepted 

investment theories and with consideration of fees ... to recommend a fund with 

superior past performance over an alternative fund in the same asset class with 

average performance but lower fees? 

Generally accepted investment theories would dictate that the superior-performing fund 

with reasonable risk levels would be recommended over a fund within the same asset 

class, with average performance and lower fees when one is able to conclude with a 

reasonable level of confidence, that the philosophy, people, process, and organizational 

structure of the investment manager with the superior performance will lead to continued 

outperformance net of fees. 

3. Should the regulation specify such conditions? 

The regulation should allow for the plan sponsor to exercise his or her own judgment in 

fund selection as described above. 

4. On what if any bases can a fund's superior past performance be demonstrated to 

derive not from chance but from factors that are likely to persist and continue to 

affect performance in the future? 

From a quantitative perspective, consistency of performance over time is a key variable 

in determining the likelihood of persistent outperformance. Conversely, concentrated or 

uneven performance may weaken the case for continue outperformance. For example, 

persistent outperformance would be more likely from a fund that performed in the top 

50%-25% of peers on a consistent basis, versus one whose historical outperformance 

hinged on just a few years of top decile performance, paired with many years of bottom 

half performance. 

From a qualitative perspective, evidence of an investment management firm’s 

organizational strength, experience, and stability are key factors in the persistence of 
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superior performance. Conversely, personnel turnover, changes in investment philosophy, 

and major organizational disruptions would reduce confidence in the investment firm’s 

ability to continue to outperform. 

5. Should the use of a fund's superior past performance as a criterion for allocating 

assets to the fund be conditioned on such demonstration? 

A model based solely on unfiltered historical performance should be expected to do no 

better than a random process at identifying superior performing funds on a forward 

looking basis. It is necessary to have a documented rationale and methodology for 

choosing investment options, but methods should be flexible/customizable to effectively 

address the sponsor/participant’s particular needs and goals. 

6. How, if at all, should a model take into account investment management style? 

For example, all else equal, should a model ascribe different levels of risk to 

passively and actively managed investment options? 

The risk of a strategy relative to the overall risk of the market is more stable than relative 

performance. Many active strategies by design are consistently less risky than the market 

(and by extension passive strategies). Others are more risky by design on a relative 

basis. Quantitative models based on past performance can be very useful in categorizing 

strategies in terms of their expected risk relative to the market. 

 

Sincerely, 

Lori Lucas, CFA 

Defined Contribution Practice Leader 

Callan Associates