Price is what you pay, value is what you receive. – Warren Buffett
A court recently dismissed an ERISA excessive fees/breach of fiduciary duty action based, at least in part, on its argument that using Vanguard mutual funds as benchmarks in ERISA cases is improper. The court’s position was based on the fact that Vanguard operates on a not-for-profit business model, while most actively managed mutual fund companies generally operate on a for-profit business model.1
Vanguard must be doing something right though, as they have more assets under management than any other mutual fund company, and growing every day. Therein lies the issue with the court’s decision-dismissing the ERISA action based on a fund’s business model, rather than the inherent value, if any, provided to a plan’s participants by an actively managed fund compared to a less expensive index fund, in this case Vanguard index funds.
ERISA’s Purpose and Standards
The purpose of ERISA is supposedly to help protect American workers’ retirement plan benefits and to help them work toward “retirement readiness.” As a result, it would seem that providing plan participants with effective investment options would be in the best interests of both plan participants and plan sponsors.
As the Supreme Court stated in their decision in Tibble v. Edison International2, the courts often look to the Restatement (Third) of Trusts (“Restatement”) for guidance on fiduciary matters, especially involving ERISA. Three sections from the Restatement stand out with regard to the fiduciary duty of prudence.
- Section 88, comment b, of the Restatement states that fiduciaries have a duty to be cost-conscious.
- Section 90, aka the “Prudent Investor Rule (PIR),” comment f, states that a fiduciary has a duty to seek the highest rate of return for a given level of cost and risk or, conversely, the lowest level of cost and risk for a given level of expected return.
- Section 90, comment h(2), goes even further regarding a fiduciary’s duty to be cost-efficient, stating that due to the extra costs and risks typically associated with actively managed mutual funds, such funds should not be recommended to and/or used unless their use/recommendation can be “justified by realistically evaluated return calculations” and can be “reasonably expected to compensate” for their additional costs and risks.
The evidence overwhelmingly shows that the majority of domestic equity-based, actively managed mutual funds do not and cannot meet the Restatement’s prudent investment requirements. Standard & Poor’s most recent SPIVA (Standard & Poor’s Indices Versus Active) report stated that approximately 86 percent of domestic equity-based funds failed to outperform their comparable benchmark over the period 2013-2017.3
However, analyzing an actively managed fund based on return is only half the needed due diligence process. Reading the three referenced Restatement sections together, the Restatement requires that a mutual fund should be cost-efficient, should provide a level of return commensurate with an actively managed fund’s additional costs and risks. Consistent underperformance, coupled with significantly higher fees than comparable index funds, results in most actively managed mutual funds not being cost-efficient, which is clearly inconsistent with the Restatement’s fiduciary standards.
In the recent court decision, the court’s position was that using Vanguard index funds for benchmarking would be like comparing “apples-to-oranges” due to the difference in the fund families’ business model. Nowhere in the decisions was there any discussion of the cost-efficiency of the funds or the actual end-return benefit or value, if any, realized by the plan participants.
Determining the cost-efficiency of a fund also requires an evaluation of a fund’s stated and effective fees and expenses. In evaluating a fund’s fees and expenses, most investors and fiduciaries only focus on a fund’s annual expense ratio and any sales charges, or loads. However, studies by respected investment experts such as Burton G. Malkiel4 and Mark M. Carhart5 have concluded that the two most reliable predictors or a fund’s success are its annual expense ratio and its trading costs. In performing the required comparisons, the Restatement and the PIR also state that fiduciaries should consider both a fund’s annual expense ratio and the fund’s trading costs.6
Financial advisers have always argued that the prudence of their advice should be evaluated on factors other than just cost. The Restatement agrees, pointing out that in assessing the prudence of investment advice, any and all costs of the investment products recommended should be evaluated relative to the value received in exchange for such costs.7
The Active Management Value Ratio™ 3.0
Unfortunately, the evidence from past and present ERISA actions suggests that more often than not, investment fiduciaries are recommending and pension plan fiduciaries are selecting investment options that are inefficient, both in terms of cost and/or risk management, and thus imprudent. Several years ago I created a metric that factors in all of the key criteria set out in the Restatement and the PIR. InvestSense’s proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR), is designed to allow investors, fiduciaries, and attorneys to evaluate the cost-efficiency, or the relative value, of actively managed mutual funds.
The AMVR is based in part on my experience as a securities compliance director at several broker-dealers. The AMVR is also based on the principles set out in the Restatement and the PIR , as well as the studies of investment icons Charles D. Ellis and Burton G. Malkiel.
The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns. – Charles D. Ellis8
Past performance is not helpful in predicting future returns. The two variable that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover. – Burton G, Malkiel9
The beauty of the AMVR is its simplicity. In interpreting a fund’s AMVR scores, an attorney, fiduciary or investor only has to answer two questions:
- Does the actively managed mutual fund produce a positive incremental return?
- If so, does the fund’s incremental return exceed it incremental costs?
If the answer to either of these questions is “no,” then the fund does not qualify as cost-efficient under the Restatement’s guidelines.
Our example compares a popular actively managed, large cap domestic fund, American Funds’ Growth of America Fund, R-6 shares (RGAGX), with a comparable large cap growth index fund, the Vanguard Growth Index Fund Admiral shares(VIGAX). Two key facts quickly indicate that RGAGX is not cost-efficient, and thus an imprudent investment choice:
- RGAGX outperforms VIGAX on both a nominal and a risk-adjusted return basis, earning a very respectable AMVR score of .50. An AMVR score greater than zero and less than 1.00 is the goal, as it shows that the fund’s incremental return was positive and exceeded the fund’s incremental costs. A score greater than zero and 50 or less is very good
- However, RGAGX has a very high R-squared rating of approximately 95, definitely in an area considered to constitute “closet index” fund status. As a result, RGAGX has a high AER score, resulting in the fund’s incremental costs significantly exceeding the fund’s incremental return, and thus not cost-efficient.
- RGAGX also fails the cost-efficiency standards, both in terms of its nominal and risk-adjusted numbers. RGAGX’s incremental return only accounts for 7 percent of RGAGX’s risk-adjusted return At the same time, RGAGX’s nominal incremental cost constitutes 81 percent of RGAGX’s total expense, while its AER-adjusted incremental cost constitutes 98 percent of the fund’s total expense. Funds whose incremental costs are greater than their incremental return are not cost-efficient.
In our forensic fiduciary analyses, we then analyze the surviving cost-efficient funds based on over-all efficiency, both in terms of cost control and risk management, and historical consistency of performance.
For additional information about the AMVR and the calculation process itself, visit our web site, “The Prudent Investment Fiduciary Rules (iainsight.wordpress.com). To view the latest AMVR forensic analysis of “Pensions & Investments,” top ten non-index funds used by 401(k) plans visit our SlideShare presentation.
Closet Indexing and the AMVR
Those statistics do not even tell the whole story. One of the most currently discussed investment issues internationally is the impact of “closet index” funds. Closet index funds are mutual funds that hold themselves out as providing active management and charge higher fees than index funds based on such claims. However, the truth is that actively managed mutual funds often closely track the performance of a comparable index fund or market index, often even underperforming the index fund due to their high costs.
Higher fees for less return than a comparable index fund, essentially a net loss for an investor. Definitely not a scenario that furthers ERISA’s purposes. And yet, the issue is rarely addressed by courts involved in ERISA excessive fees/breach of fiduciary duty actions, even though the evidence clearly shows that closet indexing is definitely a problem in the United States, one which unfairly reduces the end-returns of investors and pension plan participants.
Closet index funds are generally identified through the use of a fund’s R-squared number. Morningstar defines R-squared as “the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 100,… It is simply a measure of the correlation of the portfolio’s returns to the benchmark’s returns.”10
The AMVR factors in Ross Miller’s Active Expense Ratio (AER) metric.11 The AER uses a fund’s R-squared number to calculate the active component of an actively managed mutual fund and the resulting effective annual expense ratio an investor is paying on an actively managed mutual funds. The AER calculation allows pension plan fiduciaries and plan participants to evaluate the impact of the actively managed funds’ extra costs on the funds’ cost-efficiency.
In our example, the impact of RGAGX’s high R-squared number/closet index factor, 95, can be seen in the fact that RGAGX’s AER number rose significantly and the percentage of the incremental fee as a percentage of the fund’s overall fee rose to approximately 98 percent of the fund’s overall fee.
For 401(k) fiduciaries and plan participants, the key questions involving the selection of closet index funds for pension plans include:
- Does the selection of a closet index fund breach an ERISA fiduciary’s duties of loyalty and prudence, given the combination of the fund’s higher annual expense ratio with returns more attributable to the market than the fund’s management?
- Since the performance of closet index funds are the same (or in most cases slightly less due to the fund’s higher fees and costs) as comparable index funds, is it prudent for an ERISA fiduciary to pay the closet index fund’s higher fees and costs?
“Wasting beneficiaries’ money is imprudent.”–Section 7 of the UPIA
Under basic fiduciary law, a key concept is the “best interests” of a pension plans and its participants. I believe that the evidence discussed herein, along with the findings of most forensic analyses using the AMVR, create some pivotal questions for pension plan sponsors and other plan fiduciaries, as well as the courts, going forward, namely
- Are a plan’s investment options in the “best interest” of a customer if the historical performance of the recommended investments indicated that such investments were not cost efficient and/or would have failed to provide any inherent value for a customer, i.e., would have failed to produce a positive incremental return for a customer, at the time the recommendations were made?
- If the goals of ERISA are to be achieved, namely protection of plan participants and promotion of their “retirement readiness,” shouldn’t the inherent value of a retirement plan’s investment options in terms of benefits provided, particularly a fund’s cost-efficiency, be the overriding issue rather than the business platform chosen by a mutual fund company?
The issue with actively managed mutual funds is that the evidence clearly shows that historically, the majority of actively managed funds are not efficient, either in terms of performance or costs, as a large majority of actively managed mutual funds consistently underperform comparable, less expensive index mutual funds, thus failing to meet the fiduciary standards established by the Restatement.
Plan sponsors and other investment fiduciaries would be well-served to properly evaluate their plans in order to ensure they have a truly ERISA compliant pension plan, thereby minimizing their risk of personal liability exposure.
1. Brotherson et al. v. Putnam Investments, Inc., available online at http://www.investmentnews.com/assets/docs/Cl10985646
2. Tibble v. Edison International, 135 S. Ct. 1823, 1828 (2015)
4. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
5. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
6. Restatement (Third) Trusts, Section 90, comments b, c, f, g, h(2) and m
7. Restatement (Third) Trusts, Section 90, comments b, c, f, g, h(2) and m
8. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,”6th ed. (New York, NY: McGraw/Hill, 2018), 10
9. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
11. Ross Miller, “Measuring the True Cost of Active Management by Mutual Funds,” available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926
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This article is neither designed nor intended to provide legal, investment, or other professional advice as such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.