The Active Management Value Ratio™ 3.0: Minimizing Fiduciary Liability Exposure for 401(k) Plan Sponsors

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:

  1. Does the actively managed mutual fund produce a positive incremental return?
  2. 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?

Conclusion

“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.

Notes
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)
3. https://us.spindices.com/spiva/#/reports   
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;
10. http://www.morningstar.com/InvGlossary/r_squared_definition_what_is.aspx
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

Copyright © 2018 The Watkins Law Firm. All rights reserved.

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.

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Judge Judy and the SEC’s Best Interest Proposal

The SEC recently announced its “kinda fiduciary”proposal, allegedly to provide investors with protection against abusive marketing strategies used by the investment industry. Interestingly, the SEC choose not to use the term “fiduciary” in announcing its proposal, instead referring to new “Best Interest” (BI) proposal. The issue did not go unnoticed.

While various post and articles have been written regarding the BI proposal, two articles written by leading ERISA attorney Fred Reish provided very informative and insightful analyses comparing the BI proposal to the terms of the DOL’s recent fiduciary rule and its Best Interest Contract Exemption (BICE). I would strongly recommend that anyone in either the investment or ERISA industries take the time to read Mr. Reish’s articles.

One of the most common criticisms of the SEC’s BI proposal is the noticeable lack of any definition of “best interests.” Mr. Reish addressed the issue by referring to the DOL rule’s definition of “best interests.” Under the DOL rule, “best interests” was defied as follows:

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party. (emphasis added)

At some point, the SEC is going to have to address the issue of the definition of “best interest” under their “fiduciary” proposal. Commons sense would suggest that the easiest and most effective option would be to adopt the DOL rule’s definition of “best interests.” If, as expected, the DOL chooses to adopt the SEC’s eventual “fiduciary rule, this would obviously make the transition easier for the DOL, plan sponsors and plan participants..

The DOL’s definition of “best interest” would also further the alleged purpose of the SEC’s BI proposal – protecting investors. I’ve highlighted two sections of the DOL’s definition to illustrate how their inclusion in the DOL’s rule provides the fiduciary protection that investors need.

The United States Supreme Court recently stated that in matters involving fiduciary law, the Court often looks to the Restatement of Trusts (Restatement) for guidance. The Restatement (Third) of Trusts emphasizes two basic fiduciary duties – the duty to be cost-conscious and cost-efficient (Section 88), and the duty to be prudent (Section 90, aka “The Prudent Investor Rule”). The first part of the DOL rule is a direct quote from Section 90’s definition of the fiduciary duty of prudence.

Section 78 of the Restatement discusses a fiduciary’s duty of loyalty. Once again, the DOL rule’s language essentially tracks the Restatement’s language.

If the SEC is sincere in adopting a fiduciary standard, then the similarity in langauge between the Restatement and the DOL’s rule makes adoption of the DOL’s rule definition of “best interests” the simple and obvious solution for defining “best interests” under the SEC’s BI proposal.

I’m guessing that that is not going to happen for two reasons. I am records as stating that the SEC does not actually want to adopt, in fact cannot adopt, a true, meaningful fiduciary standard for two basic reasons. First, many SEC commissioners look to Wall Street for employment after their SEC terms end. A true fiduciary standard is not something the investment industry wants.

Why? Because Wall Street and the investment industry know that their current business model cannot comply with a true fiduciary standard, especially once based on the Restatement’s stringent standards.

For example, the investment industry relies heavily on the sale of actively managed mutual funds to individual investors and pension plans/participants. The two most noticeable aspects of actively managed mutual funds is their consistent underperformance and excessive fees when compared to comparable index funds.

Comment h(2) addresses the cost-efficiency issues involved with actively managed mutual funds, noting that such funds often involve higher costs and risk than comparable index funds. As a result, the Restatement cautions that actively managed funds should not be recommended or used in investment accounts unless  “realistically evaluated return expectations” will compensate an investor for the actively managed fund’s additional costs and risks.

Simply put, this is a hurdle that most actively managed funds simply cannot meet. The most recent S&P  Indices Versus Active report stated that 86.72 percent of actively managed domestic equity funds failed to outperform their appropriate benchmark. My own experience in performing forensic analyses on actively managed mutual funds using my metric, the Active Management Value Ratio™ (AMVR), has consistently shown that actively managed funds are not cost-efficient, in many cases even before their front-end load- adjusted and/or risk-adjusted returns are factored in.

Bottom line, the investment industry cannot effectively do business under their current business models if a meaningful fiduciary standard is imposed on them. that’s exactly why the industry fought so hard against the DOL’s proposed fiduciary rule and will fight against the SEC’s BI proposal if the SEC attempts to adopt similar fiduciary guidelines.

So I would suggest that they key to the SEC’s whole BI proposal is whether they balk in any way at adopting the DOL rule’s “best interest” definition. It’s there for the taking and perfectly describes the concept of “best interests” for investors. If the SEC balks in any way in adopting the DOL’s definition, then everyone will immediately see the BI proposal for what it is, a ruse and an accommodation to Wall Street and the investment industry. In the words of the great philosopher Judge Judy, “don’t pee on my leg and tell me it’s raining.”

Happy Memorial Day!

 

 

Posted in 401k, 401k investments, 403b, 404c, 404c compliance, BICE, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, Impartial Conduct Standards, investment advisers, investments, IRA, IRAs, pension plans, prudence, retirement plans, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , ,

May It Please the Court: Justice Denied As Courts Miss the Forest for the Trees in ERISA Actions

Price is what you pay, value is what you receive. – Warren Buffett

As any trial attorney will tell you, there are times when you wonder if a judge just does not understand a case or if you are just getting a good ‘ol serving of “home cookin’.” Reading some recent decisions in which a court has dismissed an ERISA action alleging excessive fees and/or a breach of one’s fiduciary’s duties, I can’t help but just shake my head, as the dismissals have supposedly been based at least in part on the business model of the plan’s respective mutual funds.

The courts in the cases have argued that using Vanguard mutual funds as benchmarks in ERISA cases is improper because Vanguard operates on a not-for-profit business model, while most actively managed mutual fund companies generally operate on a for-profit business model. Vanguard must be doing something right though, as they have more assets under management than any other mutual fund company, and growing every day. And therein lies the issue with the decisions to dismiss the ERISA actions based on a fund’s business model.

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 International,  the courts often look to the Restatement (Third) of Trusts (“Restatement”) for guidance on fiduciary matters, especially involving ERISA. Section 88 of the Restatement says that fiduciaries have a duty to be cost-conscious. Section 90, comment h(2) goes even further on 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 used for or recommended to clients 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.

Simply put, the evidence overwhelmingly shows that the majority of domestic equity-based actively managed mutual funds cannot and do not meet the Restatement’s prudent investment requirements. Standard & Poor’s most recent SPIVA (Standard & Poor’s Indices Versus Active) report stated that approximately 90 percent of domestic equity-based funds failed to outperform their comparable benchmark over the past year.

In the most recent court decisions, the courts claimed 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 mention as to the relative performance between the funds, the actual end-return benefit or value, if any, realized by the plan participants.

Since I enjoy doing forensic analyses of investments and pension plans, I figured I would perform such an analysis. Each year I perform a forensic analysis of the top ten mutual funds being used in defined contribution plans, as reported by “Pensions & Investments (“P&I”).” Past analyses are available online at the SlideShare site.

Using the top ten funds from P&I’s most recent report, I analyzed the five-year annualized returns (for the period ending on March 31, 2018) on the ten funds on both a nominal and risk-adjusted basis. I used four Vanguard index funds for benchmarking – VFIAX (large cap blend), VIGAX (large cap growth), VVIAX (large cap value), and VMMAX (midcap value). Total costs are based on a fund’s annual expense ratio and estimated trading costs, using John Bogle’s trading costs metric. My findings on the funds’ nominal and risk-adjusted incremental returns relative to each fund’s incremental total costs are as follows:

  • Fidelity Contrafund (FCNKX) – 91% of the fund’s fees/costs produced just 5.9% of the fund’s nominal return and 6.8% of the fund’s risk-adjusted return.
  • American Funds’ Growth Fund of America (RGAGX) – 82% of the fund’s fees/costs produced just 6.1% of the fund’s nominal return and 7.0% of the fund’s risk-adjusted return.
  • American Funds’ Washington Mutual (RWMGX)- 80% of the fund’s fees/costs produced just 4.2% of the fund’s nominal return and 5.1% of the fund’s risk-adjusted return.
  • American Funds’ Fundamental Investors (RFNGX)  – 87% of the fund’s fees/costs produced just 4.0% of the fund’s nominal return and 3.9% of the fund’s risk-adjusted return.
  • Dodge & Cox Stock (DODGX) – 88% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return and 6.9% of the fund’s risk-adjusted return.
  • Vanguard PRIMECAP (VMMAX)- 81% of the fund’s fees/costs produced just 15.2% of the fund’s nominal return and 16.8% of the fund’s risk-adjusted return.
  • Fidelity Growth Company (FGCKX) – 92% of the fund’s fees/costs produced just 25.0% of the fund’s nominal return and 25.0% of the fund’s risk-adjusted return.
  • T. Rowe Price Blue Chip Growth (RRBGX) – 95% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return. The fund failed to provide any positive incremental risk-adjusted return.
  • T. Rowe Price Blue Chip Growth (RRBGX) – 95% of the fund’s fees/costs produced just 9.5% of the fund’s nominal return. The fund failed to provide any positive incremental risk-adjusted return.
  • MFS Value (MEIKX) – 88% of the fund’s fees/costs failed to provide any positive incremental nominal or risk-adjusted return.
  • Fidelity Low Price Stock (FLPKX) – 90% of the fund’s fee failed to provide any positive incremental nominal or risk-adjusted return.

With a few exceptions, those performances obviously do not come close to meeting the Restatement’s prudent investor standards. As is noted in the notes in Section 88 of the Restatement, “wasting beneficiaries money is never prudent.”

However, 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 such funds often closely track the performance of a comparable index fund or market index, often even underperforming the index fund. Higher fees for less return than a comparable index fund, essentially a net loss for an investor. Not sure how that situation furthers ERISA’s purposes.

I performed the same forensic analysis on the same ten funds using Ross Miller’s Active Expense Ratio (“AER”). The AER  calculates an actively managed fund’s effective annual expense ratio based on its R-squared number. R-squared is a metric that measures one fund’s correlation of returns with another fund or an actual market index.

In each case a fund’s incremental return numbers remained the same, but the percentage of the fee producing the returns all rose to 98% or 99%. The average AER number for the ten funds was 4.95 percent , about 9 times higher than the  funds’ stated average annual expense ratio of 0.549 percent. Again, not sure that the results of the actively managed funds’ closet index analysis are consistent with ERISA’s purposes or further the goal of “retirement readiness” for plan participants.

Keep in mind, these are the top ten funds currently used in defined contribution plans. The findings should be alarming enough. The fact that in some cases a fund’s entire incremental fee failed to produce any positive incremental return is a clear breach of the plan sponsor’s fiduciary duty. And yet the courts in question focused not on the miserable performance of such funds and the impact of same on plan participants’ retirement accounts, but rather on the available funds’ choice of business model.

Conclusion

Brokers and broker-dealers are celebrating the 5th Circuit’s adverse ruling against the DOL’s fiduciary rule, assuming that they cannot be held to a fiduciary standard in dealing with their ERISA customers.  I would suggest that such brokers and broker-dealers might want to review my previous post discussing how the regulatory and legal system have already been addressing the fiduciary issue. I would also suggest that broker-dealers and brokers review the applicable fiduciary state law in states that have adopted their own fiduciary standards or who are classified as quasi-fiduciary states, where state courts have the power to impose a fiduciary standard on brokers on a case-by-case basis, even in connection with non-discretionary accounts.

The DOL fiduciary rule may be dead and only time will tell whether the SEC adopts a meaningful universal fiduciary standard or merely a watered-down version of FINRA’s current suitability standard. Interestingly enough, FINRA came out in FINRA Regulatory Notice 12-25 and stated that their suitability standard and the “best interest” standard are “inextricably intertwined,” seemingly opening the door to a “fiduciary standard” interpretation, although FINRA did not expressly use the “f” word. Probably more double speak.

At the very least, the debate over the DOL rule has hopefully at least better educated investors with regard to the fiduciary conflicts-of-interest issue and raised their consciousness regarding the need to be more proactive in protecting their financial interests and security. Prudent investment advisers will embrace the new fiduciary movement and capitalize on the marketing opportunity it presents for them to demonstrate their value proposition to both existing and prospective clients. Lord knows, as my forensic analyses show, too many plan participants are currently receiving little or no value for their money.

 Copyright © 2018 The Watkins Law Firm. All rights reserved.

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.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, elder law, elderly investment fraud, ERISA, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, investment advisers, investments, IRA, IRAs, pension plans, prudence, retirement plans, RIA, RIA Compliance, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , ,

“Avoiding ‘Lipstick on a Pig’: Evidence-Based Investing for ERISA Fiduciaries”

“You can put lipstick on a pig, but it’s still a pig.” – Wall Street saying

I often serve as a consultant to securities/ERISA attorneys and 401(k)/403(b) retirement plans. I am often asked to perform a forensic analysis of an investment product or an entire investment portfolio.

In my opinion, the ongoing litigation involving 401(k), 403(b) and other pension plans is simply going to increase due the fact that most plan sponsors and other fiduciaries either do not know how to properly evaluate mutual funds or fail to do so. Based on my experience, far too many plan sponsors simply decide to blindly follow whatever recommendations they receive from plan advisers and other third parties, despite the fact that the courts have consistently warned that to do so is a clear violation of a plan sponsor’s fiduciary duties.(1)

Fred Reish and Bruce Ashton, two noted ERISA lawyers, wrote an excellent article warning ERISA fiduciaries that while full implementation of the DOL’s new rule is still pending, plan advisers are currently subject to the rule’s Impartial Conduct Standards, including the “best interest” standards.(2) While some have complained that some terms, such as “reasonable” and “best interests,” are subjective and have yet to be properly defined, such arguments are without merit.

As the Supreme Court pointed out in their Tibble decision,(3) the courts often look to the Restatement (Third) Trusts (Restatement) for guidance on fiduciary issues, especially those involving ERISA questions. In my practice, I always point clients to two particular sections of the Restatement. Section 88 states that fiduciaries have a duty to be cost conscious. Section 90, known as the Prudent Investor Rule, has numerous key provisions for fiduciaries. I always point to comment h(2) which states that a fiduciary should not utilize actively managed mutual funds unless the fund’s past performance reasonably leads one to assume that the fund’s performance will more than cover the extra costs and risks typically associated with actively managed funds.

Other sections from the Restatement dealing with the importance of the fiduciary duty to be cost include the Introductory Note to Section 90 and Section 90, comments b and m. Comment b to Section 90 sums up the entire issue perfectly, stating that “[C}ost conscious management is fundamental to prudence in the investment function.”

As a securities/ERISA attorney, I put a great deal of emphasis on evidence and evidence-based investing. Since plan sponsors and other investment fiduciaries can expect the same in litigation or an audit, I strongly suggest that they adopt a similar policy.

One source of valuable information is the semi-annual SPIVA (Standard & Poor’s Indices Versus Active) reports.(4) Based on their performance over the five-year period ending June 30, 2017, 82.38 percent of large cap funds, 87.21 percent of midcap funds, and 93.83 percent of small cap funds underperformed their S&P benchmarks. Drilling down further in the large cap sector, the sector that dominates most retirement plans, over the same time period, 76.43 percent of large cap growth, 88.63 percent of large cap value, and 85.09 percent of large cap core funds underperformed their comparable S&P index.

While SPIVA reports provide valuable information for investment fiduciaries, they are based purely on absolute performance and do not factor in such issues as a fund’s cost efficiency and/or the fund’s potential classification as a “closet index” fund. Numerous studies have documented the importance of cost efficiency, particularly with regard to a fund’s expense ratio and trading costs.

“The two variables that that do the best job at predicting future performance [of mutual funds] are expense ratios and turnover.”(5)

“Expense ratios, portfolio turnover, and load fees are significantly and negatively related to [a mutual fund’s performance].”(6)

“[A fund’s) expense ratio and portfolio turnover are negatively associated with investment performance.”(7)

“On average, trading costs negatively impact fund performance….On average, [actively managed funds] fail to fully recover their trading costs-$1 in trading costs reduces fund assets by $0.41….We fund that trading costs have an increasingly detrimental impact on performance….”(8)

Despite this evidence, 401(k) plans and other types of retirement plans have historically chosen actively managed mutual funds as the primary investment options for their plans. While we are seeing a change to the inclusion of more index funds within plans, actively managed funds are still the predominant investment choice in 401(k) plans and other retirement plans.

In order to factor in the cost efficiency and closet index issues, I was asked by some of my litigation clients to create a fiduciary prudence screen that factors in such issues using Morningstar’s Research Center program.  The screen evaluated the universe of actively managed mutual funds based on their Morningstar category, progressively eliminating funds that failed to pass a component of a screening factor. The screening components and the overall findings of the study are attached as Exhibit A. (Note: The apparent discrepancy in the number of funds passing the screens and the specific funds identified is due to the fact that only retirement shares that passed the screens are identified in this exhibit.)

A number of courts have recently ruled in favor of 401(k) plans, causing plans and their attorneys to declare that the tide has turned in favor of plans in excessive fee cases. Some ERISA plaintiff attorneys have suggested that such predictions are premature based on the fact that a number of said courts failed to factor in the Restatement’s cost efficiency mandate and the entire closet index issue.

Some courts seem to have suggested that the sheer number of investment options offered by a 401(k) or other retirement plan insulates a plan from any finding of breach of their fiduciary duties, such opinion apparently being based on the Seventh Circuit’s ruling in Hecker v. Deere, Inc. (Hecker I).(9) However, the Seventh Circuit quickly went back and rejected such a notion in Hecker II(10) in what the court labeled a “clarification,” but most securities and ERISA attorneys agree was a reversal of their earlier decision.

Most of the previously mentioned pro-plan decisions have been appealed for the reasons mentioned herein. It would not be surprising to see the appellate courts reverse the pro-plan decisions and remand the cases back to the lower courts to allow further litigation on the fiduciary issues. In order to prevent such questionable decisions going forward, expect to see the plaintiff’s bar focus additional attention on the issue of a fiduciary’s duty to be cost efficient and the closet index issue, as the evidence overwhelmingly establishes the failure of most actively managed funds to meet such hurdles.

Going Forward
One of my favorite quotes is “facts do not cease to exist because they are ignored.” So, given the evidence discussed herein, what are the potential “best practices” and liability implications for investment fiduciaries?

Fiduciary law and ERISA are essentially codifications of the common law of trusts, agency and equity. Quantum meruit is a basic tenet of equity law.  In the commercial context, quantum meruit essentially says that if one provides compensation to another, whether it be cash or services, the party providing such compensation has a reasonable expectation of receiving something of equal or greater value in return.

The evidence clearly shows that in the investment industry, far too often investors are simply not receiving equal or greater value in exchange for the compensation they are paying investment advisers and mutual fund companies. That fact becomes even clearer if one applies the incremental cost/incremental return analysis developed by Charles D. Ellis.(11)

Combining Ellis’ incremental cost/incremental return approach with Burton Malkiel’s findings regarding the predictive powers of a fund’s expense ratio and trading costs, I created a metric, the Active Management Value Ratio™ (AMVR). The AMVR allows investors and investment fiduciaries to calculate the cost efficiency of an actively managed mutual fund. The AMVR often shows that a specific actively managed mutual fund is not cost efficient, and therefore not a prudent invest choice under the Restatement’s fiduciary standards. For further information on the AMVR and its calculation process, click here.

Based on data from the Morningstar Research Center, as of January 31, 2018, the difference between the expense ratios for Vanguard benchmark funds used in my analysis, VFIAX, VIGAX and VVIAX, and the average expense ratios for the funds in their respective sections is approximately 96 basis points (large cap blend), 105 basis points (large cap growth) and 109 basis points (large cap value). Add in the turnover/t rading costs for all the funds and sectors, and the cost differences rise 105 basis points (large cap blend), 162 basis points (large cap growth), and 159 basis points (large cap value).

Given the evidence that very few actively managed mutual funds manage to even cover their costs, let alone outperform their relative benchmarks at all, it is easy to see why very few actively managed funds are cost efficient. Even when an actively managed fund does manage to outperform its relative bench mark, the difference is usually less than 25-50 basis points, far below the 100+ cost basis points differential indicated in the Morningstar data.

Under both the DOL’s new Impartial Conduct Standards and basic fiduciary law, two key concepts are “reasonable compensation” and the “best interests” of a customer. I believe that the evidence discussed herein, along with the AMVR, create some pivotal questions that investment fiduciaries, both ERISA and non-ERISA, and the courts must address going forward, namely

  • Is any compensation “reasonable” or 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 not have produced a positive incremental return for a customer, at the time the recommendations were made?
  • If the goals of ERISA are to be achieved, 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, if any, be the key issue rather than the business platform chosen by a mutual fund company?

Conclusion
Existing evidence overwhelmingly establishes the failure of most actively managed mutual funds to meet the fiduciary requirements for loyalty and prudence set out in the Restatement, a resource which the Supreme Court recognized in the Tibble decision. As the plaintiff’s bar devotes more attention to such standards and evidence of non-compliance with same, it would serve plan sponsors and other investment fiduciaries to do so as well.

 Copyright © 2018 The Watkins Law Firm. All rights reserved.

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.

Notes
1. Gregg v. Transportation Workers of America Int’l, 343 F.3d 833 (2003), Liss v. Smith, 991 F. Supp 278 (S.D.N.Y. 1998)
2. Bruce L. Ashton and Fred Reish, “Under the DOL’s Fiduciary Rule, Beware the Myths,” Employee Benefit Adviser, available online at http://www.employeebenefitadviser.com/opinion/under-the-dols-fiduciary-rule-beware-the-myths
3. Tibble v. Edison International, 135 S. Ct. 1823, 1828 (2015)
4. http://us.spindices.com/spiva/
5. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
6. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
7. Zakri Y. Bello and Lisa C. Frank, “A Re-Examination of the Impact of Expenses on the Performance of Actively Managed Equity Mutual Funds,” European Journal Finance and Banking Research, Vol. 3, No. 3 (2010)
8. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/abstract=951367
9. Hecker v. Deere (Hecker I), 556 F.3d 575 (7th Cir. 2009)
10. Hecker v. Deere (Hecker II), 569 F.3d 708, 711 (7th Cir. 2009)
11. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,”6th ed. (New York, NY: McGraw/Hill, 2018), 10

EXHIBIT A

YrR – Annualized Return
ER – Expense Ratio
TO – Turnover

2018 Morningstar Cost Efficiency and R-squared Analysis
VFIAX LCB/1346 Top Quartile
5 YrR > 118
5 YrR load adj > 95
ER < .50 25 .01-.97
TO < 50 19 0-20
Rsqrd < 90 1 96-100 VFIAX
VIGAX LCG/1352
5 YrR > 400
5 YrR load adj > 332
ER < .50 31 0-.69
TO < 50 27 0-26
Rsqrd < 90 16 89-99 RGAGX, RNGGX, FNCMX, VMRAX, VPMAX, VWUAX
VVIAX LCV/1214
5 YrR > 40
5 YrR load adj > 37
ER < .50 12 .05-.65
TO < 50 6 0-26
Rsqrd < 90 1 90-97 VVIAX
VMGMX MCG/596
5 YrR > 212
5 YrR load adj > 191
ER < .50 4 0-.90
TO < 50 4 0-25
Rsqrd < 90 4 83-89 FMCSX, IRGJX
VMVAX MCV/394
5 YrR > 13
5 YrR load adj > 12
ER < .50 1 0-.77
TO < 50 1 0-32
Rsqrd < 90 1 79-90 VMVAX
VSGAX SCG/776
5 YrR > 179
5 YrR load adj > 169
ER < .50 9 ..06-.92
TO < 50 6 0-35
Rsqrd < 90 6 67-87 DSCGX, ALFYX, VRTGX
VSIAX SCV/399
5 YrR > 20
5 YrRload adj > 15
ER < .50 2 .06-.93
TO < 50 2 0-23
Rsqrd < 90 2 55-68 VSIAX, VSIIX
Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , ,

The Active Management Value Metric 3.0: Investment Returns and Wealth Preservation for Fiduciaries and Plan Fiduciaries

Studies have consistently shown that people are more likely to understand and retain information that is conveyed visually rather than verbally or in print. I regularly receive requests for copies of the PowerPoint slides. So for those of you that have never seen one of my presentations on the value of InvestSense’s proprietary metric, the Active Management Value Metric ™ (AMVR) 3.0, here is a simple explanation of how the AMVR can help you detect cost-inefficient actively managed mutual funds in your personal portfolios and 401(k) plan accounts and better protect your financial security.

The Active Management Value Metric™ (AMVR) 3.0
Active Management Value Metric (AMVR) 3.0 is based on combining the findings of two prominent investment experts, Charles Ellis and Burton Malkiel, with the prudent investment standards set out in the Restatement (Third) Trusts’ “Prudent Investor Rule.”

[R]ational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index.” – Charles Ellis

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover. – Burton Malkiel

Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs,…If the extra costs and risks of an investment program are substantial, those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;… – Restatement (Third) Trusts [Section 90 cmt h(2)]

The following slides are based on the returns and risk data, 2017of a popular actively managed mutual fund over the five-year period January 1, 2013 to December 31, 2017, compared to the returns and risk data of a comparable Vanguard index fund. The fund charges a front-end load, or purchase fee, of 5.75 percent. The Vanguard index fund does not charge a front-end load.

Nominal Returns
Mutual funds ads and brokerage accounts often provide a fund’s returns in terms of its nominal, or unadjusted returns. In our example, the actively managed fund’s incremental, or extra, costs exceed the fund’s incremental returns. This would result in a net loss for an investor, making the fund cost-inefficient and a poor investment choice. Furthermore, 67 percent of the actively managed fund’s fee is only producing 1 percent of the actively managed fund’s overall return. Yet another way of looking at the analysis – would you rather pay $31 for 15.92% in returns or $94 for an additional 0.16% of return?


Load-Adjusted Returns
However, Investors who invest in funds that charge a front-end load do not receive a fund’s nominal return since funds immediately deduct the cost of the front-end load at the time of an investor’s purchase of the fund. Since there is less money in the account to start with, an investor naturally receives less cumulative growth in their account when compared to a no-load fund with the same returns. This lag in cumulative growth will continue for as long as they own the mutual fund.

In our example, once the impact of the front-end load is factored into the fund’s returns, the investor not only charges higher fees, but also suffers an opportunity cost, as the fund underperforms the benchmark, the comparable Vanguard index fund. This double loss clearly makes the fund cost-inefficient and a poor investment choice.


Risk-Adjusted Returns
A final factor that should be considered is the risk-adjusted return of a fund. When comparing funds, it is obviously important to know if a fund incurred a higher level of risk to achieve its returns relative to another fund since investors may not be comfortable with such risk. As the quote from the Restatement points out, at the very least, investors would expect a higher return that would compensate them for a higher level of risk.

In our example, the actively managed fund assumed slightly less risk (10.01) than the Vanguard index fund (10.37). As a result, the actively managed fund’s returned improved slightly, but the fund failed to provide a positive incremental return and the fund’s incremental costs exceeded the fund’s incremental return. Once again, this double whammy makes the fund cost-inefficient and a poor investment choice.

The investment industry will often downplay unfavorable risk-adjusted results, saying that “investors cannot eat risk-adjusted returns.” However, the combined impact of additional fees and under-performance should not be ignored by an investor. Each additional 1 percent in fees results in approximately a 17 percent loss in end return for an investor over a twenty-year period. Historical under=performance can be considered an additional cost in evaluating a fund’s cost-efficiency since investor’s invest to make positive returns and enjoy the benefits of compounding of returns.

Interestingly enough, funds that may criticize risk-adjusted performance numbers have no problem touting favorable “star” ratings from Morningstar, which bases its “star” rating on, you guessed it, a fund’s risk-adjusted returns.

In my legal and consulting practices, we add two additional screens. The first screen is designed to eliminate “closet index” funds. Closet index funds are actively managed mutual funds that essentially track a market index or comparable index fund, but charge fees significantly higher, often 300-400 percent or higher, than a comparable index fund. Consequently, closet index funds are never cost-efficient.

The second additional screen InvestSense runs is a proprietary metric known as the InvestSense Fiduciary Rating (IFR). The IFR evaluates an actively managed mutual fund’s efficiency, both in terms of cost and risk management, and consistency of performance.

Conclusion
The Active Management Value Ratio™ 3.0 (AMVR) is a simple, yet very effective, tool that investment fiduciaries, plan sponsors and plan participants can use to identify cost-inefficient actively managed mutual funds and thus better protect their financial security. All of the information needed to perform the AMVR calculations is freely available online at sites such as morningstar.com, fidelity.com, and marketwatch.com.

For those willing to take the time to do the research and the calculations, the rewards can be significant. For fiduciaries, the time spent can be especially helpful in avoiding unwanted personal liability, as plaintiff’s securities and ERISA attorneys are becoming increasingly aware of the forensic value AMVR analysis provides in quantifying fiduciary prudence and investment losses. As a result, more securities and ERISA attorneys are incorporating AMVR analysis into their practices.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, BICE, closet index funds, cost consciousness, DOL fiduciary rule, DOL fiduciary standard, elderly investment fraud, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, investment advisers, investments, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , ,

2017 Year-End Top 10 DC Funds AMVR Analysis

Each year “Pensions and Investments” publishes a list of the top 50 mutual funds used by defined contribution (DC) plans. The rankings are based solely on the amount of money invested in each fund within DC plans.

I do an analysis of the top 10 tens non-index funds using my proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR) The AMVR is based on the studies of Charles Ellis and Burton Malkiel. The AMVR measures the cost-efficiency of a fund, as cost consciousness is a fiduciary duty under Sections 88 and 90 the Restatement (Third) Trusts. Funds that do not provide a positive incremental return for investor, or whose incremental costs exceed their positive incremental returns, are deemed to be cost inefficient since the investor would suffer a net loss under either scenario.

This years top 10 non-index based funds used by DC plans are:

Fidelity Conta K(FCNKX) – LCG
American Funds Growth Fund of America R-6 (RGAGX) – LCG
American Funds Fundamental Investor R-6 (RFNGX) – LCB
American Funds Washington Mutual R-6 (RWMGX) – LCV
Dodge & Cox Stock (DODGX) -LCV
Vanguard PRIMECAP Admiral (VPMAX) -LCG
Fidelity Growth Company K (FGCKX) -LCG
T. Rowe Price Blue Chip Growth (RRBGX) – LCG
MFS Value R-6 (MEIKX) -LCV
Fidelity Low Price Stock K (FLPKX) – MCV

Each of the funds was analyzed using Ellis’ incremental cost/return analysis approach, using the following Vanguard funds as their benchmarks:

Vanguard 500 S&P 500 Index Fund Admiral (VFIAX) – Large Cap Blend
Vanguard Growth Index Fund Admiral (VIGAX) – Large Cap Growth
Vanguard Value Index Fund Admiral (VVIAX) – Large Cap Value
Vanguard Midcap Value Index Fund Admiral (VMVAX) – Midcap Value

A fund’s incremental cost number is based on a combination of a fund’s annual expense ratio and its trading costs. Since funds are not required to disclose its actual trading costs, such costs are estimated using John Bogle’s trading costs metric.

A fund’s incremental return number is based on a fund’s risk-adjusted return. Many investment industry professional ignore risk related returns, with the oft heard criticism that “investors can’t eat risk-adjusted returns.” However. interestingly enough, many actively managed funds actually post lower standard deviations, and thus improve their return numbers when a risk-adjusted calculation is performed. Secondly, many actively managed funds have no problem touting their Morningstar “star” rating in marketing their funds. Morningstar is on record as stating that their star ratings are based on risk-adjusted returns.

That said, four of the ten funds failed to provide a positive incremental returns over the past five-year period, January 1, 2013 to December 31, 2017:

American Funds Fundamental Investors
Dodge & Cox Stock
T. Rowe Price Blue Chip Growth
Fidelity Low Price Stock

One fund, Fidelity Growth Company, did produce a positive incremental return. However, the fund’s incremental costs exceeded its incremental return, so the fund is deemed cost inefficient since an investor would suffer a net loss.

The remaining five funds produced positive incremental returns that exceeded their incremental costs, thus qualifying them for an AMVR score. Since AMVR measure incremental costs relative to incremental returns, the lower the AMVR score the better. The five funds and their AMVR scores were:

Vanguard PRIMECAP Admiral – .07
American Funds Growth Fund of America R-6 – .58
Fidelity Conta – .59
American Funds Washington Mutual – .76
MFS Value – .87

The optimal AMVR score would be greater than zero, but less than 1.oo since 1.00 would indicate that the fund’s incremental costs equal its incremental return.

The final fiduciary prudence consideration is the “closet index” fund screen. A familiar fiduciary axiom is that it is never prudent to waste a client’s money. Likewise, by its very nature, a closet index fund is never cost efficient or prudent. All ten funds had a correlation of 90 or above relative to their Vanguard benchmark fund. The correlations were as follows:

Fidelity Conta – 96
American Funds Growth Fund of America – 97
American Funds Fundamental Investor – 98
American Funds Washington Mutual  – 96
Dodge & Cox Stock – 90
Vanguard PRIMECAP Admiral – 95
Fidelity Growth Company – 94
T. Rowe Price Blue Chip Growth- 97
MFS Value – 98
Fidelity Low Price Stock – 93

While there is no universally agreed correlation number that classifies a mutual funds as a closet index fund, most experts agree that a correlation of 90 or above can be considered an indication of closet index status.

Conclusion
Just as the plaintiff’s bar has become more of the Restatement (Third) Trust’s position regarding a fiduciary’s duty to be cost conscious, so too must plan sponsors and other ERISA fiduciaries recognize such fiduciary duty and evaluate their plan’s investment option to maximize the effectiveness of their plan and reduce the potential for liability exposure. both for the plan and themselves.

As this study shows, it is possible for actively managed funds to achieve an acceptable AMVR score, thereby indicating that a fund is cost efficient in terms of incremental costs and incremental. returns. However, even when a favorable AMVR score is obtained, plan sponsors and other investment fiduciaries still need to address the closet index issue by comparing the costs of an actively managed fund, including the fund’s trading costs, to an appropriate benchmark to ensure that they avoid the closet index “trap.”

 

 

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, BICE, closet index funds, compliance, cost consciousness, DOL fiduciary rule, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, Impartial Conduct Standards, pension plans, prudence, retirement plans, wealth management | Tagged , , , , , , , , , , , , , , , , , , , , , ,

Fiduciary Litigation 2018: A Pure Heart and an Empty Head Are No Defense

After my recent post, “Are We At A ‘Tipping Point’ in ERISA Fiduciary Litigation,” I received a number of calls and emails from legal colleagues and investment professionals who wanted to discuss the points I raised.  In the post, I suggested that in my opinion, we are at a tipping point due to several key facts.

First, as a result of SCOTUS’ decision in Tibble v. Edison Int’l, we now know that we can look to the Restatement (Third) Trusts (Restatement) for guidance and the applicable standards in fiduciary law, including ERISA related fiduciary matters.

We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ In determining the con­tours of an ERISA fiduciary’s duties, courts often must look to the law of trusts.

Second, my LinkedIn colleague, Gina Migliore, recently posted an article,”Hey Plan Sponsor, In Case You Did Not Know, You’re a Fiduciary,” addressing the fact that far too many plan sponsors still do not realize their fiduciary status or understand the legal obligations and liability exposure resulting from this designation.

These two facts lead me to believe that 2018 will not only see an increase in fiduciary related litigation, both ERISA and non-ERISA cases, but an increased in the success of such litigation. Plans and plan sponsors have celebrated recent wins in a few ERISA fee-based cases. However, I contend that those decisions are tenuous at best, at least with regard to the technical ERISA issues, due to what appears to be incorrect interpretations of cases such as Tibble and Hecker I and Hecker II. As a result, I would expect those key ERISA related decisions to be reversed, a sentiment recently expressed by leading ERISA plaintiff’s attorney, Jerome Schlichter.

In my opinion, the primary reason that ERISA fee actions are so successful is a misunderstanding among plan sponsors, plan advisers and financial advisers in general with regard to the evaluation and ongoing monitoring of investment fees. Whenever the issues of fees is raised in ERISA cases, plan sponsors and the investment immediately respond that ERISA does not require that they select the investment options with the lowest fees.

While this is true, is does not equate with an absolute immunity from recommending and selecting investment options that lack any inherent value for investors and pension plan participants. Taking Justice Breyer’s statement with regard to the value of the Restatement in interpreting fiduciary law as a starting point allows us to evaluate the viability of investment options using the clear and simple standards set out in the Restatement. Three standards in particular stand out, two setting out core fiduciary standard, and one setting out the fiduciary standard for actively managed mutual funds, a staple in most 401(k) plans and other types of pension plans.

With regard to a fiduciary’s core duties, Section 88 states that fiduciaries have a duty to be cost conscious. Section 90, comment f, states that fiduciaries have a duty to seek the highest return for a given level of risk and cost, or conversely, the lowest level of cost and risk for a given level of return. With regard to actively managed mutual funds, Section 90, comment h(2), of the Restatement notes that such investments often carry a higher level of costs and risks than comparable index funds. Therefore, the Restatement states that actively managed funds should only be included in a plan’s investment options when the expected return from such fund can reasonably be expected to provide a commensurate level of return o compensate for the additional costs and risk of the actively managed funds.

Simply put, the current menu of investment options within most 401(k) and other pension fail to meet any of these three hurdles. Not only fail to meet them, but fail miserably to meet such standards. As Carhart’s study showed, the returns of most actively managed funds fail to even cover their costs.(1) Our proprietary metric, the Active Management Value Ratio 2.0™ (AMVR), also shows that most actively managed mutual funds are not cost efficient, as their incremental costs exceed their incremental returns, as compared to an appropriate benchmark. As has been mentioned in several ERISA fees cases, losing a client’s money is never prudent.

The fact that many plan sponsors still do not recognize their fiduciary status and resulting fiduciary duties means that they are probably not aware of the standards established by the Restatement and the resulting liability exposure for failure to adhere to same. Ergo, increased litigation and more settlements and decisions in favor of plan participants.

The first time I meet with a prospective ERISA client, I ask them to tell me everything they know about ERISA law. The usual response is either along the lines of knowing that they have to comply with the rules to an immediate “deer in the headlights” stare. They often provide audit notes from a compliance advisor that list the usual 20-25 compliance requirement under the ’40 Act.

More often than not, the compliance adviser is not attorney and does not recognize the need to integrate both compliance and legal risk management standards into a plan to provide the plan with optimum legal protection. Far too often I see plans that offer 40-50 investment options, obviously operating under the mistaken belief that more is better, when in fact just the opposite is usually true. Offering a lot of funds that are highly correlated to each other and/or are cost inefficient, e.g., closet index funds, offers nothing for either the plan or the plan participants except liability exposure for the plan and the plan sponsor.

These very issues were discussed and resolved  in the Hecker decisions. In my experience, far too many compliance consultants and plan providers rely on Hecker I without reviewing Hecker II. As Fred Reish, one of America’s leading ERISA experts, admits, Hecker II effectively reversed Hecker I. As a result, many plan sponsors are left, as we say in the South, “nekkid in the wind,” totally defenseless to any ERISA fee litigation action.

CEOs and 401(k) plan sponsors often call me asking me how they can bulletproof their plan and avoid any liability. First the bad news. Since 401(k) fee cases address thing s that have occurred within the past six years, there is nothing a plan can do about liability arising from actions during that time. You can’t unring a rung bell.

The good news is that plans can implement and monitor an effective risk management program that provides the protection and benefits that both plan sponsors and plan participants want and need. Such risk management programs do not have to be cost prohibitive either. The key is to become and remain proactive in creating such as plan and monitoring the plan to ensure continued effectiveness.

One last factor to consider is the continuing efforts of the DOL, Congress and the Trump administration to block the full implementation of the DOL’s new fiduciary standard. In so doing, the DOL and Congress, as well as the SEC, underestimated the response from the states. Some states already impose a fiduciary duty on stockbrokers and other financial advisers. Nevada and other states have announced plans to protect their own citizens by exercising their police powers under the 10th Amendment to enact their own fiduciary standards. These state fiduciary laws will presumably include full discovery rights for investors, the one thing that the investment industry fears the most due to the possibility that it will expose even greater abuses by the industry. And there is nothing that Congress, the DOL, the SEC or the Trump administration can do to prevent the states from exercising their 10th Amendment rights and powers.

Increased fiduciary related litigation and more settlements and plaintiffs’ verdicts.  That’s my prediction and I’m sticking to it!

Selah

Notes
1. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.

Copyright © 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since 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.

Posted in 401k, 401k compliance, 403b, 404c, closet index funds, cost consciousness, DOL fiduciary rule, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, financial planning, Impartial Conduct Standards, investment advisers, investments, pension plans, prudence, retirement plans | Tagged , , , , , , , , , , , , , , , , , , , , , ,