Ladies and gentlemen, at the beginning of this trial, you made a promise to both parties to give your full attention to the proceedings and the evidence presented, and you have done. I’m sure I speak for both parties when I thank you for keeping your promise.
As I explained at the beginning of the trial, the key issue in this case involves the quality of the investment advice being provided to investors. More specifically, the question is whether recommendations to purchase actively managed mutual funds that are cost inefficient and that have consistently underperformed comparable, and less expensive, passively managed index funds violates the applicable legal standards of both the brokerage and investment advisory industries.
At the present time there are two separate legal standards, one for the brokerage industry and another for the investment advisory industry. The investment advisory industry is held to a strict fiduciary standard, more commonly known as the “best interests” standard, which requires that an investment advisor always act in a client’s best interests.
The brokerage industry is currently held to a less strict standard, known as a suitability standard. Under the industry’s current rules, a stockbroker has three main suitability obligations – a reasonable-basis suitability determination, a customer-specific suitability determination, and a quantitative suitability determination.
The reasonable-basis suitability determination requires a broker to perform a due diligence review of an investment in order to fully understand the nature of the product, including the product’s potential risks and rewards. The broker must take his due diligence findings and determine whether the product is suitable for at least some investors.
The customer-specific suitability determination requires a broker to take his due diligence findings and determine whether an investment product and/or the broker’s proposed investment strategies are suitable for a specific investor given the investor’s personal investment parameters, including, but not limited to, the investor’s financial situation and needs, investment experience, and investment objectives.
The final suitability determination involves a quantitative determination by a broker that any trades made in a customer’s account are not excessive.
Taken together, the suitability requirements basically further the brokerage industry’s fundamental fairness rule. As you heard the industry’s experts admit, the industry’s fairness rule clearly states that
implicit in all member and associated person relationships with customers and others is the fundamental responsibility for fair dealing. Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of FINRA rules, with particular emphasis on the requirement to deal fairly with the public. The suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.
However, as the testimony and other evidence that we presented clearly shows, current industry practices by both the brokerage and the investment advisory raise serious questions as to whether industry is consistently meeting the legal standards and other requirements of their industry.
Most brokers and investment advisers recommend actively managed mutual funds. The investment industry basically recommends two types of mutual funds – actively managed mutual funds and passively managed mutual funds, more commonly referred to as “index” funds. Index funds basically attempt to track various stock market indices, such as the Standard & Poor’s 500 index.
Actively managed mutual funds are often marketed to investors with claims that active management allows an investor to react provide better performance, and better protection, than comparable index funds during downturns in the stock market. And yet, as we showed, there is absolutely no evidence to support such claims.
In fact, the evidence establishes that just the opposite is true in most cases. In the most recent Standard & Poor’s Index Versus Active (SPIVA) Scorecard, over the five-year and ten-year period ending June 30, 2016, 94.58 percent and 87.47 percent of actively managed mutual funds underperformed their relative benchmarks.
Our evidence also showed that after the bear market of 2008, SPIVA questioned the claimed benefits of actively managed mutual funds in bear markets, reporting that
[t]he belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes.
The defendants introduced evidence purporting to establish the significant annual returns earned by some of the leading actively managed funds. However, do such return numbers accurately reflect the return earned by such funds and the true value of such funds for investors?
Using a forensic technique known as incremental analysis to evaluate actively managed mutual funds often provides a clearer, and much different, picture of an actively managed mutual fund’s performance than just looking at the fund’s absolute performance numbers. Incremental analysis of mutual funds simply involves comparing the incremental, or additional, costs and returns of one fund with another fund.
The concept of evaluating mutual funds using incremental analysis was introduced by investment icon Charles D. Ellis. The value of incremental analysis is quickly evident, for as Ellis has pointed out,
[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. When you do this, you’ll quickly see that the incremental fees for active management are really, really high – on average, over 100 percent of incremental returns.
You heard testimony stating that many actively managed funds closely track their relative benchmark/market index, earning them the monikers of “closet index funds” and “index huggers.” As a result, many actively managed mutual funds produce little or no incremental return of their own when compared to the performance of a comparable index fund.
Therefore, it can be validly argued that a large part of a “closet index” actively managed fund’s performance is properly attributable to the performance of the underlying index rather than the actively managed fund’s management team. As our evidence shows, in such cases an investor could have achieved similar, in some cases better, overall returns, at a much lower cost, by simply investing in an index fund representing the actively managed fund’s underlying index.
We introduced into evidence testimony regarding a metric known as the Active Management Value Ratio 2.0™(AMVR) The AMVR analyzes an actively managed mutual fund based upon the fund’s incremental cost and incremental return, if any, to determine the cost efficiency of an actively managed mutual funds. Under the Prudent Investor Rule, cost efficiency is an important aspect of prudent investing. If an investment is not cost efficient and would result in a loss for an investor, how can a valid argument be made that the investment is prudent or suitable for any investor?
Using the AMVR to analyze some of the largest actively managed mutual funds, we showed you that these funds were poor investment options, as they were often cost inefficient and/or underperformed a comparable index fund, and therefore provided no benefit to investors in terms of return or cost. In fact, the AMVR calculations established that an investment in many actively managed mutual funds basically ensured that an investor would suffer a financial loss from investing in the fund.
I ask you to remember the two AMVR examples we discussed during the trial. Plaintiff’s Exhibit P-1 depicts a situation where the actively managed fund would be a poor investment choice based on the fund’s historical record of underperformance relative to that of a comparable index fund.
As a result, a recommendation to purchase the actively managed fund would be clearly unsuitable under both a fiduciary and suitability standard since the fund’s record established that the fund provided no incremental return for an investor. In fact, a proper due diligence investigation of the fund’s historical underperformance would have shown that an investment in the fund would result in a financial loss relative to what the investor could have received had the broker or adviser recommended a comparable index fund.
Remember, the quality of a broker’s or investment adviser’s investment advice is evaluated based upon the investment’s qualities at the time that the investment recommendation was made, not upon the subsequent performance of the investment. This is not only the applicable legal standard, but entirely fair to brokers and investment advisers, since they are not held responsible for the ultimate performance of their investment recommendations as long as such recommendations were suitable or prudent, as the case may be, when they were made. This rule properly recognizes the fact that no one can control the ultimate performance of the stock markets.
Plaintiff’s exhibit P-2 depicts an AMVR analysis involving a situation where the actively managed fund’s performance does outperform a comparable index fund. The issue in exhibit P-2 involves the impact of the actively managed mutual fund’s fees and trading costs on the overall quality of the investment.
Exhibit P-2 examines two mutual funds, Fund A, an actively managed mutual fund, and Fund B, a passively managed index fund. Fund A has a five-year annualized return of 10 percent, an annual expense ratio of 1 percent, and an annual turnover ratio of 50 percent. Fund B has a five-year annualized return of 9 percent, an annual expense ratio of 0.16 percent, and an annual turnover ratio of 3 percent.
Fund A has an incremental return of 1 percent, or 100 basis points, so the fund does provide an investor with a positive return. The next question is whether the incremental costs incurred in producing that positive return negate the fund’s positive incremental return.
In analyzing the importance of a mutual fund’s costs, investment icon Burton Malkiel found that
The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover.
Consequently, it is fair to evaluate the costs associated with a broker’s or investment adviser’s investment recommendations based upon both the fund’s annual expense ratio and its annual turnover ratio and associated trading costs.
As exhibit P-2 shows, the actively managed fund’s total costs would be 1.60 basis points, while the index fund’s total costs would be 20 basis points. The actively managed mutual fund’s incremental cost would therefore be 140 basis points. Without getting into an explanation of basis points, the key takeaway is that the actively managed mutual fund’s incremental costs exceed its incremental return, resulting in a financial loss for an investor in the actively managed fund.
Again, just as with the incremental return example in exhibit P-1, a recommendation to purchase the actively managed fund under such a fact scenario would clearly be unsuitable under both a fiduciary and suitability standard, as the fund’s record established that the fund not only provided no overall benefit for an investor, but would have actually caused an investor to incur a loss.
Further analysis of the actively managed mutual fund in exhibit P-2 using the fund’s AMVR calculations provides even more evidence to support the argument that the fund would fail to qualify as either a suitable or prudent investment recommendation for any investor. Exhibit P-1 shows that 87 percent of the actively managed fund’s total costs (1.40/1.60) would only be producing 10 percent of the fund’s total return (1%/10%). Another useful analogy would be a dollar cost comparison, with the question being whether an investor would rather pay $20 for a return of 9 percent, or $140 dollars for a return of 1 percent.
We also showed that these adverse consequences from investing in actively managed mutual funds are even worse when one considers the effective annual expense ratios that investors in such funds might pay. Using a metric known as the Active Expense Ratio, we showed that the effective annual expense ratio that many actively managed mutual funds charge investors is often 4-5 times higher, in some cases even higher, than the fund’s publicly stated annual expense.
As you heard from our experts, this higher effective annual expense ratio on actively managed funds is due to the fact that many actively managed mutual funds are what are known in the investment industry as “closet index” funds, funds that closely track the performance of the less expensive passively managed index funds and their relative market index. As our experts explained, many actively managed funds secretly employ this strategy in order to avoid significant differences in performance from the index funds, which could cause investors to potentially withdraw their investments in favor of less expensive index funds with comparable, or even better, performance.
Are all actively managed mutual funds unsuitable and/or imprudent? Not at all. The SPIVA reports establish that some actively funds do outperform their comparable index. Now whether that holds true once the actively managed fund’s incremental costs are factored in would require further calculations for each actively managed fund. However, experience has shown that there are some actively managed mutual funds that do prove to be cost efficient under an AMVR analysis.
The question for you now is whether a broker and/or investment adviser has a duty to ensure that his/her investment recommendations are suitable and/or prudent for a customer or client by conducting a meaningful due diligence investigation prior to making such recommendations. The evidence and testimony that we have presented clearly establishes the value of one metric, the AMVR, in performing an effective due diligence analysis and the various ways that the analysis can be used to evaluate an actively managed mutual fund in terms of its suitability and prudence, or lack thereof.
The bottom line is that despite having two distinct legal standards regarding the provision of investment advice, the fundamental requirement for both stockbrokers and investment adviser is treating customers and clients fairly. FINRA, the governing body for brokerages and stockbrokers, has rules that stress the relationship between suitability and fairness, stating that “the suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.” Investment advisers are fiduciaries under the law and are required to always put a client’s best interests first.
The question before you now is simply this – Are a stockbroker’s or investment adviser’s investment recommendations to purchase an investment product with a history of underperformance, a cost 4-5 times higher than a better performing and less expensive index fund, but providing a nice commission for the broker or adviser, consistent with FINRA’s “fair dealing and high standards of professional conduct” requirement for stockbrokers and the fiduciary standard’s “best interests” requirement for investment advisers? If you decide that they are not, are you willing to send a clear message to brokerages, stockbroker and investment adviser that such conduct is not acceptable?
Interestingly enough, even though there are the two separate standards – the suitability standard for stockbrokers and the stricter fiduciary standard for investment advisers – the courts have shown that they are willing to impose a fiduciary standard on stockbrokers in furtherance of FINRA’s rules promoting fair dealing, ethical sales practices and high standards of professional conduct. The courts have stated that they are willing to impose the fiduciary standard on stockbrokers, even in connection with non-discretionary accounts, when the stockbroker can be deemed to have assumed control of a customer’s account due to the customer’s lack of experience, intelligence and/or understanding to independently evaluate his broker’s advice.
Note :[ [t]he issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions. Carras v. Burns, 516 F.2d 251,258-259 (4th Cir. 1975)
The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable. Follansbee v. Davis, Skaggs & Co., 681 F.2d 673 (9th Cir. 1982)]
The late General Norman Schwarzkopf once said “the truth of the matter is that you always know the right thing to do. The hard part is doing it.” That is what we ask of you now, to do the right thing and make those providing investment recommendations, regardless of any professional title, do the right and fundamentally fair thing, that being to only provide suitable and prudent investment advice to the public.
We have shown both the need and the ability of stockbrokers and investment advisers to do the proper due diligence to ensure the suitability and prudence of the investment advice that they provide to the public. We now ask you to send a message to brokerage firms, stockbrokers and investment advisers that a refusal to perform such due diligence, to act fairly and to protect investors against unsuitable and imprudent invest advice, will no longer be tolerated, and that such conduct will result in significant legal and financial consequences.