“A pure heart and an empty head are no defense [to a breach of fiduciary duty claim].”
Donovan v. Bierwirth
Whenever the issue of mutual funds fees comes up, financial advisers often bemoan the scrutiny of fees, arguing that more attention should be paid to the alleged benefits that they provide to their customers. The reason that fees receive so much attention is simple-it is one of the few wealth management factors that financial advisers can truly control.
Financial advisers cannot control the performance of stock market and are not held legally liable for same. However, financial advisers can control expenses and investment risk. Investment fiduciaries have a legal duty to prudently manage expenses and investment risk.
Many financial advisers ignore such duties, claiming that they have no fiduciary duties to their clients unless they agree to such status or have been given discretionary control over their clients accounts. What many financial advisers are unaware of it is the increasing willingness of courts to impose fiduciary status on financial advisers when their customers lack the experience and/or ability to independently evaluate their financial adviser’s recommendations.
Two of the primary duties of a fiduciary are to act solely in the best interests of a client and to avoid unnecessary investment fees and costs. One of the biggest mistakes that fiduciaries make is to evaluate investment costs solely in terms of the absolute, or stated, fee. As an attorney, it especially upsets me to find courts making the same mistake.
If a fiduciary is supposed to act in the best interests of their clients, then it is imperative that they look beyond the stated fee and analyze investment fees and costs to determine the true impact of such fees and costs on their clients. Forensic analysis of such fees and costs often reveal that two funds with the same stated fee can have significantly differently impacts on an investor.
In my practice, I use four different metrics in analyzing the prudence of a fiduciary’s decisions-a fund’s R-squared rating; a fund’s Active Expense Ratio score; a fund’s AMVR™ score; and a fund’s Fiduciary Score™. Both the AMVR™ score and the InvestSense Fiduciary Score™ are proprietary metrics.
Each year “Pensions & Investments” publishes a list of the top fifty domestic equity funds used by 401(k) plan. The funds are listed in terms of assets invested in the fund. For purposes of this white paper, I have analyzed the top twenty listed funds. I have eliminated the index funds listed in the group for obvious reasons. Some funds offer various classes of retirement classes with different fees. For those funds, I have analyzed those funds in terms of the highest and lowest fee structure.
Morningstar defines R-squared as “the measure of correlation between a [mutual] fund and the market (benchmark).” In other words, R-squared reflects the percentage of a fund’s performance is attributable to the movement of a stock market index, or another benchmark , rather than the active management of a mutual fund.
Over the last decade or so, there has been a noticeable trend for mutual funds to display high R-squared ratings, especially among large-cap mutual funds. This trend is presumably an attempt to avoid significant differences in returns, which could cause investors to opt for the lesser priced index funds.
The higher a fund’s R-squared rating, the higher correlation between the fund and its appropriate index or benchmark. R-squared rating range from 100 to 0, with 100 indicating a perfect correlation between a fund and its index or benchmark. Funds with a high R-squared rating are often referred to “closet” index funds, since most of their performance is attributable to the market, not the contribution of the fund’s management. While there is no universally established R-squared rating for “closet” index funds, I use a R-squared rating of 90 in my practice. I have heard of other attorneys and analysts who have used R-squared ratings as low as 85 or 80.
From a prudence standpoint, it would be hard for a fiduciary to justify a recommendation to invest in a “closet” index fund. By its nature, the same or similar results could be obtained in a less expensive index fund. In analyzing fees, a fiduciary should always remember that each additional 1 percent in fees reduces an investor’s end return by approximately 17 percent over twenty years and approximately 9 percent over ten years.
As Exhibit A shows, only four of the nineteen funds analyzed had an R-squared rating less than 90, and three of the four had an R-squared rating above 85. A high R-squared rating often has implications with regard to the general cost efficiency of an actively managed mutual fund.
Active Expense Ratio
The Active Expense Ratio (AER) is a metric developed by Professor Russ Miller of the State University of New York-Albany. The AER essentially analyzes the true cost of a fund’s active management component. The metric is relatively simple to calculate, as it only requires a fund’s R-squared rating and the stated expense ratio of both the fund and it’s benchmark.
Professor Miller found that the effective fee for many actively managed funds was significantly higher than their stated fees. Funds having both a high R-squared rating and high incremental costs displayed the largest differences between their stated expense ratio and their AER score, in some cases six to seven times higher. Since AER analyzes cost efficiency, a high AER rating should raise a red flag for fiduciaries in terms of prudence, especially when other factors raise additional concerns.
Exhibit A shows that while all funds showed AER rating higher than their stated fees, only a few showed extremely high AER ratings. In most cases, the low AER ratings can be attributed to the low fees offered by some fund families for their retirement class shares.
Active Management Value Ratio™
The Active Management Value Ratio™ (AMVR™) is a simple cost/benefit analysis that measures the cost efficiency of an actively managed mutual fund in terms of the funds incremental cost and incremental benefit. The concept of using incremental costs and incremental benefits in evaluating the effective costs and benefits of investment management has been championed by industry legends Charles Ellis and Burton Malkiel. Using incremental costs and incremental benefits provides a truer analysis of the actual costs and benefits that an investor derives from active management.
While the AMVR™ is a proprietary metric, I have published the calculation process so fiduciaries and investors can better protect their financial security. The calculation itself only requires an ability to perform subtraction and division and be performed quickly with information that is readily available online.
For the purposes of my analysis, I used data covering the five-year period of 2009-2013 in hopes of providing a more meaningful analysis and avoiding potential skews due to one-year aberrations. Funds that fail to provide any incremental benefit to investors, meaning the fund failed to outperform its benchmark, do not qualify for an AMVR™ rating since they actually cost, not benefited, an investor.
As Exhibit A shows, only seven of the nineteen funds provided an incremental benefit for investors and therefore qualified for an AMVR™ rating. Of those seven, five has an AMVR™ above 25 percent, meaning that the fund’s incremental cost was 25 percent or more of the incremental benefit, effectively reducing the incremental benefit even further.
The AMVR™ score allows fiduciaries and investors to address both cost and performance efficiency issues. First, did the fund provide any incremental benefit in exchange for the extra cost. Second, assuming the fund provided an incremental benefit, was the cost for said benefit reasonable.
The second question is somewhat flexible and depends on the particular goals of the fiduciary. In using the AMVR™ score, I look for funds with an AMVR™ score of 50 or less.
The InvestSense Fiduciary Score™ (IFS) is a proprietary metric that I created to quantify fiduciary prudence in terms of cost efficiency, risk management efficiency and consistency of performance. The IFS allows fiduciaries, investors and others to quickly compare actively managed mutual funds and use the scores, in combination with other metrics, to prudently evaluate various funds and document the prudence of the process used in case of subsequent challenges to their investment selections.
Exhibit A shows a pattern of several funds with low rankings, which should raise prudence related questions, and several funds that stand out with high IFS scores. Since historically, three out of four stocks follow the general trend of the market, most funds will usually have similar consistently scores. In this study, only two of the nineteen funds had poor consistency scores. Risk management issues and excessive fees are usually important factors in a fund’s IFS score.
Again, IFS scores should always be used in combination with other metrics to ensure a proper and complete analysis of a fund.
The metrics that have been discussed in this white paper allow fiduciaries to protect themselves and their clients by uncovering the effective costs and impact of actively managed mutual funds. In most cases, financial advisers and other service providers are not going to supply this information to their clients, as it would reveal the true value of the products they offer or, in most cases, the lack thereof, leaving fiduciaries with undesired liability exposure.
ERISA holds fiduciaries liable for what they knew or should have known. The same argument can be made with regard to any fiduciary, as the courts have consistently held that a fiduciary’s duties are the highest known to law.
Fiduciaries, both ERISA and non-ERISA fiduciaries, need to understand the difference between a a fund’s stated expense ratio and its effective expense ratio. Courts also need to understand that two funds, with identical stated expense ratios, can be significantly different in terms of their impact on investors. The realization of this fact not only ensures that the stated goals of ERISA and the securities law will be promoted, but also that investors and plan participants will be treated in an equitable manner, both in and outside of the courtroom.
This article is for informational purposes only, and is not designed or 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.
The “Pensions & Investments” list of top domestic equity funds used by 401(k) plans can be found at http://www.pionline.com/article/20130930/INTERACTIVE/130929953/domestic-equity-mutual-funds-most-used-by-dc-plans
For additional information about the Active Expense Ratio, see http://thefloat.typepad. com/the_float/files/ross_miller_true_cost_of _active_management/.pdf
For additional information about the Active Management Value Ration, see http://investsense.com/the-active-management-value-ratio/
1. Fidelity Contrafund 89.98
2. American Funds Growth HI 93.91
3. Fidelity Growth Co. 84.89
4. Dodge & Cox Stock 96.54
5. Fidelity Low Price Stock 93.08
6. American Funds Fundamental HI 97.16
7. American Funds Washington HI 96.06
8. Price Equity Income 96.57
9. Vanguard PRIMECAP 93.62
10. Price Growth Stock 87.50
11. Price Midcap Growth 86.65
12. MFS Value HI 98.16
13. Blackrock Equity Income 95.34
14. Windsor II 97.74
15. Windsor II Admiral 97.74
American Funds Growth LO 93.95
American Funds Fundamental LO 97.18
American Funds Washington LO 95.44
MFS Value LO 98.15
Active Expense Ratio
1. Fidelity Contrafund 1.53
2. American Funds Growth HI 6.26
3. Fidelity Growth Co. 1.82
4. Dodge & Cox Stock 2.20
5. Fidelity Low Price Stock 2.38
6. American Funds Fundamental HI 8.49
7. American Funds Washington HI 7.24
8. Price Equity Income 3.15 9. Vanguard PRIMECAP 1.35
10. Price Growth Stock 1.90
11. Price Midcap Growth 2.16
12. MFS Value HI 12.4
13. Blackrock Equity Income 6.19
14. Windsor II 1.44
15. Windsor II Admiral 0.83
American Funds Growth LO 0.84
American Funds Fundamental LO 0.96
American Funds Washington LO 0.72
MFS Value LO 3.23
Active Management Value Ratio™
1. Fidelity Contrafund NA
2. American Funds Growth HI NA
3. Fidelity Growth Co. 22
4. Dodge & Cox Stock 36
5. Fidelity Low Price Stock 50
6. American Funds Fundamental HI NA
7. American Funds Washington HI NA
8. Price Equity Income NA 9. Vanguard PRIMECAP 48
10. Price Growth Stock 48
11. Price Midcap Growth 31
12. MFS Value HI NA
13. Blackrock Equity Income NA
14. Windsor II NA
15. Windsor II Admiral 10
American Funds Growth LO NA
American Funds Fundamental LO NA
American Funds Washington LO NA
MFS Value LO NA
InvestSense Fiduciary Score™
1. Fidelity Contrafund 2.48
2. American Funds Growth HI 1.37
3. Fidelity Growth Co. 2.20
4. Dodge & Cox Stock 0.77
5. Fidelity Low Price Stock 2.04
6. American Funds Fundamental HI 0.65
7. American Funds Washington HI 0.74
8. Price Equity Income 1.54
9.Vanguard PRIMECAP 3.04
10. Price Growth Stock 2.00
11. Price Midcap Growth 1.94
12. MFS Value HI 0.53
13. Blackrock Equity Income 0.71
14. Windsor II 3.00
15. Windsor II Admiral 4.50
American Funds Growth LO 3.41
American Funds Fundamental LO 3.60
American Funds Washington LO 3.98
MFS Value LO 1.72