Reports of Vanguard’s Demise are Greatly Exaggerated: A Critique of the Summary Judgement Decision in the Putman 401(k) Action

I recently read a post suggesting that the recent ruling in the Putnam 401(k) action suggests  that comparing Vanguard’s funds with actively managed mutual may no longer be permissible in 401(k) actions involving excessive fee claims.1 Having read the court’s ruling, I would suggest that the celebration may be premature, as the court’s ruling will likely be appealed. Even if not appealed, I believe the court’s ruling is suspect in several ways, most noticeably in its obvious inconsistency with the Restatement (Third) of Trusts (Restatement).

The Putnam decision is the latest in a string of ERISA excessive cases rejecting Vanguard funds as acceptable benchmarks in ERISA-related fiduciary actions. I have been involved in fiduciary law for over twenty years. However, the Putnam court’s rationale regarding Vanguard, their products and their relation to ERISA and fiduciary standards definitely has admittedly left me puzzled.

The Putnam court claimed that the plaintiff’s expert’s comparison of Vanguard and the subject Putnam funds was “flawed.”2 The court then offered the following explanation:

Vanguard is a low-cost mutual fund provider operating index funds “at cost.”…Putnam mutual funds operate for profit and include both index and actively managed investment. [The expert’s] analysis thus compares apples and oranges.”

The court cited a decision involving similar fee issues, where that court rejected fee comparisons involving Vanguard’s funds because Vanguard is “a firm known for its emphasis on keeping costs low.

The Putnam court then went on to state that even if Vanguard’s funds could  be used for benchmarking purposes, the plaintiff’s had failed to present any case law holding that the range of fees of the Putnam funds were unreasonable as a matter of law. Based on these two grounds, the courts rejected the plaintiff’s excessive fees claims.

Before we address the Putnam ruling specifically, let’s review the appropriate legal standards for plan sponsors and other ERISA investment fiduciaries in selecting investment options.

Fiduciary Standards Under ERISA and the Restatement (Third) Trusts

The Employee Retirement Income Security Act (ERISA) is the primary law regarding pension plans. ERISA states that

Congress primarily intended ERISA to be a consumer protection bill….Borrowing from trust law, ERISA imposes high standards of fiduciary duty upon those responsible for administering an ERISA plan and investing and disposing of its assets.4

ERISA imposes upon fiduciaries twin duties of loyalty and prudence requiring them to act ‘solely in the interest of [plan] participants and beneficiaries’ and to carry out their duties ‘with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man 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.’5

The Supreme Court has consistently recognized of the importance of trust law in ERISA matters, stating that

We have often noted that an ERISA fiduciary’s duty is “derived” from the common law of trusts….[I]n determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts.6

In Tibble v. Edison International, the Supreme Court reiterated the fact that the selection of investment options for a pension plan, as well as the ongoing monitoring of such investments and the replacement of imprudent investments, are among a fiduciary’s main duties.7

The Restatement, especially the Prudent Investor Rule (PIR), also recognizes a fiduciary’s duty of loyalty and duty of prudence.8 The duty of loyalty is pretty straight forward. The duty of loyalty requires that plan fiduciaries act solely in the best interests of the plan, its participants, and their beneficiaries, to always put the best interests of the plan participants and their beneficiaries first.

With regard to a fiduciary’s duty of prudence, the Restatement stresses two consistent themes – cost control/consciousness and risk management to avoid significant losses. The Restatement makes it clear that cost consciousness is fundamental to prudence in the investment function.9 Section 88 of the Restatement cites Section 7 of the Uniform Prudent Investor Act–“[w]asting beneficiaries’ money is not prudent.”10

In addressing cost consciousness, the Restatement  points out that fiduciaries must perform a thorough and objective cost comparison of viable investment alternatives, especially when the fiduciary’s advice and recommendations involve actively managed investments or strategies.11 Since such investments and strategies usually involve higher costs and/or risks, the Restatement states that a fiduciary must be able to justify choices of actively managed mutual funds, to explain why it is reasonable to assume that the returns from such investments will compensate a plan participant for the higher costs and/or risks involved.12

In performing the required cost comparisons, the Restatement states that fiduciaries should consider both a fund’s annual expense ratio and the fund’s trading costs.13 Trading costs are often overlooked in evaluating mutual funds, providing securities attorneys with a potentially valuable evidentiary advantage in proving their cases.

The SEC stressed the potential impact of trading costs in a December 2000 release, describing trading costs as “anti-performance” factors that reduce investors’ end returns.14 Like the Restatement, the SEC stated that fiduciaries need to document why they reasonably believe that a fund’s expected returns justify any additional costs associated with an actively managed mutual fund.15

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.16

The issue with actively managed mutual funds is that the evidence clearly shows that historically, the majority of actively managed funds underperform comparable, less expensive index mutual funds, thus failing to provide the required value to justify the extra expense and risk of such funds. This fact is one of the key foundations for the current trend in 401(k) and 403(b) litigation.

Fiduciaries need to remember that fiduciary liability is based on the prudence of their conduct, the prudence of the analytical process that they utilize in selecting investments and investment strategies, not on the basis of the actual performance of such investments and investment strategies. However, evidence suggests that some plan sponsors either have no acceptable due diligence process for evaluating their plan’s investment options, or they simply choose to blindly accept whatever their plan’s service providers tell them.

Several years ago I created a metric that factors in all of the key criteria set out in the Restatement and the PIR. The Active Management Value Ratio™ 2.0 (AMVR) is a simple metric that allows investors, fiduciaries, and attorneys to evaluate the cost efficiency, or relative value, of actively managed mutual funds.

The AMVR is based on principles set out in the Restatement, as well as the studies of investment icons Charles D. Ellis and Burton G. Malkiel. One of the most attractive aspects of the AMVR is its simplicity, both in terms of calculation and interpretation. The AMVR clearly indicates whether an actively managed mutual fund is imprudent due to (1) its failure to provide value in terms of a positive incremental return, or (2) its failure to provide an incremental return greater than the fund’s incremental costs. For additional information about the AMVR and the calculation process itself, click here.

The AMVR and Leading Mutual Funds in Defined Contribution Plans

The Putnam court properly noted the importance of comparing “apples to apples” in evaluating potential investments for pension plans. Based upon my experience, too often plan sponsors and other investment fiduciaries lack the ability to properly evaluate investments. As a result, they choose to blindly accept the recommendations of their service providers, even though ERISA case law clearly warns against such a policy. A plan sponsor may only accept and reasonably rely on investment recommendations from truly objective third parties.17 Even then, a plan sponsor has a legal obligation to conduct an independent and objective investigation and evaluation of the investment products chosen for their plan.18

So how does a plan sponsor properly conduct the independent investigation and evaluation required by ERISA? While there is no universally mandated procedure, InvestSense created its own proprietary due diligence system that uses the basic AMVR format and several specific and well-recognized factors, including nominal returns, load-adjusted returns, risk-adjusted returns, and Ross Miller’s Active Expense Ratio (AER) metric The AER allows investors and fiduciaries to factor in the ongoing “closet index fund, or “index hugger,” issue, where actively managed mutual funds are charging fees significantly higher than the fees of similar passively managed index funds, yet closely tracking index funds and providing similar returns.

Each year “Pensions & Investments” produces a list of the top mutual funds in defined contribution plans. Each year InvestSense performs a forensic analysis of the top ten non-index mutual funds on that list to determine the cost efficiency of those funds. Based on the most recent (2016) “Pensions & Investments” list, these were the ten funds we analyzed using twelve month data as of March 31, 2017:

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

For benchmark purposes, we used the following Vanguard funds

Vanguard Institutional Index Institutional (VINIX)
Vanguard Growth Index Institutional (VIGIX)
Vanguard Value Index Institutional (VIVIX)
Vanguard Midcap Index Institutional (VMCIX)
Vanguard Midcap 400 Value Index Institutional (VMFVX)

We evaluated each of the funds based on their five and ten-year data, where possible. A reminder, funds that fail to provide any positive incremental return, or whose incremental costs exceeds their positive incremental return, do not qualify for an AMVR score since such situations would result in a loss for an investor. The optimal AMVR score lies between zero and one, since a score below zero indicates that the fund underperformed the benchmark, and a score above one indicating that the funds incremental costs exceeded its incremental return.

The funds that merited AMVR scores are listed below, with their AMVR scores in parentheses. Since these are retirement shares with no front-end load, no such analysis was prepared for that factor. In interpreting the AMVR scores, the scores simply represent the fund’s incremental costs as a percentage of the fund’s incremental returns, i.e., the fund’s cost efficiency.

Nominal returns AMVR results – Five-year returns
American Funds Growth Fund of America R-6 (.452)
Dodge & Cox Stock (.309)
Fidelity Growth Company K (.529)
Vanguard PRIMECAP Admiral (.063)

Nominal returns AMVR results – Ten-year returns
American Funds Washington Mutual R-6 (.623)
Fidelity Growth Company K (.322)
MFS Value R-6 (.554)
Vanguard PRIMECAP Admiral (.177)

Risk-adjusted returns AMVR results – Five-year returns
American Funds Growth Fund of America R-6 (.320)
Vanguard PRIMECAP Admiral (.060)

Risk-adjusted returns AMVR results – Ten-year returns
American Funds Washington Mutual R-6 (.313)
Fidelity Growth Company K (.763)
MFS Value R-6 (.435)
Vanguard PRIMECAP Admiral (.164)

Due to their high R-Squared numbers (most were above or slightly below 90), none of the funds qualified for an AER-adjusted AMVR rating for either the five or ten-year period.

The AMVR, ERISA and the Putnam Court

So, back to the Putnam court’s original arguments against the use of Vanguard’s funds for benchmark purposes in evaluating the fees of similar actively managed funds. To be honest, as the Putman court pointed out, similar arguments have been advanced by other courts.

The problem with such arguments is that they ignore the overriding concern of ERISA – promoting the retirement readiness of plan participants by advancing the best interests of plan participants and risk management to avoid significant losses. The court’s introduction of a mutual fund company’s business platform is completely unnecessary and irrelevant to both ERISA’s primary purpose and the primary issues involved in an ERISA excessive fees action. In an ERISA action involving an excessive fees claim, the only issues properly before the court should be the actual fees involved and whether they (1) complied with both the “best interests” requirement under the fiduciary duty of loyalty, and (2) were they compliant with the fiduciary’s duty of prudence.

The interjection of the business form issue by the Putnam court is inexplicable and totally irrelevant to the issue at hand. The fees that plan participants pay have the same impact on their end returns regardless of the business form and business strategy a mutual fund company chooses. That impact on plan participants’ end returns is the only issue before the court in an ERISA excessive fees action. Since costs reduce investors’ end return, the fact that Vanguard charges lower fees and produces higher end returns for investors should be the focus of the courts, not just the absolute level of a fund’s expense ratios.

Furthermore, in evaluating the costs associated with a mutual fund, given the findings of well-respected experts such as Charles D. Ellis, Burton Malkiel and Mark Carhart, a mutual fund’s cost efficiency should be based on both its annual expense ratio and its turnover/trading costs.  The Restatement also recognizes the importance of factoring in a fund’s turnover/trading costs in evaluating the cost efficiency of a fund, stating that

trading expenses are ‘anti-performance’ and excessive investment charges can be onerous to future wealth accumulations; seemingly small changes in expenses can have a large impact on the amount of money accumulated for a long-term goal.19

Instead of labeling funds as “at cost” or “for profit,” which all mutual funds presumably are, the courts should focus on the cumulative costs of a fund since, as the GAO reported, each additional 1 percent in fees and other costs reduces an investor’s end return by approximately 17 percent over a twenty year period.20 This loss of end returns obviously impacts the retirement readiness of plan participants and is contrary to the expressed goal of ERISA.

Along those same lines, the evidence on the performance of actively managed mutual funds clearly shows that the majority of actively managed underperform similar passively managed mutual funds.21 Even the Restatement notes the historical underperformance of actively managed mutual funds.22 The evidence also refutes the claimed advantages of actively managed mutual funds during market downturns, with the majority of mutual funds underperforming comparable passively managed funds during market corrections and bear markets as well.23

The Supreme Court and other courts have consistently held that the courts look to the common law of trusts in resolving ERISA cases. The Restatement’s position is that a fiduciary needs to look at both the investment’s absolute fees and value in terms of return in evaluating the prudence of an investment.24 The combination of these two long-standing positions makes the Putnam court’s “matter of law” argument even more perplexing than its Vanguard position.

Each legal action is different. Depending on the particular facts of a case, a fee which might seem excessive based purely on its absolute numbers may not be excessive at all if the return received by the investor adequately compensates the investor for the extra cost and risk. Consequently, the determination of whether the expense ratios involved in each are excessive relative to the value delivered to an investor is properly a question of fact, not a question of law. Therefore, the Putnam court’s decision, to the extent it was based on its “matter of law” theory, being based on attempt to impose such a duty on the plan participants is contrary to law and unsupportable.

Given the historical evidence establishing the persistent pattern of underperformance of actively managed mutual funds, combined with the fee issue, an argument can be made that most recommendations for plans to select actively managed mutual funds can be shown to be imprudent. With all due respect to the Putnam court, since the likelihood of identical fact situations in two cases is unlikely, the question of excessiveness of the fees of the funds involved naturally has to be one of fact, not law, therefore making a ruling granting a motion for summary judgment inappropriate since, under the law, questions of fact are solely for juries to determine. At least, that’s my interpretation of the summary judgment rule.

The “Closet Index” Fund Issue

The Putnam court cites one of the leading excessive fees cases in support of its decision,

The fact that it is possible that some other funds might have had even lower ratios is beside the point; nothing in ERISA requires every fiduciary to scour the market to find and offer the cheapest possible fund…25

While the second part of the referenced quote is absolutely correct, the first part of the quote is absolutely wrong, and reflects a significant and ongoing oversight by some courts in handling ERISA excessive fees actions,  the reality of the increase in the number of so-called “closet index, aka “index hugger,” funds and the “best interest” and prudence issues such funds create.

Closet index funds are generally described as actively managed mutual funds that closely track the performance of a relevant index or a comparable index fund, yet charge an annual expense ratio and incur overall costs that are significantly higher than those of a comparable index fund. Closet index funds are often identified through the use of a fund’s R-squared rating. 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.”

While there is no universally agreed on threshold R-squared rating for designating a fund as a closet index fund, many people use an R-squared rating of 90 as the threshold for closet index status.  An R-squared rating of 90 can be interpreted to indicate that 90 percent of the actively managed fund’s performance can be attributed to the performance of its relevant market index, rather than the contributions of the fund’s management team.

From the wording of its decision, it appears that the Putnam court made the same mistake that other courts deciding ERISA excessive fees action have apparently made, namely basing their decision purely on a fund’s absolute annual expense ratio, with little or no consideration of the closet index issue. Courts that properly consider the closet index issue and use Ross Miller’s metric, the Active Expense Ratio (AER), to calculate the effective expense ratio of such closet index funds would have a better understanding of the real issues involved excessive fees cases involving closet index funds.

Despite their stated disdain for index funds, the number of actively managed funds qualifying for closet index status has steadily grown, as more actively managed funds attempt to avoid a significant difference in performance between such funds and the possible loss of customers to index funds. A fund’s designation as a closet index fund, or just the fact that a fund has a high R-squared rating, creates a number of potential fiduciary issues for plan sponsors and other plan fiduciaries.

  • Does the selection of a closet index fund breach an ERISA fiduciary’s duties of loyalty and/or  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 higher fees and costs) as comparable index funds, is it prudent for an ERISA fiduciary to opt for the closet index fund’s higher fees and costs?

The answer to these questions would appear to be obvious to an objective fiduciary. The Restatement requires fiduciaries to ask these very types of question, stating that

Most actively managed [funds] failed to earn market returns net of their cost….Accordingly, a decision to proceed [with a program incorporating actively managed mutual funds] involves judgments by the [fiduciary] that:
(1) gains from the course of the action in question can reasonably be expected to compensate for its additional costs and risks;…26

Given the fact that closet index funds, by virtue of their very nature, cannot be reasonably expected to compensate a plan participant for the closet index fund’s additional costs and risks, it can be argued that most closet index funds are inherently imprudent and, thus, their selection for pension plans will generally result in a violation of the ERISA fiduciary’s duties of loyalty and prudence.

Some would suggest that the failure of the Putnam court and any other courts that have, or will, consider ERISA cases involving excessive fees claims to factor in the closet index issue would constitute “willful blindness” on the part of the courts. It is a well-established legal principle that equity abhors a windfall. Even more so when the case involves a fiduciary relationship.

And yet, that is exactly the results when closet index funds are involved. Actively managed funds charge investors substantially higher fees than comparable index funds, even though the overwhelming majority of actively managed funds consistently underperform comparable index funds. Furthermore, forensic analysis shows that in many cases an actively managed fund’s returns are due more so to the performance of an underlying index rather than the fund’s management team. Bottom line – many closet index funds only serve the “best interests” of the mutual fund companies that offer them, with absolutely no overall benefit to a plan’s participants

Time for a New Epiphany

For far too many years participants in 401(k) plans suffered from the legal system’s failure to recognize and acknowledge the differences and inherent risks between defined benefit and defined contribution plans. Finally, in LaRue v. DeWolff, Boberg and Associates,27 the Supreme Court recognized that unlike participants in defined benefit plans, individual participants in defined contribution plans bear the risk of financial loss from fiduciary misconduct by the plan’s fiduciary. Therefore, the court ruled that individual participants in defined contribution plans could bring individual actions against the plan and the plans fiduciaries for misconduct that result in a financial loss for the participant.

The Putnam court’s recent ruling, as well as similar decisions by other courts rejecting the use of Vanguard funds for benchmarking purposes in ERISA actions, clearly shows the desperate need for the same type of insight and sound logic that the Supreme Court applied in LaRue. To suggest that Vanguard funds are not a valid benchmark in ERISA action simply because Vanguard chooses a different, more investor friendly and cost-efficient business model than most actively managed mutual funds is both inconsistent with the expressed goals of ERISA and the fiduciary standards set out in the Restatement.

The Active Management Value Ratio 2.0 is one metric that can be used by investors, plan sponsors and other investment fiduciaries to effectively evaluate actively managed mutual funds in terms of their efficiency, both in terms of cost and risk management. The Active Management Value Ratio 2.0 therefore helps protect defined contribution plan participants and furthers the expressed goals of ERISA.

An AMVR analysis of the current top ten mutual funds used in defined contribution plans showed that over the most recent five and ten-year periods, most of the funds were cost-inefficient, and thus imprudent. Only one of the ten funds passed the AMVR screen for every time period and would have consistently served the “best interests” of a plan participant – Vanguard PRIMECAP Admiral.

If the legal system is truly dedicated to protecting the “best interests” of pension plan participants and the integrity of ERISA, rather than the “best interests” of the mutual fund industry, then the courts must recognize and adhere to the fiduciary standards set out in ERISA and the Restatement, and acknowledge and factor in the reality of the impact of closet index funds on plan participants.

© Copyright 2017, InvestSense, LLC. All rights reserved

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.

Notes
1. Brotherson et al. v. Putnam Investments, Inc., available online at http://www.investmentnews.com/assets/docs/Cl10985646
2. Id.
3. Id.
4. 29 U.S.C. § 1001 et seq.
5. 29 U.S.C. § 1104(a)(1)(A), (B)
6. Tibble v. Edison International, 135 S.Ct. 1823, 1828 (2015); Donovan v. Mazzola, 716 F.2d 1226, 1231 (9th Cir. 1983).
7. Tibble.
8. Restatement (Third) Trusts, § 90 cmt m.
9. Restatement (Third) Trusts, § 88 cmt a.
10. Restatement (Third) Trusts, § 88 cmt a.
11. Restatement (Third) Trusts, § 90 cmt h(2) and cmt m.
12. Restatement (Third) Trusts, § 90 cmt h(2) and cmt m.
13. Restatement (Third) Trusts, § 90 cmt h(2) and cmt m;
14. “Division of Investment Management Report on Mutual Fund Fees and Expenses (December 2000), available online at https://www.sec.gov/news/studies/feestudy.htm. (SEC Release)
15. SEC Release.
16. Restatement (Third) Trusts, § 90 cmt h(2) and cmt m.
17. Bussian v. RJR Nabisco, Inc., 223 F.3d 286, 299, 301 (5th Cir. 2000); Donovan v. Bierwirth, 680 F.2d 263, 271 (2d. Cir 1982).
18. Fink v. National Savs. & Trust Co., 772 F.2d 951,957 (D.C.Cir. 1985); U.S. v. Mason Tenders Dist. Council of NY, 909 F. Supp. 882, 887 (S.D.N.Y. 1995).
19. Restatement (Third) Trusts, § 90 cmt h(2) and cmt m.
20. “Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition,” available online at http://www.gao.gov/assets/160/156959.pdf.
21. S&P Indices Versus Active (SPIVA), available online at http://www.spindices.com.
22. Restatement (Third) Trusts § 90 cmt h(2) and cmt m.
23. http://www.spindices.com/documents/spiva/spiva-us-year-end-2008.pdf.
24. Restatement (Third) Trusts § 90 cmt h(2) and cmt m.
25. Hecker v. Deere & Co, 556 F.3d 575, 586 (7th Cir. 2009).
26. Restatement (Third) Trusts § 90 cmt h(2) and cmt m.
27. LaRue v. DeWolff, Boberg and Associates, 128 S.Ct. 35 (2007).