Let’s make a dent in the universe. – Steve Jobs
Men occasionally stumble upon the truth, but most of them pick themselves up and hurry off as if nothing had happened. – Winston Churchill
There is currently a heated debate going on with regard to the adoption of a universal fiduciary standard for anyone providing investment advice to the public. The debate basically focuses on the fact that registered investment advisers are held to a fiduciary standard that requires them to always put a client’s interests first, while stockbrokers and others financial advisors are generally allowed to put their own interests ahead of their customers’ “best interests.”
There are various ways in which investment professionals can be held to a fiduciary standard. Some, like registered investment advisers and trustees, are fiduciaries by law. Others can contractually agree to be held to a fiduciary standard. Financial advisers who have discretionary control over client accounts are deemed to be fiduciaries. And courts have shown an increasing willingness to impose a fiduciary standard on stockbrokers, even on non-discretionary accounts when the court determines that a customer lacks the intelligence and/or experience to understand and independently evaluate their broker’s advice and recommendations.1
Fiduciary law is based primarily on trust and agency law. The two primary legal requirements for fiduciaries are the duties of prudence and loyalty, more commonly known as the “best interest” requirement.
ERISA’s prudent man rule is often cited in defining a fiduciary’s duty of prudence. Under ERISA, prudence requires that a fiduciary must act
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.2
The fiduciary duty of loyalty includes a number of obligations, all of which are generally summed up as a fiduciary’s obligation to always put a customer’s/client’s “best interests” ahead of the fiduciary’s personal interests. This issue is often associated with conflicts of interest between a financial adviser and a customer/client involving fees and other expenses.
As a former compliance director, for both RIAs and broker-dealers, and now a securities/ERISA attorney and fiduciary liability consultant, I realize the importance of the evolving fiduciary law, both in terms of ERISA and non-ERISA contexts. There are many in the investment industry that try to dismiss fiduciary issues by saying that the duties are too subjective and that they are not attorneys, so they do not have to deal with such issues.
My father used to say that burying one’s head in the sand just provides a larger target for people. While there may be some subjectivity involved in fiduciary law, the courts and regulators are providing more objective rules and standards which fiduciaries and financial advisers need to monitor and incorporate into their practices to both provide better services for their clients and protect their practices.
As a trial attorney, I am well aware that juries and arbitration panels are more receptive to “visual” evidence than mere testimony. With that in mind, I drew on both my legal and compliance background to create metrics that can be used to quantify the fiduciary duties of prudence and loyalty.
Before even considering the metrics, some mutual funds are “low hanging fruit” and should be quickly eliminated from consideration as appropriate based on the fund’s five year performance relative to a benchmark and/or the fund’s “closet index” status. A fund that underperforms its benchmark clearly is neither prudent nor in a client’s best interests. Likewise, a fund that qualifies as a “closet index” fund, a fund that “hugs” or closely tracks a relevant benchmark or index with comparable performance, however with a cost 3-4 times the cost of an index funds, is neither prudent nor in a client’s best interests.
I have seen many argue in favor of such investments, but never successfully. In most cases the ultimate issue is an obvious conflict of interests between a financial adviser and a client based on commissions and other fees associated with such funds.
For those funds that pass the relative performance and “closet index” screens, the metrics allow fiduciaries, attorneys and investors to assess mutual funds based on efficiency, both in terms of cost and risk management, and comprehensive performance. The ability to use these metrics to quantify fiduciary prudence and loyalty have already been used successfully by others to better protect their financial security and avoid unwanted fiduciary liability.
Cost Control Metrics
The Active Management Value Ratio 2.0™ (AMVR) is a metric I created and have shared with the public. The AMVR is a simple cost/benefit analysis that uses a fund’s incremental cost and incremental return to answer a basic investment question – does the fund’s additional, or incremental, return justify the fund’s additional, or incremental, costs.
The AMVR is calculated by dividing a fund’s incremental cost by its incremental return. A score in excess of 1.00 indicates that the fund’s incremental costs exceeds its incremental return, thus neither prudent nor in an investor’s best interest. Further information about the AMVR, including steps to calculate the metric, is available here.
As more and more actively managed funds show a tendency to closely track relevant indexes, the issue of effective fees and costs becomes a bigger issue since the contribution of active management to performance decreases. Consequently, the fiduciary duty of prudence, specifically the duty to control unnecessary fees and expenses, becomes more relevant.
Professor Ross Miller’s Active Expense Ratio (AER) uses a fund’s R-squared rating to calculate a mutual fund’s effective expense ratio. Professor Miller’s research has shown that a fund’s AER is typically 3-4 times greater than the fund’s stated expense ratio. The prudent fiduciary will factor in the impact of a fund’s R-squared rating, or “index hugging” tendency, and the fund’s effective expense ratio.
Risk Management Metrics
“Amateur investors focus on return, professional investors focus on risk” is a well-known adage in the investment industry. As an unabashed fan of investment legend Charles D. Ellis, I totally agree with his admonition that in investment management, fiduciaries and investors should “focus not on rate of return, but on the informed management of risk”3 Ellis goes on to point out that “the great secret of success in long-term investing is to avoid serious surprises.”
The value of Ellis’ advice is simple. When one suffers investment losses, it takes a greater rate of return than the amount of the loss just to get back to even since there is less money to work with. For instance, to recover from a 20 percent portfolio loss, an investor would have to earn a return of 25 percent to recover and break even.
For those who suffered the 40 percent loss in the 2008 bear market, they needed to earn a return of a little over 66 percent to recover and break even. And they also suffered an opportunity loss, as they had to use the market’s returns during the market’s recovery to their make up for their losses rather than to grow their portfolios.
The Department of Labor and the courts have adopted Modern Portfolio Theory (MPT) as the appropriate standard in assessing the prudence of ERISA fiduciary’s investment decisions.4 The cornerstone of MPT is the effective portfolio diversification of an investment portfolio by factoring in the relationship between investments in the portfolio. By mixing together investments that have low correlations of return, the theory is that the portfolio will experience less volatility and more stable returns, thereby reducing the possibility of significant financial losses.
For non-ERISA fiduciaries, it should be noted that the Prudent Investor Rule also takes the position that sound, effective diversification is fundamental to the management of risk.5 The Rule also states that a fiduciary’s failure to effectively diversify is a breach of one’s fiduciary duties.6
Effective diversification requires more than just investing in a large number of securities or different types of securities, e.g., large cap growth funds, small cap value funds. Over the last decade or so, the correlation of returns among equity-based investments, both domestically and internationally, has proven to be extremely high. This high correlation of returns denies fiduciaries and investors the effective risk management and downside protection against large losses that diversification is supposed to provide. This is why fiduciaries and investors should always prepare a correlation matrix as part of their investment process.
The inclusion of stress testing is based on an ERISA court decision that suggested that prudence should include an analysis of how investments chosen for a plan react under different market conditions.7 While a correlation matrix evaluates the interrelationship between investments, the stress test evaluates each investment based on their individual performance under various market scenarios.
The Top Ten 401(k) Mutual Fund Analysis
Fiduciaries have a duty to perform their own individual research and analysis of the investments chosen for their plans. ERISA and related legal decisions clearly state that plan sponsors cannot blindly rely on the advice and opinions of third parties such as plan service providers, e.g., mutual funds, insurance companies. And yet, experience has shown that that is exactly what may plan sponsors do, often due to financial considerations that the plan may receive from the service provider.
I love to analyze “best” or “top” lists. Each year the publication “Pensions and Investments” publishes a list of the top investments in 401(k) plans. The list is based on purely objective criteria, namely the reported assets invested in each fund.
I like to perform an annual forensic fiduciary analysis based on the “P & I” list. The results are often interesting and always spark conversations from a potential fiduciary liability viewpoint. This year is no different, as only three of the funds pass fiduciary liability scrutiny. The message should be especially meaningful for plan sponsors who face personal liability for imprudent investment decisions. The most recent forensic analysis is here.
Remember, fiduciary liability is based not on actual performance of the investment chosen for a plan, but rather on the quality of the fiduciary’s selection process. My most recent forensic fiduciary analysis of the top ten 401(k) funds can be found here. As Aldous Huxley pointed out, “facts do not cease to exist because they are ignored.”
The issue of fiduciary liability in connection with 401(k) and 404(c) defined contribution plans has taken on greater importance since the Supreme Court’s landmark 2008 decision in LaRue v. DeWolff, Boberg & Associates, Inc.8 Litigation in this area has centered on the fiduciary duties of prudence and loyalty, more commonly referred to the “best interest” requirement, specifically with regard to the issue of the excessiveness of fees of the plans investment options. All signs point to increased litigation on these issues.
They say a picture is worth a thousand words. With subjectivity often cited by plan sponsors and other investment fiduciaries in trying to excuse alleged breaches of fiduciary duties, the ability to quantify fiduciary prudence and “best interest” issues can hopefully provide fiduciaries, plan sponsors, regulators, the courts, and investors with meaningful information to better protect both fiduciaries and investors.
1.Carras v. Burns, 516 F.2d 251, 258-59 (1975); Follansbee v. Davis, Skaggs & Co., Inc., 681 F.3d 673, 677 (1982).ERISA Section 404(a)(1)(B)
2. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing.” 6th ed. (New York, NY: McGraw/Hill, 2018), 104.
3. Tittle v. Enron, 284 F. Supp. 2d 511, 547-48 (S.D. Tex. 2003); DiFelice v. U.S. Airways, 497 F.3d 410, 423 (4th Cir. 2007).
4. RESTATEMENT (THIRD) OF TRUSTS, § 90 cmt. e(1)
5. RESTATEMENT (THIRD) OF TRUSTS, § 90 cmt. e(1)
6. Laborer’s Nat’l Pension v. Northern Trust Advisors, 173 F.3d 313 (5th Cir. 1999)
7. LaRue v. DeWolff, Boberg & Assoc., Inc., 128 S.Ct. 1020 (2008)
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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.