The Two Minute ERISA Fiduciary Liability Risk Management Challenge

I love fiduciary law. In a world with so many legal uncertainties, indecision and “weasel words,” fiduciary law is demanding and direct. The Restatement (Third) of Trusts, specifically Section 90, the Prudent Investor Rule, sets out the basic fiduciary requirements. Good faith beliefs and/or lack of knowledge are not accepted as defenses to breaches of the fiduciary duties set out in the Restatement, or as the courts like to say, “a pure heart and an empty head are no defense” to breach of fiduciary duty claims.

I first became interested in fiduciary law in the early 1990’s and became even more interested in the subject when I took a job as an RIA specialist at FSC Securities in Atlanta in 1995. It has been interesting to see the fiduciary developments in the securities industry, as more and more commission-based stockbrokers are making the move  to the RIA side and the move to a fee-based, fiduciary practice.

Even now, there are those that want to argue that the “best interests” requirement of fiduciary law is ambiguous and therefore leaves investment fiduciaries unfairly exposed to potential legal liability. The Restatement defines one’s fiduciary duties in terms of the Prudent Person Standard, which requires a trustee or other fiduciary to use the same “care, skill, prudence, and diligence under the circumstances then prevailing” that a prudent person would use considering all of the relevant facts that the fiduciary knew or should have known based on their independent investigation and evaluation of the situation.

One of my favorite quotes is from the late General Norman Schwarzkopf, who said “the truth of the matter is that you always know the right thing to do. The hard part is doing it.” In the world of financial/investment advice, fiduciaries must make sure that personal conflicts do not overtake one’s recognized legal duties. An objective analytical tool can help them do that

In my legal practice, I provide consulting services to RIA firms and ERISA plan sponsors. Many of my clients originally complained that they had a hard time understanding and acting in accordance with the Restatement’s fiduciary standard and “best interest” requirement.

After considerable frustration with both the genuine and the bogus complaints, I decided to create a metric to help clarify the concepts of the prudence and “best interests” required of fiduciaries under the Prudent Person Rule. Today, I am proud to say that I am learning that fiduciaries and attorneys are increasingly using my metric. the Active Management Value Ratio™ 2.0 (AMVR) in their practices to determine the prudence, or lack thereof, of the decisions of RIAs and ERISA fiduciaries.

The strength of the AMVR is its simplicity, both in terms of calculation and interpretation. The AMVR is the same simple cost/benefit metric many of us learned in our college Econ 101 class. The AMVR calculates the cost efficiency of an actively managed mutual funds relative to a comparable passively managed, or index, fund based on the incremental cost incurred and incremental return, if any, produced by an actively managed mutual fund.

The AMVR is based on the studies of investment icons Charles Ellis and Burton Malkiel. Ellis introduced the concept of analyzing mutual funds based on their incremental costs and incremental returns. His argument is that index mutual funds have become, in essence, commodities,  and that the proper way to evaluate any commodity is in terms of their incremental, or added, costs and returns. Malkiel’s contribution to the AMVR is his research finding that the two most reliable indicators of a mutual fund’s future performance are the fund’s annual expense ratio and its trading costs.

Calculating an actively managed mutual fund’s incremental returns only requires that the annualized return of a benchmark/index fund is subtracted from the annualized return of the actively managed mutual fund. I prefer to use the funds’ five year annualized returns in order to get at least one period of down or negative returns and, thus,  a better picture of the funds performance patterns. In some cases I will also analyze rolling five-year returns to verify the funds’ historical trends.

In calculating the funds’ incremental returns, I rely on Malkiel’s findings and combine a fund’s stated annual expense ratio with its trading costs. Since mutual funds are not required to disclose their actual trading costs, I use a proxy developed by John Bogle, former chairman of the Vanguard family of funds. Bogle simply doubles a fund’s stated turnover ratio and then multiples that number by 0.60 based on historical data re trading costs. While the trading cost number may not exactly match a fund’s actual trading costs, the application of a uniform factor to get a proxy number is acceptable and helpful in getting a better picture of a fund, as trading costs for an actively managed mutual fund are often higher than a fund’s annual expense ratio and both reduce an investor’s end return.

The calculation process only require a couple of pieces of data, all of which are freely available online at sites such as and As an investor, fiduciary or attorney becomes more familiar with the calculation process, the entire calculation process takes two minutes or less per fund.

As I mentioned earlier, the simplicity of interpreting a fund’s AMVR score in terms of prudence and “best interests” is one of the metric’s strengths. An example will help demonstrate this fact.

Assume two funds, Fund A being the actively managed fund and Fund B being the benchmark/index fund. Fund A has a five-year annualized return of  10 percent, an annual expense ratio of 1.00 percent and a 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 a turnover ratio of 3 percent.

Fund A produces  1 percent, or 100 basis points, of incremental return (10-9) and incremental costs of  1.40 (1.60-0.20). (A basis point equals .01 percent of 1 percent) AMVR calculates a fund’s cost efficiency, so AMVR is calculated by dividing the fund’s incremental costs by its incremental returns. Funds that fail to provide any positive incremental returns do not qualify for an AMVR score, as they clearly do not qualify as prudent investment choices relative to the benchmark/index investment option.

In our example, Fund A’s AMVR score would be 1.4 divided by 1.0, for an AMVR score of 1.4. The optimum AMVR score will fall between one and zero. An AMVR score greater than one indicates that the fund’s incremental costs exceeds its incremental return, resulting in a loss for an investor relative to the less expensive benchmark/index fund.

The costs and returns issues becomes even more important when one considers that each additional 1 percent in costs and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period. The impact of theses costs was noted in a recent article in the Wall Street Journal, which cited a study that estimated that a working couple loses approximately a combined $155,000 over a twenty year period as a result of 401(k) fees and costs alone.

Each year I do a forensic analysis of the top ten mutual funds in 401(k) defined contribution plans, as reported by “Pensions and Investments” magazine. Using the AMVR as my primary analytical tool, the results provide a good explanation as to why so many 401(k) plans, of all sizes, could be susceptible to successful legal challenges. To view my 2016 analysis, click here.

Fidelity Contrafund is a well-known actively managed fund whose K shares appear in many 401(k), 457(b) and 403(b) plans . In fact, the fund was the number one fund in the “Pensions and Investments” article. Will Danoff, the fund’s manager has a stellar performance record and is often mentioned as one of the mutual fund industry’s best all-time managers. But does it currently pass the fiduciary prudence and “best interests” test?

Morningstar classifies Fidelity Contrafund K (FCNKX) as a large cap growth fund. For comparative purposes, we will use one of Vanguard’s leading large cap growth funds, the Value Growth Index fund. Using the same process as before, the analysis shows Contrafund has incremental costs of 86 basis points . Based on the funds’ stated annualized five-year returns, Contrafund does not produce any positive incremental returns (12.80 percent vs. Value Growth Index’s 13.14 percent) or other benefits to an investor above and beyond those provided by the comparable, and less expensive, index fund.

I deliberately chose Contrafund as an example to demonstrate another way to use the AMVR. Ellis originally suggested that in calculating incremental returns, the risk adjusted returns of funds should be used. If we substitute the two funds’ risk adjusted returns in the calculation process, Contrafund actually produces a positive incremental return of 0.69 percent, or 69 basis points (12.85 percent versus Value Growth Index’s 12.16 percent). However this would still not allow Contrafund to pass the prudence or “best interests” test since an investor would lose money by investing in the fund since Contrafund’s incremental costs exceed it’s risk-adjusted incremental returns.

A third way of interpreting the cost effectiveness of a fund’s AMVR score is by comparing the percentage of returns produced by a fund to the fund’s incremental costs as a percentage of the fund’s total costs. In the immediate example, the incremental. or added costs, of the actively managed fund equal 87.5 percent of the fund’s cost (1.40/1.60), yet such costs are only adding an additional 1 percent of return. Again, hard to argue that such results indicate a prudent investment that is in the client’s “best interests,” especially given the other findings that indicate that the comparable index fund is a better investment choice.

Based on my experience in running forensic analyses for investors, retirement plans and investment fiduciaries, I would estimate that approximately 70 percent of actively managed mutual funds would not qualify as prudent or in an investor’s “best interests” under my prudent/”best interests” analysis. When I run an analysis I actually use a progressive system that uses five qualitative screens. Three of the five screens are based on the AMVR, including the positive incremental returns and incremental returns greater than incremental costs screens. Those two screens will effectively eliminate a significant number of actively managed mutual funds from consideration, making the investor’s or fiduciary’s job that much easier and less time-consuming.

I think it is worth noting that the DOL adopted a prudence standard in defining “best interests” in connection with their recently adopted fiduciary standard. The SEC has recently stated that it too will consider implementing a fiduciary standard for the investment industry as a whole. When, and if, that does actually happen, I think it is safe to assume that the SEC’s fiduciary standard will adopt the same prudence and “best interest” standards that the DOL chose since it is consistent with the Restatement’s position.

The AMVR helps avoid the confusion over one’s fiduciary duties and “best interests” obligations by providing a quick and simple means of quantifying prudence and “best interests,” one that is based on the sound, proven findings of two of the investment industry’s most respected icons. As the use of the AMVR continues to grow,  plan sponsors and other investment fiduciaries will hopefully incorporate the metric into their required ERISA due diligence process in selecting and monitoring their plan’s investment options in order to reduce their risk of potential personal liability.

© Copyright 2016 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.


About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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