The vast majority of active managers are unable to produce excess returns that cover their costs.¹

I recently posted an article discussing a brilliant complaint that was filed in connection with a new 401(k) excessive fees/breach of fiduciary duties action. The beauty of the complaint was that it was the first time that I have seen any attorneys address the alleged breaches in terms of the fiduciary duty of cost-consciousness, as set out in the Restatement.

Comment b of Section 90 of the Restatement (Third) Trusts states that a fiduciary has a duty to be cost-conscious in carrying out their duties.² I have long wondered why more plaintiffs’ attorneys, plan sponsors and other investment fiduciaries have not fully utilized the cost-consciousness “blueprint” that the Restatement provides in drafting pleading and addressing potential liability exposure based on alleged breaches of a fiduciary’s duties of loyalty and/or prudence. The blueprint is a four-step process:

1. The fiduciary duties of loyalty and prudence, as set out in both ERISA³ and the Restatement.⁴
2. The duty of cost-consciousness as a sub-set of the duty of prudence.⁵
3. The fiduciary duty to efficiently managing the cost/return/risk relationship of investments.⁶
4. The fiduciary duty of cost-consciousness relative to the selection of actively managed mutual funds.”⁷

The investment industry and even some courts have been quick to reference that fact that ERISA does not require an ERISA fiduciary to always select the least expensive investment option, which is true. However, neither ERISA nor the Restatement gives an ERISA fiduciary carte blanch power to just select any investment option without consideration of the corresponding benefit derived from any additional costs and/or risks associated with the more expensive investment option. The absurdity of such an argument is obvious, as it would essentially nullify the basic fiduciary duties of loyalty and prudence.

The stated mission of ERISA and the Restatement is to protect the rights and interests of American workers and the public. In addressing the selection of investment options for a pension plan, the Restatement sets out two vital considerations,

[Fiduciaries], like other prudent investors, prefer (and, as fiduciaries, ordinarily have a duty to seek) the lowest level of risk and costs for a particular level of expected return-or, inversely, the highest return for a given level of risk and cost.⁸  

A decision to [select actively managed mutual funds] involves judgments by the [fiduciary] that a) gains from the course of action in question can be reasonable expected to compensate for its additional costs and risks;…⁹

And there it is, the potential cost-consciousness “gotcha.”  As the opening quote states, not only do a large percentage of actively managed mutual funds fail to outperform a their appropriate benchmarks, they fail to even covert their own costs! Studies such as the Standard & Poor’s SPIVA reports¹⁰ and academic studies¹¹ consistently show that the overwhelming majority of actively managed mutual funds underperform comparable index funds, thus failing to compensate for their often significantly higher fees and expense. As the introduction to Section Seven of the Uniform Prudent Investor states, “wasting beneficiaries’ money is imprudent.” The combination of an imprudent recommendation/ selection of investment options and engaging in conduct that is not in the best interest of clients/ beneficiaries clearly indicates a breach of one’s fiduciary duties.

Bottom line – There is no carte blanch power in plan advisors, plan sponsors or other plan fiduciaries in recommending and/or selecting investment options. Incurring additional costs or risks without a commensurate benefit for such additional costs or risks is a violation of the fiduciary duties of loyalty and prudence.

The Active Management Value Ratio™ 3.0
The fact that the referenced complaint chose to expressly incorporate the fiduciary duty of cost-consciousness, combined with the above-referenced requirements, creates a difficult hurdle for any defense to overcome for one simple reason-most of the investments products currently on the market do not satisfy these requirements.

I have written extensively on a metric that I created, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR is based on the studies of investment icons Charles D. Ellis and Burton G. Malkiel. Ellis advocates that the proper way to evaluate investment costs is in terms of an investment’s incremental costs relative to its incremental return.¹² Malkiel studies have concluded that the two best predictor’s of as mutual fund’s performance are its annual expense ratio and its portfolio turnover.¹³

The AMVR evaluates the cost-efficiency of an actively managed mutual fund in terms of its incremental, or additional, costs relative to its incremental return, if any, over and above a comparable benchmark, usually a comparable index fund. My experience has been that very few funds are able to produce positive incremental returns. Even when an actively managed fund does produce positive incremental returns, they often fail to produce returns that exceed the incremental costs incurred in producing such positive returns. Articles regarding the AMVR can be found here and here. In addition, each year I do a forensic analysis of the top ten non-index funds used within defined contribution plans, as reported by “Pensions and Investments.” Samples of past analyses are available here.

The “Closet Index Fund” Factor
Another issue that makes it difficult for plan sponsors to meet the “commensurate benefit” requirement of the fiduciary duty of cost-consciousness is the increasing use of “closet indexing” by mutual funds. Closet indexing refers to situations where a mutual fund holds itself out as an actively managed mutual fund, and charging higher fees for such active management, but whose actual performance closely tracks that of a comparable, but less expensive, index fund.

Two well-known methods for assessing “closet indexing are Russ Miller’s Active Expense Ratio (AER) metric, and Martijn Cremer and Antti Patejisto’s Active Share metric. For my forensic analyses I prefer to use AER because I find it easier to calculate and interpret. The AER is based on a fund’s R-squared rating, which is widely available online

There is no universally mandated level of R-squared for designating a fund as a closet index fund. However, a fund’s R-squared rating does help to provide a meaningful analysis of the effective expense costs that an investor is paying due to the misrepresentation of the extent of active management that a fund is providing. Miller’s research found that funds with high R-squared ratings, and thus low contributions from active management, often had effective expense rates 300-400 percent higher than their stated expense ratios.

My experience has been that very few plan sponsors and other investment fiduciaries even factor in a fund’s R-squared rating in their required due diligence process. This could result in increased personal liability exposure since the courts and regulators assess compliance with one’s fiduciary duties based upon what a fiduciary knew or should have known as a result of a properly conducted due diligence analysis.¹⁴

I recently ran a forensic analysis on the mutual fund universe of retirement shares of domestic equity-based mutual funds. The purposes of the analysis was to study the impact of various levels of a fund’s R-squared rating on fiduciary cost-consciousness/ fiduciary prudence standards. The results of my analysis on the large cap retirement funds sectors is attached as Appendix A.

In my analysis, I used the five-year trailing returns of Admiral shares of three Vanguard funds as my benchmarks: Vanguard S&P 500 Index Fund, Vanguard Growth Index Fund, and Vanguard Value Index Fund. I used data provided on the Morningstar Investment Research Center program. In my “closet index” analysis, I screened for retirement class funds that outperformed the relative benchmark fund with R-squared rating of 95 or below, 95 and above, 90 or below and 90 and above.

The analysis produced good news and potentially bad news for plan advisors, plan sponsors and other plan fiduciaries.  The good news – there were a number of funds that did outperform their relative benchmark’s return performance in all three large cap categories. The bad news – once cost-consciousness factors such as a fund’s annual expense ratio and turnover ratio were factored in, only the benchmark fund, and in some cases other share classes of the benchmark fund, survived the cost-efficiency screen.

Additional analyses could be done increasing the turnover and/or expense ratio numbers. However, anyone making such changes needs to consider two key issues. First, each additional 1 percent in additional fees reduces an investor’s end return by approximately 17 percent over a twenty year period. Second, increasing a fund’s incremental costs with a corresponding increase in the fund’s incremental return increases the odds of a fund failing the AMVR’s fiduciary cost-efficiency screens. Once again, “wasting beneficiaries’ money is imprudent.”

Conclusion
While most people are aware of the fiduciary duty of prudence, my experience has been that most are not aware of the Restatement’s position on the duty of cost-consciousness as a sub-set of the duty of prudence. I believe that the recently filed complaint in the MFS ERISA 401(k) action has alerted some people to the cost-consciousness requirement for fiduciaries.

With increasing awareness of a fiduciary’s duty of cost-consciousness, and the difficulty in complying with such duty give the qualities of many of the investment products currently in the market, I believe that plan sponsors and other plan fiduciaries face a daunting challenge to make their plans ERISA compliant and to reduce their risk of personal liability for a failure to do so.  The selection of truly objective, informed and experienced ERISA experts to help them face such challenges will therefore become more valuable than ever before.

Notes
1. Philipp Meyer-Browns, “Mutual Fund Performance Through a Five Factor Lens,” DFA White Paper (August 2010)
2. Restatement (Third) Trusts, Section 90 cmt. b; Tibble v. Edison Int’l, 843 F.3d 1187, 1197
3. 29 C.F.R. Section 2550.401a-1 et seq.
4. Restatement (Third) Trusts, Sections 77, 78 and 90
5. Restatement (Third) Trusts, Section 90, cmt b
6. Restatement (Third) Trusts, Section 90, cmt f
7. Restatement (Third) Trusts, Section 90, cmt h(2)
8. Restatement (Third) Trusts, Section 90, cmt f
9. Restatement (Third) Trusts, Section 90, cmt h(2)
10. http://us.spindices.com/spiva/
11. Mark M. Carhart, “On Persistence in Mutual Fund Performance, ”The Journal of Finance, Vol. 52, Issue No. 1 (March 1997), 57-82.
12. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing.”6th ed. (New York, NY: McGraw/Hill, 2018), 104.
13. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
14. 29 C.F.R. Section 2550.404a-1

© 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor 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.

APPENDIX A