“Avoiding ‘Lipstick on a Pig’: Evidence-Based Investing for ERISA Fiduciaries”

“You can put lipstick on a pig, but it’s still a pig.” – Wall Street saying

I often serve as a consultant to securities/ERISA attorneys and 401(k)/403(b) retirement plans. I am often asked to perform a forensic analysis of an investment product or an entire investment portfolio.

In my opinion, the ongoing litigation involving 401(k), 403(b) and other pension plans is simply going to increase due the fact that most plan sponsors and other fiduciaries either do not know how to properly evaluate mutual funds or fail to do so. Based on my experience, far too many plan sponsors simply decide to blindly follow whatever recommendations they receive from plan advisers and other third parties, despite the fact that the courts have consistently warned that to do so is a clear violation of a plan sponsor’s fiduciary duties.(1)

Fred Reish and Bruce Ashton, two noted ERISA lawyers, wrote an excellent article warning ERISA fiduciaries that while full implementation of the DOL’s new rule is still pending, plan advisers are currently subject to the rule’s Impartial Conduct Standards, including the “best interest” standards.(2) While some have complained that some terms, such as “reasonable” and “best interests,” are subjective and have yet to be properly defined, such arguments are without merit.

As the Supreme Court pointed out in their Tibble decision,(3) the courts often look to the Restatement (Third) Trusts (Restatement) for guidance on fiduciary issues, especially those involving ERISA questions. In my practice, I always point clients to two particular sections of the Restatement. Section 88 states that fiduciaries have a duty to be cost conscious. Section 90, known as the Prudent Investor Rule, has numerous key provisions for fiduciaries. I always point to comment h(2) which states that a fiduciary should not utilize actively managed mutual funds unless the fund’s past performance reasonably leads one to assume that the fund’s performance will more than cover the extra costs and risks typically associated with actively managed funds.

Other sections from the Restatement dealing with the importance of the fiduciary duty to be cost include the Introductory Note to Section 90 and Section 90, comments b and m. Comment b to Section 90 sums up the entire issue perfectly, stating that “[C}ost conscious management is fundamental to prudence in the investment function.”

As a securities/ERISA attorney, I put a great deal of emphasis on evidence and evidence-based investing. Since plan sponsors and other investment fiduciaries can expect the same in litigation or an audit, I strongly suggest that they adopt a similar policy.

One source of valuable information is the semi-annual SPIVA (Standard & Poor’s Indices Versus Active) reports.(4) Based on their performance over the five-year period ending June 30, 2017, 82.38 percent of large cap funds, 87.21 percent of midcap funds, and 93.83 percent of small cap funds underperformed their S&P benchmarks. Drilling down further in the large cap sector, the sector that dominates most retirement plans, over the same time period, 76.43 percent of large cap growth, 88.63 percent of large cap value, and 85.09 percent of large cap core funds underperformed their comparable S&P index.

While SPIVA reports provide valuable information for investment fiduciaries, they are based purely on absolute performance and do not factor in such issues as a fund’s cost efficiency and/or the fund’s potential classification as a “closet index” fund. Numerous studies have documented the importance of cost efficiency, particularly with regard to a fund’s expense ratio and trading costs.

“The two variables that that do the best job at predicting future performance [of mutual funds] are expense ratios and turnover.”(5)

“Expense ratios, portfolio turnover, and load fees are significantly and negatively related to [a mutual fund’s performance].”(6)

“[A fund’s) expense ratio and portfolio turnover are negatively associated with investment performance.”(7)

“On average, trading costs negatively impact fund performance….On average, [actively managed funds] fail to fully recover their trading costs-$1 in trading costs reduces fund assets by $0.41….We fund that trading costs have an increasingly detrimental impact on performance….”(8)

Despite this evidence, 401(k) plans and other types of retirement plans have historically chosen actively managed mutual funds as the primary investment options for their plans. While we are seeing a change to the inclusion of more index funds within plans, actively managed funds are still the predominant investment choice in 401(k) plans and other retirement plans.

In order to factor in the cost efficiency and closet index issues, I was asked by some of my litigation clients to create a fiduciary prudence screen that factors in such issues using Morningstar’s Research Center program.  The screen evaluated the universe of actively managed mutual funds based on their Morningstar category, progressively eliminating funds that failed to pass a component of a screening factor. The screening components and the overall findings of the study are attached as Exhibit A. (Note: The apparent discrepancy in the number of funds passing the screens and the specific funds identified is due to the fact that only retirement shares that passed the screens are identified in this exhibit.)

A number of courts have recently ruled in favor of 401(k) plans, causing plans and their attorneys to declare that the tide has turned in favor of plans in excessive fee cases. Some ERISA plaintiff attorneys have suggested that such predictions are premature based on the fact that a number of said courts failed to factor in the Restatement’s cost efficiency mandate and the entire closet index issue.

Some courts seem to have suggested that the sheer number of investment options offered by a 401(k) or other retirement plan insulates a plan from any finding of breach of their fiduciary duties, such opinion apparently being based on the Seventh Circuit’s ruling in Hecker v. Deere, Inc. (Hecker I).(9) However, the Seventh Circuit quickly went back and rejected such a notion in Hecker II(10) in what the court labeled a “clarification,” but most securities and ERISA attorneys agree was a reversal of their earlier decision.

Most of the previously mentioned pro-plan decisions have been appealed for the reasons mentioned herein. It would not be surprising to see the appellate courts reverse the pro-plan decisions and remand the cases back to the lower courts to allow further litigation on the fiduciary issues. In order to prevent such questionable decisions going forward, expect to see the plaintiff’s bar focus additional attention on the issue of a fiduciary’s duty to be cost efficient and the closet index issue, as the evidence overwhelmingly establishes the failure of most actively managed funds to meet such hurdles.

Going Forward
One of my favorite quotes is “facts do not cease to exist because they are ignored.” So, given the evidence discussed herein, what are the potential “best practices” and liability implications for investment fiduciaries?

Fiduciary law and ERISA are essentially codifications of the common law of trusts, agency and equity. Quantum meruit is a basic tenet of equity law.  In the commercial context, quantum meruit essentially says that if one provides compensation to another, whether it be cash or services, the party providing such compensation has a reasonable expectation of receiving something of equal or greater value in return.

The evidence clearly shows that in the investment industry, far too often investors are simply not receiving equal or greater value in exchange for the compensation they are paying investment advisers and mutual fund companies. That fact becomes even clearer if one applies the incremental cost/incremental return analysis developed by Charles D. Ellis.(11)

Combining Ellis’ incremental cost/incremental return approach with Burton Malkiel’s findings regarding the predictive powers of a fund’s expense ratio and trading costs, I created a metric, the Active Management Value Ratio™ (AMVR). The AMVR allows investors and investment fiduciaries to calculate the cost efficiency of an actively managed mutual fund. The AMVR often shows that a specific actively managed mutual fund is not cost efficient, and therefore not a prudent invest choice under the Restatement’s fiduciary standards. For further information on the AMVR and its calculation process, click here.

Based on data from the Morningstar Research Center, as of January 31, 2018, the difference between the expense ratios for Vanguard benchmark funds used in my analysis, VFIAX, VIGAX and VVIAX, and the average expense ratios for the funds in their respective sections is approximately 96 basis points (large cap blend), 105 basis points (large cap growth) and 109 basis points (large cap value). Add in the turnover/t rading costs for all the funds and sectors, and the cost differences rise 105 basis points (large cap blend), 162 basis points (large cap growth), and 159 basis points (large cap value).

Given the evidence that very few actively managed mutual funds manage to even cover their costs, let alone outperform their relative benchmarks at all, it is easy to see why very few actively managed funds are cost efficient. Even when an actively managed fund does manage to outperform its relative bench mark, the difference is usually less than 25-50 basis points, far below the 100+ cost basis points differential indicated in the Morningstar data.

Under both the DOL’s new Impartial Conduct Standards and basic fiduciary law, two key concepts are “reasonable compensation” and the “best interests” of a customer. I believe that the evidence discussed herein, along with the AMVR, create some pivotal questions that investment fiduciaries, both ERISA and non-ERISA, and the courts must address going forward, namely

  • Is any compensation “reasonable” or in the “best interest” of a customer if the historical performance of the recommended investments indicated that such investments were not cost efficient and/or would have failed to provide any inherent value for a customer, i.e, would not have produced a positive incremental return for a customer, at the time the recommendations were made?
  • If the goals of ERISA are to be achieved, protection of plan participants and promotion of their “retirement readiness,” shouldn’t the inherent value of a retirement plan’s investment options in terms of benefits provided, if any, be the key issue rather than the business platform chosen by a mutual fund company?

Existing evidence overwhelmingly establishes the failure of most actively managed mutual funds to meet the fiduciary requirements for loyalty and prudence set out in the Restatement, a resource which the Supreme Court recognized in the Tibble decision. As the plaintiff’s bar devotes more attention to such standards and evidence of non-compliance with same, it would serve plan sponsors and other investment fiduciaries to do so as well.

 Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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.

1. Gregg v. Transportation Workers of America Int’l, 343 F.3d 833 (2003), Liss v. Smith, 991 F. Supp 278 (S.D.N.Y. 1998)
2. Bruce L. Ashton and Fred Reish, “Under the DOL’s Fiduciary Rule, Beware the Myths,” Employee Benefit Adviser, available online at http://www.employeebenefitadviser.com/opinion/under-the-dols-fiduciary-rule-beware-the-myths
3. Tibble v. Edison International, 135 S. Ct. 1823, 1828 (2015)
4. http://us.spindices.com/spiva/
5. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460;
6. Mark Carhart, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
7. Zakri Y. Bello and Lisa C. Frank, “A Re-Examination of the Impact of Expenses on the Performance of Actively Managed Equity Mutual Funds,” European Journal Finance and Banking Research, Vol. 3, No. 3 (2010)
8. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Tradings Costs,” available at http://www.ssrn.com/abstract=951367
9. Hecker v. Deere (Hecker I), 556 F.3d 575 (7th Cir. 2009)
10. Hecker v. Deere (Hecker II), 569 F.3d 708, 711 (7th Cir. 2009)
11. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,”6th ed. (New York, NY: McGraw/Hill, 2018), 10


YrR – Annualized Return
ER – Expense Ratio
TO – Turnover

2018 Morningstar Cost Efficiency and R-squared Analysis
VFIAX LCB/1346 Top Quartile
5 YrR > 118
5 YrR load adj > 95
ER < .50 25 .01-.97
TO < 50 19 0-20
Rsqrd < 90 1 96-100 VFIAX
5 YrR > 400
5 YrR load adj > 332
ER < .50 31 0-.69
TO < 50 27 0-26
5 YrR > 40
5 YrR load adj > 37
ER < .50 12 .05-.65
TO < 50 6 0-26
Rsqrd < 90 1 90-97 VVIAX
5 YrR > 212
5 YrR load adj > 191
ER < .50 4 0-.90
TO < 50 4 0-25
Rsqrd < 90 4 83-89 FMCSX, IRGJX
5 YrR > 13
5 YrR load adj > 12
ER < .50 1 0-.77
TO < 50 1 0-32
Rsqrd < 90 1 79-90 VMVAX
5 YrR > 179
5 YrR load adj > 169
ER < .50 9 ..06-.92
TO < 50 6 0-35
Rsqrd < 90 6 67-87 DSCGX, ALFYX, VRTGX
5 YrR > 20
5 YrRload adj > 15
ER < .50 2 .06-.93
TO < 50 2 0-23
Rsqrd < 90 2 55-68 VSIAX, VSIIX

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member 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 on sound, proven investment strategies that will help them protect their financial security.
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