May It Please the Court: Vanguard Funds As ERISA Benchmarks Study

InvestSense – The art of combining sound, proven investment strategies with common sense.

I recently posted an article on one of my blogs discussing my concerns over some of the reasons given by some courts for dismissing actions against 401(k) and 403(b) plans. The actions basically alleged that the plans had charged excessive fees and/or had chosen imprudent investment options for plan participants.

One of the specific decisions I discussed involved a judge refusing to accept Vanguard funds as acceptable benchmarks to evaluate a plan’s actual investment options. My objection was with the court’s refusal to accept the Vanguard funds based purely on the fact that their low-fee business model is different from most actively managed funds, which are for-profit models that charge significantly higher fees, yet consistently underperform comparable Vanguard fees.

[the expert’s] comparison, however, is flawed. 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. Moreover, even if the Court were to accept the Plaintiffs’ account of the range of Putnam mutual fund expense ratios or average management fees, the Plaintiffs cite no relevant case law holding that such ranges or averages are unreasonable as matter of law.1   

As I stated in my post, the court’s “apples and oranges” argument completely ignores the fact that the whole purpose of retirement plans is to provide plan participants with legally prudent investment options in hopes of allowing them to become “retirement ready.” ERISA, the primary law covering most retirement plans, and the Restatement of Trusts both impose strong legal duties on plan sponsors, including a duty of loyalty to plan participants and a duty to select prudent investment options for a plan.

One of the legal duties set out in the Restatement is that a defined contribution plan’s actively managed investment options be cost-efficient, that the reasonably projected returns of each actively managed investment within a plan will cover the costs and risks associated with that investment.2 Most 401(k) and 403(b) plans still select actively managed mutual funds as their investment options. And yet, the evidence clearly shows that most actively managed mutual funds fail to meet this requirement, with studies noting that

“the investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.3

“there is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.”5

If the plan participants’ best interests are truly what matters, then how do all the actively managed mutual funds measure up to comparable Vanguard benchmark funds? Using the Morningstar Data Research Center, I ran screens on each of the nine investment styles that Morningstar uses in analyzing the mutual fund universe: LCB, LCG, LCV, MCB, MCG, MCB, SCB, SCG, SCV.

Most of the criteria I used in the screens are based on a simple metric I created a couple of years ago, the Active Management Value Ratio™ 3.0 (AMVR). The AMVR is based largely on the studies of investment icons Charles D. Ellis and Burton Malkiel:

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.6 – Charles D. Ellis

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover.7
Burton G. Malkiel

The screens were intended to evaluate relative performance, cost-efficiency, and potential “closet indexing” issues. The screens reflect the progressive  result after the application of each screen element.

The Screens Results
LCB – 1294 funds
Benchmark: Vanguard S&P 500 Index Fund-Admiral shares (VFIAX)
5-Year Performance > 74
Expense Ratio < 6
Turnover < 1
R-squared < 90 1 (VFIAX)

LCG –  1387 funds
Benchmark: Vanguard Growth Index Fund-Admiral shares (VIGAX)
5-Year Performance > 387
Expense Ratio < 2
Turnover < 2
R-squared < 90 2 (VIGAX and Vanguard Growth Index Fund-Institutional shares)

LCV –  1176 funds
Benchmark: Vanguard Value Index Fund-Admiral shares (VVIAX)
5-Year Performance > 32
Expense Ratio < 2
Turnover < 2
R-squared < 90 2 (VVIAX and Vanguard Value Index Fund-Institutional shares)

MCB –  422 funds
Benchmark: Vanguard Midcap Index Fund-Admiral shares (VIMAX)
5-Year Performance > 50
Expense Ratio < 4
Turnover < 4
R-squared < 90  4 (Vanguard Midcap Index Fund-Admiral, Institutional and InstitutionalPlus shares; Fidelity Midcap Index-Institutional shares)

MCG –  581 funds
Benchmark: Vanguard Midcap Index Growth Fund-Admiral shares (VMGMX)
5-Year Performance > 237
Expense Ratio < 2
Turnover < 1
R-squared < 90 1 (VMGMX)

MCV –  398 funds
Benchmark: Vanguard Midcap Index Value Fund-Admiral shares (VMVAX)
5-Year Performance > 24
Expense Ratio < 1
Turnover < 1
R-squared < 90 1 (VMVAX)

 744 funds
Benchmark: Vanguard Small Cap Index Fund-Admiral shares (VSMAX)
5-Year Performance > 99
Expense Ratio < 3
Turnover < 3
R-squared < 90  3 (Vanguard Small Cap Index Fund-Admiral, Institutional and Investor shares)

SCG –  702 funds
Benchmark: Vanguard Small Cap Growth Index Fund-Admiral shares (VSGAX)
5-Year Performance > 307
Expense Ratio < 2
Turnover < 2
R-squared < 90  2 (VSGAX and Vanguard Small Cap Growth Index Fund-Institutional shares)

SCV –  398 funds
Benchmark: Vanguard Small Cap Value Index Fund-Admiral shares (VSIAX)
5-Year Performance > 18
Expense Ratio < 2
Turnover < 2
R-squared < 90  2 (VSIAX and Vanguard Small Cap Value Index Fund-Institutional shares)

Pretty impressive showing by Vanguard’s fund if “retirement readiness” and the “best interests” of plan participants is the true evaluation standards for the fiduciary duties of loyalty and prudence. As a fiduciary attorney, the results of the study remind me of the prediction made by John H. Langbein, who served as the Reporter of the committee that authored the Restatement (Third) of Trusts:

We think we should conclude our review of the trust law by warning fiduciaries that they cannot ‘play safe’ by ignoring the new learning and continuing uncritically to put trust money into old-fashioned, managed portfolios. When market funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantages for the beneficiaries of his trust may in the future find his conduct difficult to justify.8

It is a liability/risk management question that plan sponsors, investment advisers, and other investment fiduciaries should consider. To quote Aldous Huxley, “facts do not cease to exist because they are ignored.”

1. Brotherson et al. v. Putnam Investments, Inc., available online at
2. Restatement (Third) Trusts, Section 90, comment h(2).
3. Carhart, Mark, “On Persistence in Mutual Fund Performance, Journal of Finance, 52, 57-82.
4. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.
5. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
6. Ellisa, Charles D., “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018, 10.
7. Malkiel, Malkiel, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
8. Langbein, John H. and Posner, Richard A., “Market Funds and Trust-Investment Law, (1976), Faaculty Scholarship Series. Paper 498.

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.
This entry was posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, compliance, cost consciousness, cost efficient, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, wealth management, wealth preservation and tagged , , , , , , , , , , , , , , , , , , , , , . Bookmark the permalink.