In my last post, I suggested that the correlation of returns between funds in a 401(k)/403(b) plan might be considered the “X” factor in ERISA litigation going forward. In this post, I want to discuss another emerging factor in ERISA 401(k)/4o3(b) excessive fees/breach of fiduciary litigation: cost-efficiency.

In the Tibble decision, SCOTUS expressly recognized the Restatement (Third) Trusts (Restatement) as a legitimate resource for resolving fiduciary questions, especially those involving ERISA. Section. Section 90 of the Restatement, otherwise known as the Prudent Investor Rule, establishes several standards that investment fiduciaries, including plan sponsors should be aware of:

• fiduciaries have a duty to be cost-conscious (cmt. a)
• A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return.(cmt. f), and
• actively managed funds that are not cost-efficient, that do not cover their additional costs and risks, are imprudent. (cmt. h(2)).

At the end of each calendar quarter, InvestSense conducts a forensic analysis of the top ten non-index mutual funds from “Pensions and Investments” annual survey of the top mutual funds in defined contribution plans, based on invested assets in U.S. 401(k) plans. I recently used our proprietary metric, the Cost-Efficiency Quotient (CEQ) to analyze the cost-efficiency of the top ten funds in our current quarterly analysis.

In calculating a fund’s cost-efficiency InvestSense uses John Bogle’s “all-in” costs metric, which includes a proxy for an actively managed fund’s trading expenses. Trading costs are not included in a fund’s annual expense ratio number, as they are included in a fund’s operation costs. The problem is that trading costs are not broken out separately in operational cost. Therefore, an investor or investment fiduciary is not able to include an exact number for trading costs.

Trading costs are often simply too significant to ignore in calculating a fund’s cost-efficiency. In fact, trading costs are sometimes greater than a fund’s annual expense ratio.

To avoid frivolous arguments, we also calculate a fund’s CEQ based only on a fund’s annual expense ratio. The annual expense ratio-only CEQs for the retirement shares of the current top ten funds are as follows

• Vanguard PRIMECAP – 40%
• Fidelity Growth Company – 26%
• TRP Blue Chip Growth – 18%
• TRP Growth Stock – 7%
• Fidelity Contrafund – 5%
• AF Growth Fund of America – 4%

AF Washington Mutual, AF Fundamental, Dodge & Cox Stock, and MFS Value all underperformed their respective benchmark, so their cost-efficiency number was zero. Vanguard’s Growth Index (LC), Value Index (LV) and the S&P 500 Index (LB) funds were used for cost and return comparative purposes.

The Active Expense Ratio (AER) is a metric that factors in the impact of correlation of returns on an actively managed fund’s annual expense ratio. The higher the correlation of returns between between an actively managed and a comparable index fund, the lower the effective contribution of active management. Created by Ross Miller, the AER allows plan sponsors and plan participants to to identify and avoid “closet” index funds and their unnecessary fees and costs. Closet index funds are imprudent investments.

The AER-adjusted CEQs for the retirement shares of the current top ten funds are as follows

• Vanguard PRIMECAP – 25%
• Fidelity Growth Company – 22%
• TRP Blue Chip Growth – 16%
• TRP Growth Stock – 6%
• Fidelity Contrafund – 4%
• AF Growth Fund of America – 2%

Just as with the annual expense ratio-only CEQs, AF Washington Mutual, AF Fundamental, Dodge & Cox Stock, and MFS Value all underperformed their respective benchmark, so their cost-efficiency number was zero. Vanguard’s Growth Index (LC), Value Index (LV) and the S&P 500 Index (LB) funds were used for cost and return comparative purposes.

Two obvious observations:

• No fund managed to post a cost-efficiency number of 50% of higher, using either an annual expense ratio-only CEQ or an AER-adjusted CEQ. In fact, only three of the ten funds even posted a cost-efficiency number in double digits.
• With the exception of the Vanguard PRIMECAP fund, the cost-efficiency numbers for the funds were essentially consistent regardless of the cost method used.

Going Forward
So what do the CEQ numbers mean for ERISA plan sponsors and ERISA attorneys? For ERISA plan sponsors, cost-efficiency should definitely be incorporated into the plan’s due diligence process.  Based on my experience as an ERISA attorney, far too many plan sponsors only look at a fund’s annualized returns and standard deviation in selecting funds for their plan. This limited evaluation often results in imprudent investments and unwanted and unnecessary liability for a 401(k)/403(b) plan and the plan’s fiduciaries.

Plan advisers and mutual funds do not like to discuss the cost-efficiency of the funds they recommend or select, for reasons shown herein. Maybe that is why so many plan advisers bury fiduciary disclaimer clauses in their advisory contracts, leaving plan sponsors exposed to any and all liability in connection with the funds actually chosen for their plans, even if the plan adviser recommended such investments.

Advisers and funds also do not like to discuss the issue of “closet indexing.” Closet indexing is evident when a fund claims to provide active management, but actually provides the same returns as a comparable, less expensive, index fund, albeit at much higher fees. Closet index funds are not cost-efficient.

Even worse, some plan sponsors do not perform their legally required individual investigation and analysis. The courts have consistently stated that the failure of a plan sponsor to conduct their own investigation is a clear breach of their fiduciary duties.

Studies have shown that most actively managed mutual funds simply are not cost-efficient.

• 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.¹
• [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.²
• [T]he 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

For attorneys, focusing on cost-efficiency appears to provide a clear advantage for plaintiff’s attorneys. First, cost-efficiency issues create genuine questions of fact. Since judges are allowed to only rule on questions of law, incorporating cost-efficiency issues in a action should preclude early dismissals of 401(k)/403(b) actions. Incorporating cost-efficiency issues in an action would also provide a legitimate means of getting the court to focus on the meaningful issues, the “retirement readiness” and overall best interests of the plan participants and their beneficiaries, rather than some of the questionable corollary issues that have been cited in recent court decisions dismissing 401(k)/403(b) actions.

As the late John Bogle was fond of saying, “costs matter.” Prudent plan sponsors and other investment fiduciaries will factor in all costs associated with a fund and determine whether the fund is cost-efficient, thereby providing a plan participant’s with an opportunity to improve and protect their financial security.

Copyright © 2019 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only. It 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.

Notes
1. Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
2. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
3. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82