When I read the district court’s decision in Brotherston v. Putnam Investments, LLC1, I read all the social media stories and posting proclaiming the end of 401(k)/403(b) fiduciary breach actions. My email accounts were flooded with “I told you so” emails. I especially loved those emails citing the court’s “apples versus oranges” language.
I responded online by posting my opinion that the district court’s rationales were flawed and that the First Circuit would vacate the district court’s decision, which it did. My opinion was simply based on the actual facts that are involved in the current 401(k)/403(b) debate and applicable law.
Now here is the part that should concern plans, plan sponsors and plan service providers. In my opinion, the plaintiff’s bar has not yet made its strongest fiduciary breach argument
In Tibble v. Edison International2, the Supreme Court acknowledged that the courts frequently turn to the Restatement (Third) Trusts (Restatement)3 to resolve fiduciary questions, especially those involving ERISA. Section 90 of the Restatement, commonly known as the “Prudent Investor Rule,” sets out various prudence standards for fiduciaries. Besides the basic fiduciary standards of loyalty and prudence, three particular standards have always stood out to me:
- Fiduciaries have a duty to be cost-conscious. (cmt. a)4
- 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)5
- Actively managed funds that are not cost-efficient, that do not cover their additional costs and risks, are legally imprudent. (cmt. h(2))6
From a potential fiduciary liability standpoint, comment h(2) is the potential time bomb. I believe the actively managed mutual funds cost-efficiency issue, along with the variable annuity issue, are the two reasons that the investment/financial service has been fighting any type of true fiduciary standard, as they know that very few of those two products can pass a true fiduciary standard in their current form.
Various studies by well recognized investment experts have concluded that most actively managed mutual funds 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.7
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.8
[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.9
The First Circuit also addressed the issue of risk-management within a plan and cost-efficiency in actively managed mutual funds, stating that
any fiduciary of a plan such as the Plan in this case can easily insulate itself byselecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry ‘wolf.’10
“Facts Do Not Cease to Exist Because They Are Ignored”
Like it or not, the cost-inefficiency of actively managed mutual funds, as well as the associated issue of “closet” indexing, are going to have to be addressed by both the investment and financial services industries. With the string of recent questionable dismissals of 401(k)/403(b) fiduciary breach actions, the time for the ERISA plaintiff’s bar has come to fully address the issue.
In 2016, I created a simple metric, the Active Management Value Ratio (AMVR). Now in its fourth iteration, the AMVR allows plan, plan sponsors, plan participants and attorneys to easily evaluate the cost-efficiency of actively managed mutual funds. The AMVR only requires the basic My Dear Aunt Sally (multiplication, division, addition and subtraction) math skills that everyone learned in elementary school. The AMVR only requires 5-6 pieces of data, all of which are freely available online. Additional information on the AMVR and the calculation process required is available here.
I represent myself as a forensic ERISA attorney. Based upon my time as a compliance director in the brokerage and RIA business, my services include performing forensic investment analyses for pension plans, trusts, and attorneys. My experience with regard to the cost-efficiency issue has been consistent with the previously mentioned studies-the majority of actively managed mutual funds are not cost-efficient.
Those findings should not come as a surprise to anyone if they objectively consider the current situation. The Morningstar Investment Research Center recently reported that the average expense ratio of a U.S. domestic large cap mutual fund was 1.11% (111 bps), as compared to the 0.17 expense ratio (17 bps) of the Vanguard Growth Index Investor shares.
Common sense should tell a plan sponsor or other investment fiduciary that if an actively managed fund has a high R-squared, or correlation of return, number to a comparable index fund, it is highly unlikely that the actively managed fund is going to outperform a comparable index to the extent necessary to make up the cost difference between the two funds. Based on my experience, even when an actively managed fund does outperform a comparable index fund, the difference in returns is usually less than 0.50% (50 bps).
Bottom line-the greater the incremental cost between an actively managed mutual fund and a comparable index fund, the greater the likelihood of the actively managed fund being cost-inefficient, and thus violating the Restatement’s cost-efficiency requirement.
Furthermore, since costs are essentially negative returns, the size of an actively managed fund’s incremental costs will also reduce the fund’s annualized returns, further increasing the negative impact of an actively managed fund on a plan participant’s end-return and “retirement readiness.”
As more focus has been directed toward the issues of cost-efficiency and the underperformance of actively managed mutual funds r4elative to lower-cost index funds, the issue, and costs, of “closet,” or “shadow,” indexing has gained greater attention.
A former general counsel of the Securities and Exchange Commission made these comments addressing “closet” indexing:
The presence of the virtual hedge fund is, of course, why you chose active management. If there were zero holdings in the virtual hedge fund — no overweightings or underweightings — then you would have only an index fund.
Indications from the academic literature suggest in many cases the virtual hedge fund is far smaller than the virtual index fund. Which means…investors in some of these [actively managed funds]… are paying the costs of active management, but getting instead something that looks a lot like an over-priced index fund.
So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether or not they’re getting the desired bang for their buck?11
While there is no universally agreed upon “line in the sand” to determine a fund’s status as a “closet” index fund, there is a generally agreed upon concept of a “closet” index funds’ basic characteristics. Two different metrics are currently used to identify potential “closet” index funds. One metric, developed by K. J. Martijm Cremers, is known as Active Share. Active Share essentially measures the overlap between an actively managed mutual fund and a comparable index, or benchmark fund. In describing “closet” indexing, Cremers has stated that
Closet indexing in U.S. mutual funds is a problem that harms investors through high costs and low returns. Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially.12
The second metric currently being widely used to identify potential “closet” index funds is known as the Active Expense Ratio (AER). Developed by professor Ross Miller, the AER factors in an actively managed fund’s R-squared, or correlation of returns, number and the fund’s incremental, or additional, costs, to produce a fund’s AER number, or effective expense ratio. In addressing “closet” indexing and the AER, Miller has stated that
[M]utual funds are more expensive than commonly believed. Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.13
Legal Liability Issues
Based upon my experience, I believe that very few plan fiduciaries and plan service providers consider a plan’s cost-efficiency and potential “closet” indexing classification when selecting and monitoring a plan’s investment options. As a result, as plaintiffs’ attorneys focus more on both issues, I believe that not only will we see a continual stream of 401(k)/430(b) fiduciary breach actions, but also a stream of large settlements. The evidence is abundant and persuasive.
In my opinion, most of the arguments put forth by the courts as grounds for dismissing fiduciary actions, such as a fund family’s business platform, legally approved ranges of expense ratios, amount of money currently invested in an actively managed fund and the number of investments offered by a plan, are totally inconsistent with ERISA’s stated goal of protecting plan participants and/or have already been rejected by courts. Another reason for my belief that 401(k)/403(b) breach of fiduciary actions will continue and be successful.
I have presented the bad news. Now, the good news. By identifying and acknowledging any cost-efficiency and/or “closet issues that exist within their plan, , proactive plan sponsors and plan service providers can easily create a win-win 401(k) or 401(b) plan. A win-win plan is one that truly assists plan participants in working toward “retirement readiness,” while also protecting plan sponsors and other plan fiduciaries from unwanted unlimited personal liability., making life good for everyone…except plaintiffs’ attorneys.
As my colleague, the highly respected ERISA attorney Fred Reish, is fond of saying, “forewarned is forearmed.”
© Copyright 2019 The Watkins Law Firm. 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.
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018) (Brotherston)
2. Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
3. Restatement (Third) Trusts (American Law Institute) (Restatement)
4. Restatement, Section 90, cmt. b.
5. Restatement, Section 90, cmt. f.
6. Restatement, Section 90, cmt. h(2).
7. 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.
8. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
9. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-8.
11. SEC Speech: The Future of Securities Regulation; Philadelphia, Pennsylvania; October 24, 2007 (Brian G. Cartwright), available online at http://www.sec.gov/news/speech/2007 /spch102407bgc.htm (last visited Mar 27, 2012).
12. K.J. Martijn Cremers Quinn Curtis, “Do Mutual Fund Investors Get What They Pay For? The Legal Consequences of Closet Index Funds”, 42, 67 available online at https://bit.ly/2FHKJQE.
13. Ross Miller, “Measuring the True Cost of Active Management by Mutual Funds,” 1, available online at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926