SCOTUS has yet to decide whether to hear the case of Putnam Investments, LLC v. Brotherston. I continue to argue that the ultimate decision in this case could have a significant impact on the future of the 401(k) industry and the ability of plan participants to have a meaningful opportunity to work towards their goal of “retirement readiness.”
As the Supreme Court’s blog, www.scotusblog.com, points out, the case involves the following issues:
(1) Whether an ERISA plaintiff bears the burden of proving that “losses to the plan result[ed] from” a fiduciary breach, as the U.S. Courts of Appeals for the 2nd, 6th, 7th, 9th, 10th and 11th Circuits have held, or whether ERISA defendants bear the burden of disproving loss causation, as the U.S. Court of Appeals for the 1st Circuit concluded, joining the U.S. Courts of Appeals for the 4th, 5th and 8th Circuits; and (2) whether, as the U.S. Court of Appeals for the 1st Circuit concluded, showing that particular investment options did not perform as well as a set of index funds, selected by the plaintiffs with the benefit of hindsight, suffices as a matter of law to establish “losses to the plan.
To me the first question is the more important of the two, primarily because under ERISA and basic fiduciary law, prudence is based on the process used by a fiduciary in selecting and monitoring a plan’s investment options, not their ultimate performance.
The “burden of proof” question is the key issue, as I believe that plans and other 401k related industries would be hard pressed to carry that burden of proof in connection with most of the current actively managed mutual funds. And yet, if SCOTUS agrees to hear the case and upholds the First Circuit’s decision, or SCOTUS decides not to hear the case, leaving the First Circuit’s decision as the final word in the case, that would be the formidable challenge facing pension plans.
Why do I say “formidable challenge?”
Exhibit A, from Nobel laureate William F. Sharpe:
[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.1
So how would one carry the burden of proof on the question of causation? SCOTUS has provided an answer to that question.
Exhibit B, from SCOTUS
ERISA is essentially a codification of the Restatement (Third) of Trusts (Restatement). SCOTUS has recognized that the Restatement is a legitimate resource for the courts in resolving fiduciary questions, especially those involving ERISA.2
The Restatement states that actively managed mutual funds are imprudent unless they are also cost-efficient.3
So, what would be an appropriate test for meeting the burden of proof as to causation, or, more specifically, the cost-efficiency of an actively managed mutual fund?
Exhibit C, from Charles D. Ellis:
So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!4
As mentioned earlier, studies that have been conducted using such comparisons have consistently found that the overwhelming majority of actively managed mutual funds are not cost efficient, and therefore imprudent. (Exhibits D-G)
- 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.5
- 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.6
- [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.7
- [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.8
As Ellis suggests, the actual calculation process required to evaluate the cost-efficiency of an actively managed mutual fund need not be complicated. In fact, using the Restatement and the findings of studies by Ellis and Burton Malkiel, I created a simple metric, the Active Management Value Ratio™ (AMVR), that uses simple, what Bogle referred to as “humble arithmetic,” to calculate the cost-efficiency of an actively managed mutual fund.9
People are constantly asking me what SCOTUS is going to do. Obviously, I do not know. Personally, I do not think that SCOTUS wants to hear the case, as I believe that the First Circuit’s decision was both logically and technically correct. I believe that is why we have yet to hear a decision on whether SCOTUS will hear the case. Plus, they have already agree to hear several ERISA related cases during their next term.
I believe SCOTUS may eventually feel compelled to hear the case in order to resolve the existing conflict between the federal appellate courts on this issue. Again, just my opinion. Employees’ ERISA rights are simply too important to depend on whatever jurisdiction in which they happen to reside.
Bottom line is that while the 401k industry and so many pension plans “talk a good game” about “retirement readiness” and wanting to help their employees achieve such a goal, the fact that actively managed mutual funds are still the predominant investment option in so many 403(k) and 403(b) plans effectively renders “retirement readiness” a cruel hoax, at least in terms of providing plan participants with a meaningful opportunity to maximize their retirement savings. As the saying goes, “actions speak louder than words.” “Cost-inefficient” and “wealth maximization” are mutually exclusive. Always have been, always will be.
Whatever SCOTUS’ ultimate decision is, I for one believe the integrity of ERISA in requiring that employees be given a meaningful opportunity to work toward “retirement readiness” hangs in the balance.
1. Willam F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
2. Tibble v. Edison International, 135 S. Ct 1823 (2015)
3. Restatement (Third) Trusts, Section 90, cmt. h(2) (American Law Institute).
4. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
5. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
6. 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.
7. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
8. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE, 52, 57-8 (1997).
© 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.