On January 13, 2020, SCOTUS officially denied Putnam Investment, LLC’s petition for writ of certiorari to review the First Circuit Court of Appeals’ decision in Brotherston v. Putnam Investments, LLC. The First Circuit had ruled that plan sponsors have the burden of proof in ERISA actions once the plan participants prove that the plan’s sponsor breached their fiduciary duties, resulting in financial losses for the plan participants. SCOTUS also ruled that index mutual funds are acceptable for the purpose of establishing the damages suffered by a plan’s participants as a result of the fiduciary breach.
SCOTUS’ decision has caused a lot of concern among plan sponsors and the wealth management industry, as they know, and have known for some time, that in most cases they will not be able to carry that burden of proof. Studies have consistently shown that most actively managed mutual funds are not cost-efficient and, therefore, do not meet the fiduciary prudence standards established by the Restatement (Third) of Trusts. Despite these findings, actively managed funds are still the predominant investment options within most 401(k) and 403(b) plans.
While the First Circuit’s decision is technically only binding within the First Circuit’s jurisdiction, it is reasonable to assume that attorneys and other courts will follow the First Circuit’s well-reasoned and technically correct decision. The challenge for plan sponsors and the wealth management industry will be even harder given the simplicity of establishing a breach of their duties.
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.1 Charles D. Ellis
The breach of fiduciary duty and the damages caused thereby is even more devastating when one factors in the impact of the high correlation of returns that often exists between an actively managed mutual fund and a comparable, less expensive index fund. Since the First Circuit validated the used of index funds in ERISA fiduciary breach actions, it can be argued that attorneys and fiduciaries will need to consider the correlation of returns factor.
One commonly used metric in factoring in the impact of correlation of returns is the Active Expense Ratio (AER) metric. Ross Miller, creator of the AER, explained the value of the metric, stating that
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.2
I provide forensic investment analysis and litigation support services for fiduciaries attorneys. Being a firm believer in the saying, “a picture is worth a thousand words,” I combined those two concepts to create a metric, the Active Management Value Ratio (AMVR), and a simple and easy to use worksheet to explain the metric.
A fund’s AMVR number is simply its incremental costs divided by its incremental return. Here, the fund’s AMVR number would be zero since the fund provided no positive incremental return. Additional information on the AMVR is available on this blog.
In an interesting twist with regard to the issue of fiduciary liability involving ERISA plans in general, as well as any concerns by plans about having to meet the burden of proof with regard to causation, the Court of Appeals offered ERISA plans the following advice:
Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting 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.”3 (citations omitted)
Interestingly enough, this was essentially the same advice offered over forty years ago by John Langbein, the reported on the committee that drafted the Restatement (Third) of Trust, with his prediction that
When market [aka index] 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 advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.”4
It should be noted that while Brotherston was an ERISA action, the First Circuit and the Solicitor General discussed a fiduciary’s duties regarding the burden of proof on causation in terms of general fiduciary law. Therefore, I would not be surprised to see plaintiffs’ attorneys use the same points and logic in actions involving other investment fiduciaries, such as trustees, investment advisers, and even stockbrokers in some cases, using the decisions in Carras v. Burns5 and Follansbee v. Davis, Skagg & Co., Inc.6 as applicable authority to impose fiduciary duties on same.
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This article is for informational purposes only, and is neither designed nor 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. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
2. Ross M. Miller, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol. 5, No. 1, First Quarter 2007. https://ssrn.com/abstract=972173
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
4. Langbein, John H. and Posner, Richard A., “Market Funds and Trust-Investments Law,” (1976), Faculty Scholarship Series Paper 498, http://digitalcommons.law.yale.edu/fss_papers/498.
5. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975).
6. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9th Cir. 1982).
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