I have written posts regarding the trends in 401(k) and 403(b) fiduciary breach litigation, including Common Sense and Cost-Efficiency: Making ERISA Meaningful Again | The Prudent Investment Fiduciary Rules (wordpress.com) and The Active Management Value Ratio™3.0: Cost-Efficiency and Compliance With Securities AND ERISA Regulations | The Prudent Investment Fiduciary Rules (wordpress.com). Prematurely dismissing such cases without honoring the generally recognizing the practice of notice pleading and denying the plan participants the opportunity defeats both the spirit and purpose of ERISA.
The First Circuit recognized this issue in its Brotherston decision.1 The Court noted that far too often in these cases, the plan has all or virtually all of the relevant information. As a result, demanding more than notice pleading at the initial stages of such actions and dismissing such actions for an inability to do so inequitable and draconian
In dismissing such actions, courts often cite Judge Doty’s decision, in the Meiners decision in which he stated that
In order to plausibly allege a fund is underperforming, Meiners must provide some benchmark against which the Wells Fargo funds can meaningfully be compared.
Meiners must plead something more to make his excessive fees claim plausible….Nothing in the complaint suggests that the Vanguard and Fidelity funds are reliable comparators….Without a meaningful comparison, the mere fact that the Wells Fargo funds are more expensive than the other two funds does not give rise to a plausible breach of fiduciary duty.2
Cost-efficiency provides plan sponsors, plan participants and attorneys with a simple, equitable and objective means of providing “more,” of comparing and monitoring investment options within a plan. Cost-efficiency avoids the dubious “apples to oranges” argument and focus entirely on the plan participants financial welfare. Using cost-efficiency, there are but two categories-cost efficient and cost-inefficient. The use of cost-efficiency in evaluating investments is consistent with the fiduciary standards established by the Restatement (Third) of Trusts, as well as FINRA and SEC standards, including Regulation Best Interest.
I created a simple metric, the Active Management Value RatioTM (AMVR), that allows for a quick and simple calculation of the cost-efficiency of actively managed mutual funds. The AMVR only requires a minimal amount of data, all of which is available for free online, and the ability to do simple math calculations.
Every Pictures Tell A Story
As more people have read about the AMVR, I have received an increasing number of calls, emails and other forms of correspondence on how to interpret the metric. As a result, I have prepared a presentation that I use in meeting with prospective clients such as plan sponsors, trustees and plaintiff’s attorneys. The slides below are some of the slides from that presentation.
Many people only evaluate mutual funds in terms of a fund’s nominal, or publicly stated, costs, expense ratios and annualized returns. That approach completely overlooks other important costs and expenses, such as a fund’s trading costs. While funds are not legally required to disclose their actual trading costs, such costs are required to be deducted from the fund’s gross return in reporting their nominal returns.
In the slide below, it is obvious that the fund is not cost-efficient, as the fund fails to provide any positive incremental returns (IR), i.e., underperforms the relative benchmark.
The next step in an AMVR cost-efficiency analysis is evaluating cases in which a fund does produce a positive incremental return. However, this slide shows that a fund that produces a positive incremental return, or “alpha,” is not necessarily cost-efficient because the fund’s incremental costs exceed the fund’s incremental returns.
That’s how simple and straightforward the AMVR metric is. The AMVR is essentially the basic cost-benefit analysis technique used in various forms of business. The only difference is that the AMVR uses a fund’s incremental costs and incremental return for input data. The data are expressed in terms of basis points, a common financial term. A basis point equals 1/100th of a point (0.01), with 100 basis points equaling one point.
For those that find basis points confusing, I suggest “monetizing” the results by thinking of basis points in terms of dollars. In the example below, would anyone pay $72 in order to receive $7 dollars in return?
The following chart chart illustrates the goal-a fund whose incremental returns (5.78 bps) exceed the fund’s incremental costs (0.735 bps) .
At that point, many people, both investment professionals and ordinary investors, stop their AMVR analysis of the actively managed fund in question, unnecessarily exposing themselves to potential financial losses. When InvestSense provides pension plans and attorneys with consulting services and forensic audits, we re-calculate a fund’s incremental costs using the Active Expense Ratio (AER) metric.
Created by Ross Miller, the AER factors in the implicit impact of a fund’s correlation of returns to the benchmark used in the AMVR analysis. The importance of this step in an AMVR analysis is that the higher the active fund’s correlation of returns to the applicable benchmark, the less contribution that the actively managed fund’s management is actually providing to the active fund’s overall performance. As Professor Miller explained,
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs 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.(19)
The AER also helps identify and avoid so-called “closet index” funds. Closet index funds are, by definition, cost-inefficient, charging excessive fees for underperformance. As one noted expert explained,
a large number of funds that purport to offer active management and charge fees accordingly , in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by for fees for active management that they do not receive or receive only partially. .
Closet indexing raises important legal issues. Such funds are not just poor investments; they promise investors a service that they fail to provide. As such, some closet index funds may also run afoul of federal securities laws.3
Over the last decade or so, there has been a definite trend of extremely high correlation of returns between U.S. domestic equity funds and comparable index funds. Professor Miller’s study found that the AER number for most U.S. domestic equity funds was often 400-500 percent higher than the fund’s publicly stated expense ratio, sometimes even higher.
Today, it is not uncommon to find that most U.S. domestic equity funds have high R-squared, or correlation, numbers, often 90 percent of more. The higher a fund’s R-squared number and its incremental costs are, the higher the fund’s AER number will be.
Charles D. Ellis, one of America’s most respected investment experts, stressed the importance of an actively managed fund’s correlations of returns numbers by pointing that on a fund that has an R-squared number of 95, that leaves the remaining 5 percent of the fund’s return having to try to justify the fund’s incremental costs. The odds of that happening are extremely unlikely, especially on a consistent basis, given the high correlation between the funds.
Studies have consistently concluded that the overwhelming majority of actively managed funds are not cost-efficient, with conclusions such as
- “99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.”4
- “[I]ncreasing 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
- “[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.”6
- “[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”7
Primarily for those reasons, I am on record as saying that the ERISA plaintiff’s bar should never lose a properly vetted case, e.g., AMVR evaluated. Granted, a court may have other ideas. However, in speaking with former judges and legal colleagues, they all say that the simplicity of the AMVR metric and the sheer disparity in the numbers in most cases should make it difficult for a court to ignore such evidence.
Likewise, using the AMVR, a plan sponsor can provide their plan participants with a meaningful opportunity to work toward retirement readiness, as well as avoid unnecessary liability exposure for themselves, to conduct the “thorough and objective” analysis and selection of each investment option within their plan, as required under ERISA.
Too ERISA cases are now seemingly being determined in large part on where the plan participants reside, as some courts continue to apply inconsistent and often puzzling interpretations of ERISA and applicable regulations. SCOTUS is currently considering a case involving the Northwestern University 403(b) plan, which could dramatically change the entire 401(k)/403(b) litigation landscape and ensure that a uniform and equitable process is in place and plan participants’ rights and guarantees under ERISA are protected.
In closing, perhaps the best way to summarize the data and arguments presented herein are to reference a quote made by John Langbein shortly after the Restatement (Third) of Trusts was released. Langbein, the reporter on the Restatement, made the following prediction:
When market 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 accounts. 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.8
I would argue that the evidence, and the Brotherston Court’s comments, indicates that that day has arrived.
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018).
2. Meiners v. Wells Fargo & Company, United States District Court (D. Minnesota), Civil No. 16-3981.
3. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133
4. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
5. 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.
6. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
7. Mark Carhart, On Persistence in Mutual Fund Performance, Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
8. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 https://digitalcommons.law.yale.edu/fss_papers/498
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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 facts and circumstances. If legal or other professional assistance is needed, the services of an attorney other appropriate professional adviser should be sought.
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