[C]ost-conscious management is fundamental to prudence in the investment function,…1
Two consistent themes of ERISA are cost-consciousness and risk management through diversification. With regard to cost-consciousness, studies have consistently shown that the overwhelming majority of actively managed mutual funds, the primary investment option in most 401(k) plans, are not cost-efficient.
- 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.2
- 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.3
- [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4
- [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.5
The studies’ findings are presumably based on the funds’ nominal, or stated, returns. However, there is an increasing awareness among investors and within the legal community, that nominal returns may not accurately reflect the degree of cost-inefficiency of actively managed funds
R-squared has been explained by Morningstar as follows:
R-squared measures the strength of the relationship between a fund’s performance and a benchmark’s performance, specifically, the degree to which a fund’s performance can be explained by the performance of the benchmark.
A higher R-squared value indicates a higher correlation, or relationship, between a fund’s performance and the benchmark’s performance, whereas a lower R-squared value indicates that a fund’s performance hasn’t behaved like the benchmark’s [performance]. R-squared is expressed as a percentage and ranges from 0%, or no correlation, to 100%, or perfect correlation, where a fund’s performance has moved in lockstep with the benchmark’s [performance.
A word of caution though: If a fund’s R-squared is very close to 100%, there’s a chance it may be hugging its index too closely, and that its returns can be replicated by an inexpensive fund that tracks that benchmark.6
In fact, over the past decade or so, there has a noticeable trend of U.S. domestic actively managed equity funds with r-squared numbers of 90 and above, many of 95 and above. Such high r-squared numbers strongly suggest that such funds may be fairly classified as “closet index” funds.
Closet index funds are actively managed mutual funds that claim to be providing active management and charge higher annual fees based on such representations. However, history has shown that such funds usually provide returns that are essentially the same or lower than comparable, less expensive index funds.
Martijn Cremers, creator of the Active Share metric, goes further, stating that actively managed mutual funds are arguably guilty of investment fraud.
[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 law.7
Based on the Morningstar definition of r-squared, it can be argued that r-squared provides a means for investors and investment fiduciaries to screen for closet index funds.
However, the value of r-squared as an analytical tool goes far beyond its use to screen for closet index funds. There is a growing trend within the legal community, in both ERISA and general securities litigation, to use r-squared to calculate the implicit damages from imprudent/unsuitable investment products.
One of the two thought leaders in this area has been Ross Miller. Miller is the creator of the Active Expense Ratio (AER) metric, which uses an actively managed fund’s r-squared number to calculate the fund’s implicit, and often excessive, expense ratio. Miller found that an actively managed fund’s AER was generally 4-6 times higher than its publicly stated expense ratio.
So why calculate an actively managed fund’s correlation-adjusted expense ratio? As Miller explains,
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, 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.8
Although not widely known, another advocate of the use of r-squared to determine the cost-efficiency of actively managed mutual funds was the legendary John Bogle. Bogle explained the value of both r-squared and factoring in a fund’s implicit costs as follows:
As active management continues to morph into passive indexing-already approaching the commonplace in the large-cap fund category-managers will have to reduce their fess commensurately. After all, a correlation of 99 comes close to meaning that 99 percent of the [the fund’s] portfolio is effectively indexed. A 1.5 percent expense ratio on the remaining portfolio, therefore, represents an annual fee of 150 percent(!) on the actively managed assets.
Even if investors are willing to tolerate that cost at the moment, it is only a matter of time until they realize that their ongoing deficit to the stock market’s return is a reflection of the simple fact that they effectively own an index fund, but at a cost that is grossly excessive.9
Bogle’s comments are obviously equally applicable to plan sponsors and other investment fiduciaries. Whether by using the AER or Bogle’s methodology, it can be argued that a fiduciary’s duty of prudence and the duty to avoid unnecessary costs requires that a fiduciary factor in an investment’s implicit costs.
This is yet another reason that the #Northwestern403 action currently pending before SCOTUS is so important, not just for plan sponsors, but for any and all investment fiduciaries. Many expect SCOTUS to uphold the notice pleading rule generally applied in the courts. If so, it would make sense that the Court will also rule that plan sponsors, rather than plan participants, have the burden of proof with regard to causation, or the prudence of their plan’s investment options.
Many have asked me whether I believe that r-squared and cost-efficiency are the future of fiduciary litigation. While no one knows for sure, my experience with my Actively Managed Value Ratio, which incorporates the AER in part, would support such an argument.
As the 3Q 2021 quarterly AMVR “cheat sheet” shows, the cost-inefficiency of some frequently used actively managed funds within 401(k) plans remains a serious issue for plan sponsors. Note the disparity between a fund’s nominal expense ratio and the fund’s implicit expense using the AER. Also note the direct relationship between a fund’s incremental costs, r-squared number and its AER.
FWIW, I would strongly suggest that the evidence regarding the cost-inefficiency of actively managed mutual funds, both in terms of their nominal and its correlation-adjusted/r-squared expense ratio, could make the potential burden of proof for plan sponsors and other investment fiduciaries, that much more formidable. That burden may be made even more difficult as there are some ERISA plaintiff’s attorneys who are already successfully using AER and implicit costs in calculating damages.
1. “Introductory Note” to Restatement (Third) Trusts, Section 90. (American Law Institute. All rights reserved.)
2. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
3.. 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.
4. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
5. Mark Carhart, On Persistence in Mutual Fund Performance, Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
6.“The Morningstar Dictionary: R-Squared” https://www.morningstar.com/articles/873622/the-morningstar-dictionary-r-squared)
7. 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.
8. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
9. John C. Bogle, “Don’t Count On It: Reflections on Investment Illusions, Capitalism, ‘Mutual’ FDuns, Indexing, Entrepreneurship, Idealism, and Her
oes,” (John Wiley & Sons: Hoboken, NJ, 2011), 432.
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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.
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