In a recent post, I wrote (1) that plan participants should never lose a properly vetted 401(k)/403(b) litigation action, and (2) a properly designed and maintained 401(k)/403(b) plan should should never lose a breach of fiduciary duties action based on imprudent investment options. As anticipated, the statements drew some strong responses. The most frequent responses focused on “properly vetted” and “properly designed and maintained.”
In my practice, I serve as a fiduciary compliance counsel to both attorneys and 401(k)/403(b) plans. I believe the blueprint for fiduciary compliance for both sides already exists. To help my clients remember the blueprint, I tell them to remember the phrase, “The Really Smart Experts Measure AMVR.”
Studies have shown that people often remember information by using acronyms, with each letter representing an important fact. While the phrase I suggest is not technically an acronym due to AMVR at the end, the phrase serves the same purpose.
1. “The” – “T” stands for the Supreme Court case of Tibble v. Edison International.1 The key quote for our purpose is the Court’s statement that.
We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ In determining the contours of an ERISA fiduciary’s duty, court often must look to the law of trusts.1
2. “Really” – The “R” stands for the Restatement (Third) of Trusts. One of the key concepts throughout the Restatement is the importance of costs and cost-consciousness. Section 90 of the Restatement is commonly known as the Prudent Investor Rule. Comment b states that
[C]ost-conscious management is fundamental to prudence in the investment function,…2
Comments f, h(2) and m also reference the importance of cost-efficiency.
3. “Smart” – The “S” stands for Nobel laureate Dr. William F, Sharpe. Dr. Sharpe stated that in assessing the prudence of actively managed mutual funds,
Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs…. The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.”3
4. “Experts” – The “E” stands for Charles D. Ellis. A well-known and highly respected expert on investing, Ellis suggested the following technique in assessing the prudence of actively managed funds.
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
5. “Measure” – The “M” stands for Ross Miller, the creator of the Active Expense Metric (AER).
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.5
Miller recognized that given the current high R-squared/correlation of returns between actively managed U.S. domestic equity mutual funds and comparable index funds, most of the returns on actively managed can be properly attributed to underlying market indices rather than the active funds’ management teams. As a result, investors can receive comparable, in many cases better, returns at a much lower price using comparable index funds. As a result, the implicit costs that investors are paying for actively managed mutual funds are significantly higher than the funds’ stated expenses. Miller found that the implicit costs of an actively managed fund were often 4-6 times higher than their stated costs.
The Active Management Value RatioTM
All of these are fundamental concepts that form the foundation for the Active Management Value Ratio metric (AMVR). The AMVR is essentially nothing more that the well-known cost-benefit metric often used in the business world. The only difference is that AMVR uses incremental cost and incremental returns as the input data. More specifically, the AMVR compares an actively managed fund’s risk-adjusted incremental returns with the fund’s correlation-adjusted incremental costs, using a comparable index fund as a benchmark.
By using nothing more than “simple third grade math,” the AMVR provides a simple, yet powerful, analysis of an actively managed fund’s cost-efficiency relative to the comparable index fund benchmark. Back when I was developing the AMVR, I was introduced to a brilliant man, Bert Carmody, by some mutual friends. Bert quickly understood the concepts involved in the AMVR and decided to create a more sophisticated model.
My favorite memory of that day was Bert starting to write on the expensive white knapkins and the people next to us laughing as I quickly told Bert that I was not paying for the knapkins. Unfortunately, Bert passed away shortly after that infamous lunch. However, his friends continued his work, resulting in the patented PlanAnalyzer metric. Both metrics are being successfully used in both the legal and financial fields.
The AMVR addresses a simple question that every question should know.
Does the actively managed fund provide a commensurate return for the additional costs and risks an investor is asked to assume?
To answer that question, an investor and/or investment fiduciary simply has to answer two simple questions:
- Does the actively managed fund provide a positive incremental return relative to a comparable index fund?
- If so, does the actively managed fund’s positive incremental return exceed the actively managed fund’s incremental costs?
If the answer to either of these questions is “no,” then the actively managed fund is not a prudent investment choice relative to the benchmark index fund. The goal is an AMVR score that is greater than zero (indicating a positive incremental return), but less than one (indicating that incremental returns exceed incremental costs). As far as the actual formula for the AMVR,
AMVRTM = Incremental Correlation-Adjusted Costs/Incremental Risk-Adjusted Returns
To illustrate the value and power of the AMVR in assessing cost-efficiency, let’s look at a well-known actively managed fund. In the first example, we will calculate cost-efficiency of the actively managed fund using both funds’ nominal returns and costs.
The chart shows that while the actively-managed fund does produce a small positive incremental return, the fund’s incremental costs significantly exceed the fund’s positive incremental return. Therefore, the actively-managed fund is deemed cost-inefficient relative to the benchmark fund. In this case, the actively-managed fund is classified as the retirement shares of a large cap growth fund. Therefore, the benchmark used in this example is the Admiral shares of Vanguard’s Large Cap Growth fund.
Because of the clients InvestSense serves, we calculate a fund’s AMVR based on risk-adjusted returns and AER-based correlation-adjusted costs. Note the dramatic increase in the actively-managed fund’s expense ratio (0.65) when the fund’s R-squared/correlation of returns number, in this case 98, is factored into the equation (5.44). The combination of high incremental costs and a high R-squared number basically ensures that a mutual fund will not be considered cost-efficient.
At the end of each calendar quarter, I prepare a “cheat sheet” on some of the more commonly used mutual funds in U.S. 401(k) plans. The five-year “cheat sheet for the 3Q of 2021 is shown below.
A common question I get is how consistent are these numbers. Very consistent, as shown in the ten-year “cheat sheet.” as of the 3Q 2021.
John Langbein served as the Reporter on the committee that drafted the Restatement (Third) of Trusts. Once the Restatement was published, he 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.6
The 1st Circuit suggested the same outcome in its Brotherston decision”
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.”
The Restatement (Third) of Trusts, Section 90, comment h(2) states that active strategies are imprudent unless it can be objectively anticipated that such strategies will provide a commensurate return for the additional costs and risks typically associated with such strategies/funds. So, to return to my two earlier suggestions:
- An ERISA plaintiff’s attorney who can present evidence of the underperformance and cost-inefficiency of a plan’s investment options should defeat a motion to dismiss and should prevail on the merits.
- A plan sponsor who is able to present evidence of the positive incremental performance and cost-efficiency of their plan’s investment options should be able to defeat an allegation of imprudent investment options. Such evidence would also provide proof of a plan actually designed to promote their employee’s “retirement readiness” and “financial well-being.
1. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
2. Restatement (Third) Trusts, Section 90, cmt. b. (American Law Institute. All rights reserved)
3. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
4. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
5. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
6. John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law(1976). (Faculty Scholarship Series: Paper 498) available online at http://digitalcommons.law.yale.edu/fss_papers/498
7. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018
© Copyright 2021 InvestSense, LLC. All rights reserved.
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.
You must be logged in to post a comment.