Connecting the Dots: Correlation of Returns and Fiduciary Prudence

With SCOTUS’ recent decision in Hughes v. Northwestern University1, we now have what I like to refer to as the “fiduciary responsibility trinity” (Trinity). The Trinity consists of the Tibble v. Edison International2 (Tibble), Brotherston v. Putnam Investments, LLC3(Brotherston), and Hughes/Northwestern decisions.

I recently reviewed the relevant language from each decision in a post on a sister blog, the “CommonSense 401(k) Project.”4 To summarize:

Hughes/Northwestern ruled that a plan sponsor has a fiduciary duty to ensure that each investment option within a plan is prudent and to remove any that are not.

Tibble recognized the Restatement of Trusts (Restatement) as a legitimate resource in resolving fiduciary issues and ruled that a plan sponsor has an ongoing fiduciary duty to monitor plan investment options for prudence.

Brotherston ruled that comparable index funds can be used for benchmarking purposes, citing Section 100 of the Restatement.

The question that I am constantly asked by plan sponsors and other investment fiduciaries, as well as attorneys, is “so how do I use all this to evaluate the fiduciary prudence of an investment option?” Obviously, my first response is to use InvestSense’s proprietary metric, the Active Management Value RatioTM (AMVR) to evaluate the investment’s cost-efficiency. But I also suggest that they look at the “AER” column and calculate the investment’s incremental costs using that number>

Why? “AER” stands for Ross Miller’s Active Expense Ratio (AER) metric. The AER uses a mutual fund’s r-squared, or correlation of returns, number to calculate a fund’s effective expense ratio. Based on the AER, Miller found that investors in actively managed mutual funds effectively pay expense ratios 400-500 percent higher than the fund’s publicly 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, 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

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 paying 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.6

And there it is-“closet indexing.” Closet indexing has become an international issue for the very reasons stated above. Closet indexing refers to a situation where a fund charges a high expense ratio, citing the benefits of the fund’s active management. However, the fund shows a high correlation of returns to a much less expensive, comparable index fund with the same, or better, returns.

Financial advisers and actively managed mutual funds do not like to talk about the costs associates with their funds. Research has consistently shown that the overwhelming majority of actively managed are not cost efficient.

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.7
  • 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.8
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.9
  • [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.10

Cost-consciousness, or cost-efficiency is a constant theme throughout the Restatement. Three comments in Section 90, also known as the Prudent Investor Rule, contains three comments that could, and should, define prudence in future ERISA excessive fees/breach of fiduciary duty actions.

  • A fiduciary has a duty to be cost-conscious. (Introductory Section to Section 90)
  • A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return. (cmt. f)
  • Actively managed mutual funds that are not cost-efficient, that cannot objectively be projected to provide a commensurate return for the additional costs and risks associated with active management, are imprudent. (cmt. h(2).

Actively managed mutual funds with high r-squared scores relative to comparable, less costly, index funds are potential candidates for “closet index” fund status. While there is not a universally designated r-squared number for “closet fund” status, most people agree that an r-squared number of 90 or above is a indication that a fund is a “closet index,” aka “index hugger” fund. Morningstar uses an even lower r-squared score of 80.

Over the past decade, the overwhelming majority of actively managed U.S. domestic equity funds have shown an r-squared of 90 or above relative to comparable index funds. The fund used in the AMVR forensic analysis shown below had an r-squared score of 98 relative to the benchmark index fund. The analysis is a perfect example of the potential impact of a fund’s high r-squared score on both its effective expense ratio and resulting cost-efficiency.

Closet index status indicates that an investor could achieve the same, in many cases better returns, at a much lower cost. Cost-inefficient investments waste plan participants’ money. As the Uniform Prudent Investor Act states, “Wasting beneficiaries’ money is imprudent.”11

Going Forward
The Hughes/Northwestern and the resulting “fiduciary responsibility trinity” have raised a plan sponsor’s fiduciary’s duty of prudence to an even higher level than before. In assessing the prudence of a plan’s potential or actual investment option, do plan sponsors, for that matter any investment fiduciary, have a duty to address whether a mutual fund qualifies as a “closet index” fund? Should they have such a duty in order to protect plan participants and other beneficiaries given the obvious harm of “closet indexing?” Is factoring in funds’ r-squared scores/correlations of returns the “next big thing” in 401(k) and fiduciary investment prudence litigation?

1. Hughes v. Northwestern University, 19-1401 (January 24, 2022).
2. Tibble v. Edison International, 135 S. Ct 1823 (2015).
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
5. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
6. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds
7. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
8. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at 
9. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
10. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
11. Uniform Prudent Investor Act (UPIA), Section 7 (Introduction).

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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