In my last post, I analyzed the popular Fidelity Freedom Active Suite and Fidelity Freedom Index target date funds. The Fidelity Freedom and TIAA-CREF Lifestyle target date funds are arguably the two most popular groups of target date funds in 401(k) and 403(b) defined contribution plans.

However, popularity does not necessarily equate to fiduciary and regulatory prudence. Many mutual funds are cost-inefficient when compared to comparable index funds. Many fiduciaries and investors alike choose mutual funds based on their publicly advertised, aka nominal, returns.

Nobel laureate Dr. William Sharpe has stated that

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.¹

Noted wealth management expert, Ellis, goes further, stating that

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.²

Ellis’ suggestion is a variation of the cost-benefit analysis commonly used by businesses every day. Several years ago, I created a simple metric based on Ellis’ studies, the Active Management Value Ratio (AMVR). The AMVR allows fiduciaries, attorneys, and investors to quickly assess the cost-efficiency of an actively managed mutual relative to a comparable index fund.

Most index funds have higher fees and expenses than comparable actively managed funds. Those higher fees and expenses effectively reduce an actively managed fund’s performance. As a result, studies have consistently shown that most actively managed mutual funds are cost-inefficient when compared to comparable index funds.

• 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.³
• 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.⁴
• [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.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

Such is the case when TIAA-CREF’s active and index target date funds are compared over the most recent ten-year and five-year periods.

In analyzing the TIAA-CREF Lifestyle TDFs over the most recent five and 10-year periods (ending September 30, 2022) all of the funds proved to be cost-inefficient, i.e., incremental costs greater than incremental returns, relative to their comparable index version. As a result, it can be said that the actively managed TIAA-CREF Lifestyle funds would be an imprudent investment choice relative to the indexed version of the same funds.

Going Forward
401(k) and 403(b) plan sponsors are legally fiduciaries. As such, they are held to “the highest duties known to law,” including the duties of prudence and undivided loyalty to the plan participants and their beneficiaries. Bottom line, a plan sponsor’s selection of cost-inefficient investment options for a plan is an unquestioned violation of their fiduciary duties.

A common risk management mistake I see made by plan spsonsors is agreeing to a plan advisory contract that contains a so-called “fiduciary disclaimer clause.” I have argued that agreeing to such a clause is a violation of both the plan sponsor’s fiduciary duties of prudence and loyalty.

Without a fiduciary disclaimer clause, a plan adviser would be subject to the same fiduciary duties that a plan sponsor is required to honor. I maintain that that would force a plan provider to offer all investments that their broker-dealer sells, not just the overpriced and consistently underperforming products of their so-called “preferred partners.”

Plan sponsors often agree to such fiduciary disclaimer clauses in exchange for revenue sharing payments from the broker’s/adviser’s broker-dealer. The plan sponsor then uses such revenue sharing payments to reduce the plan’s administration costs.

The legal issue with such fiduciary disclaimer clause/revenue sharing arrangements is that reducing administrative costs does not change the cost-inefficiency of imprudent investment options within the plan or otherwise reduce the ongoing financial impact of such imprudent investments. As the TIAA-CREF charts herein show, those costs and expenses can add up quickly and compound over time. Each additional one percent in costs and expenses reduces an investor’s end return by approximately seventeen percent over a period of twenty years.

My fiduciary consulting clients are very familiar fiduciary risk management sayings – “Why even go there” and “Don’t even go there.” Far too many plan sponsors fail to follow such advice and expose themselves to unnecessary and unwanted fiduciary liability.

Notes
1. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
2. 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.
3. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
4. 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. 
5. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
6. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997). 24.

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