By James W. Watkins, III, J.D., CFP Board EmeritusTM, AWMATM
Fortunately, there is currently a case pending in the 10th Circuit, the Matney case, which may go a long way in resolving two of the primary issues that continue to result in such inconsistent rulings. At the same time, I think a lot of the problems with ERISA cases could be avoided if the ERISA plaintiff attorneys and the courts would simply use what John Bogle referred to as “Humble Arithmetic.”
Several years ago I created a metric, the Active Management Value RatioTM 3.0 (AMVR). The AMVR is based on the research of investment icons such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, and Burton L. Malkiel.
The AMVR allows plan sponsors and other investment fiduciaries, to quickly evaluate the cost-efficiency of an actively managed mutual fund. The legal system’s continued focus on the active/passive debate, rather than on the cost-inefficiency of most 401(k) investment options, is part of the current problem with ERISA litigation.
In Tibble, SCOTUS recognized the Restatement (Third) of Trusts (Restatement) as a legitimate resource in resolving fiduciary disputes, including questions regarding fiduciary duties under ERISA. The Restatement clearly recognizes the importance of cost-efficiency, stating that fiduciaries should carefully compare the costs associated with a fund, especially when considering funds with similar objectives and performance.1 The Restatement advises plan fiduciaries that in deciding between funds that are similar except for their costs, the fiduciary should only choose an active fund with higher costs and/or risks if
the course of action in question can reasonably be expected to compensate for its additional costs and risk,…2
Studies have shown that the public is more visually oriented than verbally oriented. The AMVR allows us to visually demonstrate the value of the Restatement’s position.
Burton L. Malkiel said that the best two predictors of future performance are a fund’s expense ratio and turnover, or trading costs.3 Mutual funds are not legally required to disclose their actual trading costs. However, recognizing the importance of such costs in analyzing the prudence of funds, John Bogle created a proxy that allows investors to factor in such costs in selecting mutual funds. Bogle’s proxy is simply to double a fund’s reported turnover ratio, and then multiply that number by 0.60. Under Bogle’s proxy, a fund with a turnover ratio of 25 percent would have estimated trading costs of 30 basis points, or 0.30 ( a basis point is equal to 1/100th of 1 percent).
For purposes of this post I want to compare the costs and performance of two actively managed mutual that are commonly found in 401(k) plans: Fidelity Contrafund Fund K shares (FCNKX) and T. Rowe Price Blue Chip Growth Fund R shares (RRBGX). The funds will be compared to the Vanguard Growth Index Fund Admiral shares (VIGAX).
First, a comparison of the funds based on the expense ratios and trading costs.
We’ll come back to this later. For now, just remember Bogle’s quote: “You get what you don’t pay for.”
The 5 and 10-year AMVR charts for FCNKX provide some interesting insights.
The 5-year AMVR slide shows that FCNKX is an imprudent investment choice relative to VIGAX based on the fact that
(1) FCNKX fails to provide a positive incremental return relative to VIGAX, and
(2) FCNKX’s incremental costs (0.42) obviously exceeds FCNKX’s negative incremental return.
The 10-year AMVR slide shows that FCNKX is arguably prudent investment choice relative to VIGAX based on the fact that
(1) FCNKX provides a positive incremental return relative to VIGAX, and
(2) FCNKX’s positive incremental return (0.81) exceeds FCNKX’x incremental costs (0.42).
But is it possible that looks could be deceiving, that other factors need to be considered to gain a more accurate evaluation of FCNRX relative prudence?
Ross Miller created a metric, the Active Expense Ratio (AER), that factor in rhe correlation of returns between two funds. If an actively managed fund’s returns are highly correlated to the less-expensive index fund, one should question how much active management the actively managed fund actually provided. Are investors getting a fair return on their investment in terms of cost-efficiency.
Miller explained the value of the AER as follows:
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds 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.3
In the two AMVR slides. the “AER” column provides an interesting insight into the prudence of FCNKX. The correlation of returns between FCNKX and VIGAX was extremely high over the time period in question, 98 percent. As a result, the actual active value contribution for FCNKX was estimated to be approximately 12.5 percent, resulting in much higher, 6-7 times higher, implicit expense ratio over each time period. Based on these findings, one can argue that FCNKX was actually an imprudent investment option relative to VIGAX for 401(k) plans and other investment fiduciaries, as well as for investors in general.
The AMVR slide for RRBGX provides an even more compelling reason for factoring in an actively managed fund’s AER.
From what I have been able to tell, to date no court or attorney has utilized such a cost-efficiency process to evaluate the fiduciary prudence of investment options. The actual calculation process is extremely simple and straightforward. I have actually had occasion to do the calculations on a napkin using my cell phone. So, if ERISA’s original purpose and goals are to be realized, I have to wonder why the process described herein have not been at least explored and argued.
The argument becomes even more compelling if we incorporate the findings from Malkiel’s performance predictors. Malkiel’s theory definitely held true in our examples, especially when the AEWR was considered.
I often use a RRBGX AMVR slide to show just how damaging the combination of high expense ratios and a high correlation of returns between an actively managed funds and a comparable index fund can have on fiduciary prudence realized returns. The correlation between RRBGX and VIGAX was 98. While the 10-year AMVR slide showed improvement, RRBGX still failed to produce a positive incremental return
I believe that recent developments suggest that significant changes are coming in 401(k) and 403(b) litigation. One of the key unresolved issues involves which party has the burden of proof on the issue of causation in ERISA 401(k) litigation. The DOL recently filed an amicus brief in the Home Depot 401(k) litigation in the 11th Circuit. The DOL’s amicus brief supports the position of the common law of trusts, the First Circuit Court of Appeals’ and the Solicitor General position that the plan sponsor has that burden. As the AMVR slides herein suggest, that burden may prove a difficult one to carry in most cases if SCOTUS adopts that position as well.
1. Restatement (Third) Trusts (American Law Institute) All rights reserved. (Restatement)
2. Restatement, Section 90, comment h(2)
3. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926
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