The Prudent Investment Fiduciary Rules

If we desire respect for the law, we must first make the law respectable.”
Justice D. Brandeis Brandeis

SCOTUS is currently deciding whether to hear the Hughes v. Northwestern University¹ 403(b) case. The key issue in the case is an allegation of fiduciary breach by the plan with regard to the level of the plans fees.

SCOTUS had an opportunity to address this issue earlier in the Brotherston² decision. However, SCOTUS decided not to hear the Brotherston decision, based largely upon the Solicitor General’s amicus brief advising them not to do so.

However, the Solicitor General’s recommendation not to hear the case was based primarily on the fact that the Brotherston case was an interlocutory appeal, as the case was still ongoing and all the evidence had not been presented. The Solicitor General’s amicus brief actually presented a compelling and well-reasoned discussion in support of shifting the burden of proof as to causation in 401(k) fiduciary litigation once the plan participants have met their burden of notice pleading on the fiduciary’s breach of duty and a resulting loss.

The Solicitor General’s argument was based on the common law of trusts. The Solicitor General referenced several sections of the Restatement (Third) of Trusts³ (Restatement) in support of his arguments. This is consistent with the Court’s acceptance of the Restatement as a valued resource in resolving fiduciary questions.

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.⁴

Just as in the Brotherston decision, SCOTUS has asked the current Solicitor General to file an amicus brief in the Hughes case. Since both Brotherston and Hughes involve similar issues, there would nothing improper about SCOTUS from going back and reconsidering the Solicitor General’s research and opinions on such issues. In short, the Solicitor concluded that Section 100 of the Restatement supported both the use of index funds as comparators in ERISA cases and the shifting of the burden of proof as to causation.

Citing the First Circuit’s Brotherston decision and Section 100, comment f, of the Restatement, the Solicitor General pointed out that

ERISA incorporates the ‘the common law of trusts’ and that trust law ‘places the burden of proof of disproving causation on the fiduciary once the beneficiary has established that there is a loss associated with the fiduciary’s breach._⁵

The Solicitor General, like the First Circuit, noted the equitable nature of such a shift given the fact that plans usually are the only party with all of the relevant information during the early stages of such litigation. Citing Section 100, comment c, the Solicitor General stated that

[t]he fiduciary is in the best position to provide information about how it would have made investment decisions in light of the objectives of the particular plan and the characteristics of plan participants. Indeed, this Court recognized in {earlier cases] that it is appropriate in some circumstances to shift the burden to establish ‘facts peculiarly within the knowledge of one party.”⁶(cites omitted)

The Solicitor General noted other benefits from shifting the burden of proof regarding causation to plans.

Applying trust law’s burden-shifting framework to ERISA fiduciary-breach claims also furthers ERISA’s purposes. In trust law, the burden shifting rests on the view that ‘as between innocent beneficiaries and a defaulting beneficiary, the latter should bear the risk of uncertainty as to the consequences of its breach of duty…Indeed, in some circumstances, ERISA reflects congressional intent to provide more protections than trust law.⁷ (cites omitted)

The amicus brief went on to note that

Applying trust law’s burden-shifting framework which can serve to deter ERISA fiduciaries from engaging in wrongful conduct, thus advances ERISA’s protective purposes. By contrast, declining to apply trust-law’s burden-shifting framework could create significant barriers to recovery for conceded fiduciary breaches.⁸ (emphasis added) (cites omitted)

As several of my other posts on this site have noted, ERISA fiduciary breach litigation has already seen too many instances of this type of injustice through legal fictions such as the “apples to oranges” and “menu of options” defenses, both of which are seemingly inconsistent with both ERISA and/or the Restatement.

Humble Arithmetic and ERISA Fiduciary Breach Litigation
With the end of the quarter approaching, I will be preparing my “cheat sheet” on the most popular mutual funds in U.S. defined contribution plans, based on invested amounts. A recent Active Management Value Ratio (AMVR) has caused some discussion.

• 

This image is a perfect example of the truth of Justice Brandeis’ statement regarding the “relentless rules of humble arithmetic.” Both of the funds are categorized as large cap growth funds by Morningstar. Both funds are from same fund family. Fidelity Contrafund is consistently ranked as one of the top five mutual funds offered as an investment option within U.S. defined contribution plans.

Based on this AMVR analysis, thi image would seem to provide the evidence plan participants need to prove both a fiduciary breach and a sustained loss. On the other hand, if the burden of proof regarding causation were shifted to the plan, it would seem to be a heavy burden to fulfill.

From years of conducting such AMVR forensic analyses, I can state that the image is a fairly consistent representation of the cost-inefficiency of most U.S. domestic equity funds. Those findings are also consistent with most academic studies of the such funds, resulting in findings such as

• “99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.”⁹
• “[I]ncreasing 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.¹⁰
• “[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.”¹¹
• “[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”¹²

Going Forward
A number of large financial services firms have recently sold their 401(k)/403(b) divisions. Could a possible explanation be concern over a possible review and adverse decision by SCOTUS and the inability to successfully such a burden? Could the humble arithmetic and simplicity of the Active Management Value Ratio metric be be a contributing factor in these decisions to leave the 401(k)/403(b) arena?

While this post has discussed the issues in terms of 401(k)/403(b) plans, it should be noted that the Solicitor General’s amicus brief addressed the issues in terms of the Restatement in general, which applies to all investment fiduciaries, e.g., trustees, RIAs, wealth managers, not just plan sponsors. Therefore, to use 401(k) legend Fred Reish’s familiar admonition, “forewarned is forearmed.”

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir, 2018.
2. Hughes v. Northwestern University
3. Restatement (Third) Trusts (American Law Institute).
4. Tibble v. Edison, Intl., S. Ct. 1823 (2015).
5. Restatement (Third) Trusts, (American Law Institute).
6. “Brief for the United States as Amicus Curiae,” Putnam Investments, LLC v. Brotherston, available at Hughes v. Northwestern University – SCOTUSblog
7. Ibid.
8. Ibid.
9.Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
10. 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.
11. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
12. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).

© 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 facts and circumstances. If legal or other professional assistance is needed, the services of an attorney other appropriate professional adviser should be sought.

After reading the court’s opinion dismissing the Intel 401(k) action, two things immediately came to mind: (1) the brilliance of the First Circuit’s Brotherston decision, and (2) how increasingly some of the dismissals of 401(k) actions seem to be more focused on improperly preventing the plan participants from having discovery and the opportunity to discover the truth about the plans actions.

The second point may seem harsh at first, but the Brotherston decision essentially made the same suggestion. And if we examine the rationales commonly expressed by some of the courts in dismissing 401(k) breach of fiduciary duties actions, I believe there is strong evidence to support my suggestion.

ERISA’s Purpose Diverted
ERISA was enacted to provide employees with protection against employer abusive practices in connection with company pension plans. However, some of the recent arguments by the courts seemingly inequitably protect the employers at the expense of the employees.

For instance, one rationale cited by the court’s is the “apples and oranges” concept, the argument being that comparisons between actively managed mutual funds and passively managed index funds are inherently inequitable and inadmissible. The First Circuit quickly dismissed that argument, pointing out that with regards to ERISA, the primary focus should be on what is in the best financial interests of plan participants as they work toward “retirement readiness.”

In Tibble v. Edison International, Inc,² SCOTUS recognized the Restatement of Trusts (Restatement) as a resource often used by the courts in resolving fiduciary questions. Section 90 of the Restatement, more commonly known as the Prudent Investor Rule, cites three particularly pertinent.

As SCOTUS pointed out in their Tibble decision, ERISA is essentially the codification of the common law of trusts. The Restatement is simply that, a restatement of the common law of trusts. Section 90 of the Restatement, more commonly known as the Prudent Investor Rule, sets out three core obligations for fiduciaries:

• A duty to be cost-conscious;³
• A duty to seek the highest return for a given level of cost and risk, or, conversely, the lowest level of cost and risk for a given level of return;⁴ and
• A duty to avoid the use or recommendation of actively managed mutual funds unless it can be objectively estimated that the actively managed fund will provide a level of return that is at least commensurate with the extra costs and risk associated with the actively managed fund.⁵

Academic studies have consistently shown that very few actively managed funds meet the last requirement. The studies have consistently shown that the overwhelming majority of actively managed funds are not cost-efficient, with conclusions such as

• “99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.”⁶
• “[I]ncreasing 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.”⁷
• “[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.”⁸
• “[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”⁹

I would also suggest that a simple cost-efficiency analysis using InvestSense’s proprietary metric, the Active Management Value Ratio^TM (AMVR), would expose a major shortcoming of the “apples/oranges” argument.

Below are the basic forensic AMVR analyses for two well known known mutual funds that are often selected by 401(k) plans-Fidelity Contrafund class K shares and American Fund’s Growth Fund of America class R-6 shares. In both analyses, Fidelity’s Large Cap Growth Index Fund is used for benchmarking purposes.

Interpreting the AMVR is equally easy. Once an actively managed fund’s cost efficiency has been calculated relative to a comparable benchmark, usually a comparable index fund, the plan sponsor or the ERISA attorney only have to answer two simple questions:

1. Did the actively managed fund provide a positive incremental return?
2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs

If the answer to either of these of these questions is “no,” the actively managed is not cost-efficient and, therefore, does not meet the plan sponsor’s fiduciary duty of prudence.

While these simple analyses make the point that comparing two cost-inefficient actively managed mutual funds in no way benefits or protects plan participants, a strong argument could be made that doing so, that not including a cost-efficiency analysis using a comparable index funds, would violate a plan sponsor’s duties of loyalty and prudence.

When we prepare AMVR analyses for plans, attorneys, and trusts and other fiduciary entities, we provide a more in-depth analyses using risk-adjusted returns and correlation-adjusted costs. Such advanced analyses often illustrate just how egregious the cost-inefficiency of an actively managed fund, and the breach of fiduciary duties, can be. For further discussion of the “apples/oranges argument can be found on this site at Winds of Change | The Prudent Investment Fiduciary Rules (wordpress.com) and The CareerBuilder 401(k) Decision: Three Key Lessons for Plan Sponsors and ERISA Attorneys | The Prudent Investment Fiduciary Rules (wordpress.com)

These two articles and others on this site also address another rationale often cited by courts in dismissing 401(k) fiduciary breach actions, the “menu of options” argument. The argument is basically that a plan can insulate itself from fiduciary liability by just offering a large number of investment options within the plan.

The “menu of options” defense has never had any legal merit. ERISA Section 404(a) itself points out that ERISA requires that each investment option offered within a plan must be prudent both individually and in terms of the plan as a whole. Both the Hecker II decision¹⁰ and the DeFelice decision¹¹ reiterated ERISA’s position.

Plans often reference the Hecker I decision¹² in support of the “menu of options” defense. For some reason they never mention that the 7th Circuit quickly back and “clarified” their earlier decision. While the Court referenced their Hecker II decision as a “clarification,” many attorneys deemed it to be a reversal of their Hecker I decision, and rightfully so.

The Secretary [of Labor] also fears that our opinion could be read as a sweeping statement that any Plan can insulate itself from liability by the simple expedient of including a vey large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It would also place an unreasonable burden on unsophisticated plan participants who do not have the resources to prescreen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such “obvious, even reckless, imprudence in the selection of investments (as the Secretary puts in her brief.)¹³

And yet, the courts continue to argue the “menu of options” defense in dismissing 401(k) actions..

The “Meaningful Benchmark” Argument
The “meaningful benchmark” argument is increasingly being cited by courts in dismissing 401(k) actions alleging a plan sponsor’s breach of their fiduciary duties. In most cases, courts asserting this rationale cite Judge Doty’s decision in Meiners v. Wells Fargo Co.¹⁴ (Meiners).

The Meiners action involved the common issues of the underperformance and the excessive fees of the plan’s investment options. In addressing the underperformance issue, Judge Doty notes that the fund in question had a larger allocation to bonds than the fund used by the plaintiff in benchmarking. Therefore, Judge Doty said that relative underperformance was understandable, adding that

In order to plausibly allege a fund is underperforming, Meiners must provide some benchmark against which the Wells Fargo funds can meaningfully be compared.=¹⁵

In addressing the use of funds as comparators in general, Judge Doty stated that

[A] comparison of the returns of two funds is insufficient because ‘funds…designed for different purposes…choose their investments differently, so there is no reason to expect them to make similar returns over any given span of time.¹⁶

Judge Doty concluded by citing the 8th Circuit’s Tussey v. ABB, Inc. decision¹⁷ for the proposition that

Making [a] comparison [between two funds] would…imply a (mistaken view that whichever fund earned more over the relevant time frame ‘should’ have been offered to the participants, or even that it performed ‘better’ in a meaningful sense.¹⁸

Hold onto that thought.

On the subject of fees, Judge Doty stated that just as with the issue of performance, Meiners failed to provide a “meaningful benchmark” against which the Wells Fargo funds’ fees could be compared. Judge Doty made the familiar argument about plan sponsors not being obligated to select the cheapest investment option. Judge Doty concluded by stating that

Meiners must plead something more to make his excessive fees claim plausible….Nothing in the complaint suggests that the Vanguard and Fidelity funds are reliable comparators….Without a meaningful comparison, the mere fact that the Wells Fargo funds are more expensive than the other two funds does not give rise to a plausible breach of fiduciary duty.¹⁹

A Common Sense and Cost-Efficiency Solution
Of note, in neither Meiners nor any of the other 401(k) actions that have been dismissed upon reliance on the “meaningful benchmark” theory, have I seen an explanation or example of what would constitute an acceptable “meaningful benchmark.” I immediately thought of the First Circuit’s discussion about the inequity of forcing plan participants to try to read a plan sponsor’s mind, only to get a series of “nopes” and mind games.

We already have an unacceptable and inequitable situation where plan participants’ rights and protections under ERISA are being determined on where they live, not on the stated purpose and principles of ERISA. With the goal of fundamental fairness, equity and a purposeful advancement of participants’ goal of “retirement readiness,” I suggest that SCOTUS and the Restatement (Third) of Trusts have already provided a viable blueprint for making ERISA meaningful again.

In analyzing an investment option, Nobel laureate William F. Sharpe has stated that

‘[T]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’¹²⁰

Building on Sharpe’s theory, investment icon Charles D. Ellis has provided further advice on the process used in evaluating the cost-efficiency of an actively managed mutual fund.

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.²¹

Ellis’ argument on behalf of forensic cost-efficiency analyses is consistent with SCOTUS’ endorsement of the Restatement of Trusts as a resource in resolving fiduciary issues. As mentioned earlier, the Section 90 of the Restatement stresses the importance of a fiduciary being cost-conscious.

The Restatement even sets out three core principles regarding the prudent evaluation and selection of actively managed mutual funds. One of the core principles is that an actively managed fund is an imprudent investment choice unless it can be objectively determined that the fund will provide a commensurate return for the additional costs and risks generally associated with actively managed funds. As mentioned earlier, the evidence overwhelmingly indicates that most actively managed funds do not even come close to meeting this hurdle.

Going Forward
Remember Judge Doty’s statements that

In order to plausibly allege a fund is underperforming, Meiners must provide some benchmark against which the Wells Fargo funds can meaningfully be compared.

[We need to avoid] a (mistaken view that whichever fund earned more over the relevant time frame ‘should’ have been offered to the participants, or even that it performed ‘better’ in a meaningful sense.

As outlined in this post, I believe analyzing actively managed funds based on a simple, cost-efficiency basis provides the objective and “meaningful” benchmarking Judge Doty was advocating and other courts are adopting . The AMVR metric allows investment fiduciaries such as plan sponsors and trustees, as well as litigators, to easily perform such an analysis, as the AMVR only requires the ability to perform what one judge described as “simple, third grade math.”

Neither cost-efficiency based benchmarking should not draw valid opposition in court. Cost-efficiency as a meaningful benchmark has been explicitly endorsed by the Restatement (Third) of Trusts and implicitly by SCOTUS, which recognized the Restatement as a viable resource in resolving fiduciary responsibility questions.

The use of the AMVR metric to perform cost-efficiency analyses in ERISA actions should also not encounter any serious opposition in litigation. The AMVR is simply a modified version of the widely accepted cost/benefit equation, using a fund’s incremental costs and incremental returns as the input data. Common sense tells us that when an investment’s incremental costs exceed its incremental returns, the investment is not prudent.

The rights and protections guaranteed to American workers are too important to depend on where a worker resides, the questionable misinterpretation of ERISA or various individual court interpretations of what constitutes a “meaningful” benchmark. Brotherston provided a meaningful and well-reasoned analysis of the current situation and a common sense solution to the problem by placing the burden of proof as to causation on plan sponsors since, in most cases, they alone have the relevant evidence on such issues.

SCOTUS is currently considering hearing the Northwestern University 403(b) case. The Northwestern case involves many of the issues discussed herein. SCOTUS desperately need to hear the Northwestern case to ensure that ERISA remains meaningful and American workers are protected against the abusive practices that are being exposed in the current 401(k)/403(b) fiduciary breach actions, decisions and settlements.

In my closing statement to the jury, I always asked the jury to do justice, citing the following quote by the late General Norman Schwarzkopf:

The truth is, we always know the right thing to do. The hard part is doing it.

SCOTUS, American workers desperately need a hero.

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018).
2. Tibble v. Edison, Intl. 135 S. Ct. 1823 (2015)
3. Restatement (Third) Trusts, Section 90, cmt. b. (American Law Institute)
4. Restatement (Third) Trusts, Section 90, cmt. f .(American Law institute)
5. Restatement (Third) Trusts, Section 90, cmt. h(2). (American Law Institute)
6. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
7. 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.
8. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
9. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
10. Hecker v. Deere & Co. (Hecker II), 569 F.3d 708, 711 (7th Cir. 2009).
11. DiFelice v. U.S. Airways, 497 F.3d 410, 423 fn. 8 (4th Cir. 2007).
12. Hecker v. Deere & Co. (Hecker I), 556 F.3d 575 (7th Cir. 2009).
13. Hecker II, supra.
14. Meiners v. Wells Fargo & Company, United States District Court (D. Minnesota), Civil No. 16-3981.
15. Ibid.
16. Ibid.
17. Tussey v. ABB, Inc., 138 S. Ct. 281 (2017).
18. Ibid.
19. Meiners, supra
20. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
21. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”               available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c

© Copyright 2021, The Watkins Law Firm. 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 facts and circumstances. If legal or other professional assistance is needed, the services of an attorney other appropriate professional adviser should be sought.

For the first new blog post since our blog and domain name were recovered, I figured it was only appropriate to re-christen the blog with our popular quarterly “cheat sheet” of the top non-index mutual funds in U.S. 401(k) plans. “Pensions & Investments” publishes an annual list of the top 50 mutual funds used in U.S., 401(k) 401(k) plans based on the cumulative amounts invested in each fund within the plans.

We then perform a quarterly analysis of the actively managed funds from the top ten funds in Pensions & Investments’ list. The forensic analysis, or the “cheat sheet,” for the 4Q of 2020 is shown below.

For those unfamiliar with InvestSense’s Active Management Value Ratio (AMVR), the AMVR calculates an active fund’s cost-efficiency. A fund may produce a positive incremental return relative to a comparable passive benchmark, such as an index fund. However, if the fund’s incremental costs exceed the fund’s positive incremental returns, the fund would actually be an imprudent investment for an investors, as it result in an overall loss for an investor.

The AMVR is simply an adaptation of the common cost/benefit ratio, using the incremental cost/incremental benefit concept from Charles Ellis’ classic, “Winning the Loser’s Game.” Increasing, plaintiff’s attorneys in both ERISA fiduciary breach actions and general fiduciary breach investment actions are using both the correlation-adjusted and risk-adjusted numbers to calculate the damages in their cases.

For example, Vanguard PRIMECAP’s AMVR using the fund’s nominal, or publicly reported, data would be 0.27/0.94, or 0.28. The lower a fund’s AMVR score, the greater the fund’s cost-efficiency. An AMVR score above 1.00 indicates that a fund is not cost-efficient, as its incremental costs exceed its incremental returns. If a fund fails to provide a positive incremental, it does not qualify for an AMVR score, since the fund has underperformed its benchmark.

The AMVR simplifies the cost-efficiency evaluation process. Once an actively managed fund’s cost efficiency has been calculated relative to a comparable benchmark, usually a comparable index fund, the plan sponsor or the ERISA attorney only have to answer two simple questions:

1. Did the actively managed funds provided a positive incremental return?
2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs

If the answer to either of these of these questions is “no,” the actively managed is not cost-efficient and, therefore, does not meet the plan sponsor’s fiduciary duty of prudence.

Using the funds’ 4Q nominal data, three of the funds, failed to provide a positive nominal return at all- American Funds’ Growth Fund of America fund (R-6 class shares), Fidelity Contrafund fund (K class shares) and T. Rowe Price Blue Chip Growth fund (R class shares. The AMVR score for the remaining three funds would have been American Funds Washington Mutual fund (R-6 class shares)-0.10, Dodge & Cox Stock-0.10, and, as previously mentioned, Vanguard PRIMECAP (Admiral class shares)-0.28.

When InvestSense performs a full forensic audit for a 401(k)/403(b) plan, a trust, an attorney or another type of client, we then perform a second analysis using our proprietary metric, the InvestSense Quotient (IQ). Where the AMVR provides more of a quantitative analysis, the IQ provides more of a qualitative analysis, measuring the efficiency of an actively managed fund, both in terms of cost management and risk management, as well as the consistency of performance of a fund.

While an AMVR analysis using a fund’s nominal data provides a quick and simple analysis, it may not provide the depth of analysis that a professional fiduciary, e.g., plan sponsor, trustee, or an attorney needs. Fortunately, there is a relatively easy way of obtaining such additional details. By substituting an actively managed fund’s risk-adjusted incremental return and a fund’s correlation-adjusted incremental costs into the AMVR cost/benefit equation, some funds that appear to be cost-efficient using their nominative data are exposed as cost-inefficient.

Why substitute risk-adjusted incremental return for nominal-based incremental return? Simply because it is a generally accepted fact that risk drives returns, that an investor has a right to expect a level of return commensurate with the additional costs and risks that are generally associated with actively managed mutual funds relative to comparable index funds. This concept is consistent with the prudence standards set out in the Restatement (Third) of Trusts’ Prudent Investor Rule.

Why substitute correlation-adjusted incremental costs for nominal-based incremental costs? This is a little more complicated. However, Ross Miller, the creator of the Active Expense Ratio (AER) metric, provided an excellent explanation. Miller explained the reasoning behind the AER as follows:

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.(1)

For example, assume the following scenario:

Active Fund > Expense Ratio 1.00

Benchmark Fund > Expense Ratio 0.05

Assuming that the correlation of returns between the funds is 95 percent, I could theoretically achieve 95 percent of the actively managed fund’s return for only 5 percent of the cost of the actively managed fund.

The chart shows how impactful factoring in a fund’s risk-adjusted incremental returns and correlation-adjusted costs can be in evaluating the cost-efficiency of an actively managed fund. None of the three funds that survived the initial AMVR analysis would have a passing AMVR score using the adjusted cost/return numbers. This is due primarily to the 95+ R-squared scores of the funds, which in turn increases the implicit costs associated with each of the three surviving funds.

Going Forward

I am often asked why I I keep writing and talking about cost-efficiency and the AMVR. My answer:

1. To help investors, including pension plan participants, to maximize their investment returns by knowing how to spot and avoid imprudent investments. Studies have consistently shown that the overwhelming majority of actively managed mutual funds are not cost-efficient, with conclusions such as

“[I]ncreasing 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.”(2)

“[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.”(3)

“[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”(4)

2. To help investment fiduciaries such as 401(k) plan sponsors and trustees recognize the risks inherent in actively managed mutual funds and avoid unnecessary fiducairy liability exposure. Shortly after the Restatement (Third) of Trusts was released over forty years ago, John Langbein, reporter on the Restatement (Third) of Trusts and noted law professor Richard. A. Posner warned that,

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.(5)

The Brotherston decision, more specifically the First Circuit Court of Appeal’s words regarding index funds, would suggest that that day has arrived.

The AMVR has received favorable reviews and is reportedly being used in the fields of finance/invest and law. The simplicity and power of the metric have been the two most cited aspects of the metric, consistent with the late John Bogle’s concept of “Humble Arithmetic.” Those willing to take the time to study my writings on the metric and practice the calculation, process will be rewarded with the ability to better protect their financial security and avoid unnecessary fiduciary liability exposure.

For more information about the Active Management Value Ratio and the calculation process, please use the site’s “Search” function and search for “Active Management Value Ratio” and/or “AMVR.”

Notes
1. 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
2. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8ez.
3. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P. (August 2016).
4. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997).
5. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498.

© Copyright 2021 InvestSense, LLC. All rights reserved.

This article 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.

I recently posted on both Twitter and LinkedIn my belief that plan participants should never lose a properly vetted 401(k)/403(b) fiduciary breach action. As expected, the posts drew a strong response.

I recently participated in a private conference to discuss my rationale and theories on the future of 401(k)/403(b) litigation. What was slated for an hour presentation turned into a two-hour plus presentation. I thoroughly enjoyed every minute of it. The participants echoed that sentiment.

We discussed some of my prior blog posts addressing the current state of 401(k)/403(b), including the courts’ misguided application of the “apples to oranges” and “menu of options” defenses commonly put forth by plans. Brotherston effectively nullified the “apples and oranges” defense by pointing out that the goal of ERISA is to use whatever products and strategies most effectively serve the plan participants’ goal of “retirement readiness.

The “menu of options” defense has never had any legal merit. ERISA Section 404(a) itself points out that ERISA requires that each investment option offered within a plan must be prudent both individually and in terms of the plan as a whole. Both the Hecker II decision and the DeFelice decision reiterated ERISA’s position.

Plans often reference the Hecker I decision in support of the “menu of options” defense. For some reason they never mention that the 7th Circuit quickly back and “clarified” their earlier decision. While the Court referenced their Hecker II decision as a “clarification,” many attorneys deemed it to be a reversal of their Hecker I decision, and rightfully so.

The Secretary[of Labor] also fears that our opinion could be read as a sweeping statement that any Plan can insulate itself from liability by the simple expedient of including a vey large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It would also place an unreasonable burden on unsophisticated plan participants who do not have the resources to prescreen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such “obvious, even reckless, imprudence in the selection of investments (as the Secretary puts in her brief.)(1)

And yet, the courts continue to dismiss 401(k) action, citing the “menu of options” defense.

SCOTUS recently announced that it was considering hearing the Northwestern University 403(b) decision. The Court needs to hear the case to ensure that courts are applying ERISA uniformly. The rights and guarantees provided by ERISA are far too important to be depend on questions of geography.

At the end of each calendar quarter I prepare an analysis of the non-index funds in the top ten mutual funds in “Pensions & Investments” top 100 mutual funds in defined contribution plans. The 3Q 2020 analysis is available here.

During the recent Zoom presentation, I offered some additional research that I typically provide to clients. John Langbein, the reporter for the committee that drafted the Restatement (Third) of Trusts, had expressed a warning in 1976, stating that

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.(2)

The 1st Circuit suggested the same thing in Brotherston, with the court suggesting that plans who had a problem with their decision might consider simply utilizing index funds. This statement upset many in the investment and pension industries, but an objective analysis of a key category of funds that 401(k)/403(b) plans commonly use, large cap funds, supports the 1st Circuit’s statement.

During the Zoom conference, I offered some additional research that I have provided to my consulting clients. Using the Morningstar Investment Research Center application, I created a screen for comparing large cap retirement funds-large cap blend, large cap growth and large cap value-to comparable Vanguard retirement funds.

The screen I created was as follows:

• 5-year annualized return > benchmark
• Expense ratio < benchmark
• Standard deviation < benchmark

The screen was applied progressively, meaning that a fund was disqualified as soon as it failed to any of the screens.

The results were as follows:

Large Cap Blend (benchmark – Vanguard S&P 500 Index Admiral shares=VFIAX)
Funds in category – 1252
5-year annualized return >= benchmark – 99
Expense ratio <= benchmark – 8
Standard deviation <= benchmark – 6
Final results: Vanguard Large Cap Blend Fund Admiral shares, Fidelity 500 Index Fund, iShares S&P 500 Index K shares, and State Street Equity 500 index Fund. The other two Vanguard Institutional funds had extremely high minimums)

Large Cap Growth (benchmark – Vanguard S&P 500 Index Admiral shares=VFIAX)
Funds in category – 1282
5-year annualized return >= benchmark – 283
Expense ratio <= benchmark – 7
Standard deviation <= benchmark – 4
Final Results: Vanguard Growth Index Admiral shares, Fidelity Advisor Series Equity Growth Fund. and American Century NT Growth Fund G shares. The TIAA-CREF Institutional fund had an extremely high minimum)

Large Cap Value (benchmark – Vanguard S&P 500 Index Admiral shares=VFIAX)
Funds in category – 1103
5-year annualized return >= benchmark – 139
Expense ratio <= benchmark – 2
Standard deviation <= benchmark – 1
Final Results: Vanguard Value Index Fund Admiral shares

The end-results were the same for analyses using the 10-year annualized returns. Perhaps the 1st Circuit and John Langbein should not be so easily dismissed by plans and the investment industry.

As I told those on the call, IMHO decisions such as the Salesforce and CareerBuilder serve no real purpose other than providing plans with a false sense of security. Those decisions that are appealed are usually reversed, as the evidence just does not support the lower court’s decision and the lower court’s decision is often based on theories that have been rejected by appellate courts.

Going Forward
I know that there are many who will disagree with my research and conclusions. Again, that is why I hope SCOTUS grants cert to the Northwestern University case and creates one uniform standard for sufficiency of pleadings in ERISA actions. As those who follow me know, I support a standard which places the burden of proof regarding causation on plans since they are the party with the relevant specifics.

Earlier, before the Brotherston decision was announced, I suggested that the decision would be a pivotal point in the 401(k) arena. I now suggest that SCOTUS’ decision whether to hear the SalesForce decision and the decision it hands down may also be a pivotal point in further defining the 401(k)/403(b) arena, especially if the burden of proof as to causation is imposed on plans going forward. Both plans and the investment industry realize that they cannot carry such a burden of proof, as the evidence clearly shows that most actively managed funds are not cost-efficient, and do in fact cause the overwhelming losses within pension plans and accounts.

Referenced previous posts:

https://iainsight.wordpress.com/2020/05/25/plan-sponsor-special-report-401k-fiduciary-liability-risk-management-in-a-post-brotherston-world/

https://iainsight.wordpress.com/2020/10/04/q3-2020-amvr-investsense-quotient-cheat-sheet/

Notes
(1) Hecker v. Deere & Co., 569 F.3d 708 (7th Cir. 2009).
(2)2. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498

(c) Copyright 2020, The Watkins Law Firm. 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 facts and circumstances. If legal or other professional assistance is needed, the services of an attorney other appropriate professional adviser should be sought.

The quarterly AMVR/InvestSense Quotient “cheat sheet” analyzes the non-index mutual funds in the top ten mutual funds used in U.S. 401(k) plans, based upon the Top 100 list compiled annually by “Pensions and Investments.” For the 3Q 2020, only six of the top ten funds were actively managed funds.

The Active Management Value Ratio (AMVR) is based largely on Charles Ellis’ classic, “Winning the Loser’s Game.” Ellis provided the blueprint for the AMVR with his observation that

[t]he incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.

Academic studies have consistently shown that that the overwhelming majority of actively managed funds are not cost-efficient, with conclusions such as

“99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.”

“[I]ncreasing 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.”

The AMVR simplifies the cost-efficiency evaluation process. Once an actively managed fund’s cost efficiency has been calculated relative to a comparable benchmark, usually a comparable index fund, the investor, plan sponsor or the ERISA attorney only has to answer two simple questions:

1. Did the actively managed funds provided a positive incremental return?
2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs

If the answer to either of these of these questions is “no,” the actively managed fund is not cost-efficient and , therefore, does not meet the plan sponsor’s fiduciary duty of prudence.

People frequently ask me what “CAC” stands for and why I include it in the AMVR/IQ calculations. “CAC” stands for “Correlation-Adjusted Costs.” The reason I include such calculations is to help investors, investment fiduciaries and attorneys to recognize potential “closet index funds.” The problem of “closet index” funds and the harm they create has been aptly described by Martijn Cremers, creator of the Active Shares metric, as follows:

“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 laws.”

Funds with high R-squared numbers or low tracking numbers are naturally candidates for “closet index” status. Closet index funds are never prudent under the Restatement (Third) of Trusts’ fiduciary standards. most notably Section 90, comments b, f, and h(2). SCOTUS recognized the Restatement as the legal authority for addressing fiduciary issues in Tibble v. Edison International.

The Correlation-Adjusted Cost calculations are based on Ross Miller’s Active Expense Ratio (AER) metric. A fund’s AER score shows the implicit cost of a fund’s expense ratio based on the fund’s incremental costs and the fund’s R-squared correlation to a comparable index fund. Miller explained the reasoning behind the AER as follows:

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.

“RAR” refers to a fund’s risk-adjusted returns. Factoring in the riskiness of a fund is important since the standard belief in the investment industry is that return is a function of risk. Investors should expect a higher return if their fund’s manager assumes greater risk in managing their money.

The truth is that there is no exact way to measure a fund’s risk. In accordance with general investment practices, the AMVR uses a fund’s standard deviation number as a proxy for the fund’s “risk.”

An actively managed mutual fund that fails to provide an investor with a positive incremental return, i.e., has underperformed a comparable index fund benchmark, is not eligible for an AMVR score since it provided no benefit to an an investor.

A fund’s AMVR score provides a quantitative analysis of an actively managed fund. A fund’s InvestSense Quotient (IQ) provides a qualitative analysis of the fund by factoring in a fund’s efficiency, both in terms of cost management and risk management, as well as a fund’s overall consistency of performance.

The Q3 2020 AMVR numbers speak for themselves. Three key takeaways for investors, investment fiduciaries and attorneys are:

1. While funds and advisers often calculate a fund’s AMVR score based on a fund’s nominal, or stated, incremental costs/fees and incremental returns, InvestSense and plaintiff’s attorneys calculate a fund’s AMVR score based on a fund’s correlation-adjusted costs and risk-adjusted returns, as they provide a truer picture of such data. In this case, only two of the six funds provided positive incremental returns over the most recent five-year period (October 1, 2015-September 2020) and qualify for an AMVR score.

The “cheat sheet” numbers support my contention that arguing cost-efficiency, or more appropriately cost-inefficiency, instead of simply absolute costs of actively managed mutual funds, could help plaintiff’s attorneys create a genuine issue of fact, thereby reducing the chances of dismissal of their cases.

2. Given the high R-squared correlation numbers for each of the six funds, an argument can be made that these funds are closet index funds. While no universal number exists for classifying a fund as a closet index fund, an R-squared correlation number of 90 or above is certainly suspect. Morningstar uses a much lower R-squared threshold, 70, and to designate a fund as being highly correlated to the benchmark used in calculating the fund’s R-squared number.

3. The data for the retirement shares of the T. Rowe Price’s Blue Chip Growth Fund (RRBGX) shows the impact that a combination of high incremental costs and high R-squared correlation numbers can have on the overall prudence of a fund. In the case of RRBGX, the combination of the fund’s high incremental costs (1.18) and high R-squared (97) resulted in RRGBX’x AER score/implied incremental costs increasing by over 800%, significantly impacting the overall cost-efficiency of the fund.

For more information about the Active Management Value Ratio and examples of the the AMVR worksheet, click here and here. As John Bogle said, the power of “Humble Arithmetic.”

(c) Copyright 2020, The Watkins Law Firm. 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 facts and circumstances. If legal or other professional assistance is needed, the services of an attorney or other appropriate professional adviser should be sought.