The Prudent Investment Fiduciary Rules

The CareerBuilder 401(k) Decision: Three Key Lessons for Plan Sponsors and ERISA Attorneys

Posted on August 31, 2020 by jwatkins

“If we desire respect for the law we must first make the law respectful.”
Supreme Court Justice Louis Brandies

Currently, we have different federal courts handing down various interpretations of ERISA. As a result, in some cases the public’s guaranteed rights and protections under ERISA are dependent on where the plan participants reside. This is neither equitable nor just.

These inconsistent interpretations and rulings are unnecessarily exposing plan sponsors to potential liability exposure. The purpose of this post is to alert plan sponsors, as well as attorneys, to these “traps” to ensure that plan participants are properly protected.

However, as I read the recent ruling by a 7th Circuit court in the CareerBuilder, LLC (“CareerBuilder”) 401(k) case.(1) I noticed that the court was arguing two common defense tactics, both of which have been soundly rejected, one by the 7th Circuit Court of Appeals itself. Technically, the court dismissed the plan participants’ action, for allegedly improper pleadings. To its credit, the court dismissed the action “without prejudice,” thereby allowing the plan participants to file amended leadings.

The court essentially ruled that the plan participants did not provide the plan with sufficient information to understand the nature of the plan participants’ claims. As a plaintiff’s attorney, I immediately thought of the 1st Circuit’s Brotherston decision(2) and the fact that the CareerBuilder court’s decision might have been different had the court followed the 1st Circuit’s position and shifted the burden of proof as to causation to the plan.

However, the court went on to discuss two commonly used defenses, (1) the “apples to oranges” comparison argument; (2) the “menu of funds” defense, neither of which have any merit with regard to 401(k) actions. The other thing that struck me was the availability of a perfect strategy to comply to the court’s request for more “detailed and specific” information regarding the plan sponsor’s deficiency in overall performance-the cost-inefficiency of actively managed mutual funds within a 401(k) plan.

The “Apples-to Oranges” Comparison Issue

In discussing the plan participants’ breach of fiduciary claims as to the plan’s responsibility to prudently select, monitor, and replace the investment options within a plan, the CareerBuilder court mentioned the same “apples to oranges” argument that Judge Young had announced in the lower court’s Brotherston decision.

As the 1st Circuit pointed out in reversing Judge Young’s decision, the “apples to oranges” argument simply has no merit in ERISA 401(k) actions, as the only question that matters is what best serves the plan participants’ goal of building their retirement plan accounts to achieve “retirement readiness. Not only did the 1st Circuit approve the use of Vanguard for benchmarking purposes, the court went on to suggest that if plan sponsors have a problem with the court’s ruling, the expeditious solution might be to only offer cost-efficient index funds in their plans.

While the CareerBuilder court did not ultimately base their decision on the “apples to oranges” argument, I found it puzzling why the court would even mention the theory after the 1st Circuit had completely discredited the argument in connection with ERISA 401(k)actions.

The “Menu of Funds” Defense
The CareerBuilder court cited the Hecker I decision several times for the proposition that plans and plan sponsors are insulated from liability as long as the plan offers “a comprehensive-enough menu of options,” “a ‘mix’ of alternatives,” and “an acceptable mix of options.” The court’s suggestion as to the viability of the “menu of options,” defense is not only inconsistent with ERISA itself, but totally inconsistent with the 7th Circuit’s statements in its Hecker II decision..

Fred Reish, one of the nation’s preeminent ERISA attorneys, wrote an excellent article addressing the question of whether 401(k) fiduciary prudence is determined by the prudence of each individual fund offered by a plan, or rather by the overall menu of funds offered.

The obligation of fiduciaries under ERISA is to prudently select, monitor, and remove individual investments, as well as to consider the performance of the portfolio as a whole. It is not an ‘either-or’ scenario; both requirements must be satisfied.(3)

Reish supported his position by pointing to the actual wording within the preamble to Section 404(a), which states that

[t]he regulation , however, is not intended to suggest either that any relevant or material attributes of a contemplated investment may be properly ignored or disregarded, or that a particular plan investment should be deemed to be prudent solely by reason of the propriety of the aggregate risk/return characteristics of the plan’s portfolio. (4)

The CareerBuilder court repeatedly cites the 7th Circuit’s initial Hecker v. Deere decision, aka Hecker I, in support of the “menu of funds” argument.(5) The reaction was so strong against the 7th Circuit’s suggestion as to the protection offered by the “menu of funds” defense that that the court quickly offered a “clarification” of its ruling in Hecker I, stating that

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.)(6)

So the 7th Circuit unequivocally denounced the “menu of funds” defense in Hecker II. And yet, the CareerBuilder court never referenced Hecker II in its discussion of the “menu of funds” defense. One could argue that the omission certainly raises a number of questions. However, once again, to be fair, the CareerBuilder court did not ultimately base its decision on the “menu of funds” argument.

Going Forward
The CareerBuilder court did base it decision to dismiss the plan participants’ case on their alleged failure to provide sufficient information to the plan to allow the plan to understand the nature of the participants’ claims. Once again, this would presumably not be an issue if the 7th Circuit followed the 1st Circuit’s position on shifting the burden of proof to the plan.

Be that as it may, the reality is that the 7th Circuit has not adopted the 1st Circuit’s Brotherston positions. So, both plan sponsors and ERISA plaintiff’s attorneys should heed the pleading policy statements provided by the CareerBuilder court.

In citing ERISA 401(k) cases that had survived a motion to dismiss, the CareerBuilder court noted that “the plaintiffs had included “numerous and specific factual allegations,” and “offered specific comparisons between returns on Plan investments and readily available alternatives,…” The court went to add that such information

permitted the inference of imprudence-[that] it was plausible that the [Plan] had a flawed process given that it, anomalously among its peers, retained clunker funds notwithstanding the availability of cheaper and higher performing alternatives.(7)

“Cheaper and higher performing alternatives,” in other words, more cost-efficient alternatives.

In my opinion, that is a key takeaway from the CareerBuilder decision for both plan sponsors and ERISA plaintiff’s attorneys. Plan sponsors that focus on cost-efficiency can ensure that their process is consistent with the prudence standards established by the Restatement (Third) of Trusts (Restatement), which SCOTUS recognized as a resource that the courts often turn to in resolving fiduciary questions.

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;(8)
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; (9) 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.(10)

Hint: 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.”(11)
“[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.”(12)
“[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.”(13)
“[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”(14)

ERISA plaintiff’s counsel should keep a copy of these studies in their trial notebook to support their arguments in favor of cost-efficiency as a determining factor in opposing any motions to dismiss

The final piece of the puzzle is calculating the cost-efficiency, or cost-inefficiency, of the actively managed funds within a 401(k) plan. Fortunately, there is a simple, yet powerful, metric that I created, the Active Management Value Ratio (AMVR), which simplifies the cost-efficiency calculation process. After a little practice, most people have told me that they can perform an AMVR calculation on a fund in less than one minute. For more information about the AMVR and the calculation process, click here and here.

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.

Bottom line: Calculating the AMVR numbers for actively managed funds within a 401(k) plan allows a plan sponsor to demonstrate the prudence of their selection and monitoring process. The AMVR numbers attorneys with the details that some courts continue to require in order to defeat a motion to dismiss.

AMVR cost-efficiency numbers provide information regarding a fund’s underperformance and costs, and the extent of the resulting damages, thereby creating “genuine issues of fact” for litigators. As all litigators know, courts can only determine issues of law. Questions of fact are the sole province of the jury

Cost-efficiency is the financial services industry’s kryptonite. It is the reason they so vigorously oppose any mention of a true fiduciary standard for the industry. They have no defense against such evidence, as they know that the overwhelming majority of their investment products, and thus, their advice regarding same, is not cost-efficient and could never meet the “best interest” demands of a true fiduciary standard.

Conclusion
As I stated at the outset, SCOTUS needs to determine the issues addressed herein, especially the rule as to the burden of proof regarding causation, so that ERISA is uniformly applied in all courts. The rights and protections guaranteed to workers under ERISA are simply too important to be determined by where they reside.

Notes
1. Martin v. CareerBuilder, LLC, Case No. 19-cv-6463 (N.D. Ill 2020).
2. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018.
3. Fred Reish, “Removal Spot: The Duty to Remove Investments,” https://www.faegredrinker.com/en/insights/publications/2009/12/removal-spot-the-duty-to-remove-investments.
4. ERISA 404(a) (Preamble)
5. Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009)
6. Hecker v. Deere & Co., 569 F.3d 708 (7th Cir. 2009).
7. CareerBuilder, Ibid.
8. Restatement (Third) Trusts, Section 90, cmt. b. (American Law Institute)
9. Restatement (Third) Trusts, Section 90, cmt. f .(American Law institute)
10. Restatement (Third) Trusts, Section 90, cmt. h(2). (American Law Institute)
11. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
12. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8ez.
13. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P. (August 2016).
14. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997).

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.

Posted in 401k compliance, 401k investments, 404c, 404c compliance, Active Management Value Ratio, AMVR, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, pension plans, prudence, retirement plans | Tagged 401k, 401k compliance, 404c, 404c compliance, Active Management Value Ratio, AMVR, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans | 1 Comment

Plan Sponsor Special Report: 401(k) Fiduciary Liability Risk Management in a Post-Brotherston World

Posted on May 25, 2020 by jwatkins

My firm, InvestSense, provides fiduciary oversight services to pension plans, trust, and other investment fiduciaries. One of the most requested services is a fiduciary audit, including a forensic fiduciary prudence analysis of the entity’s investments.

After a recent audit, the company’s CEO and legal counsel asked me why no one had ever warned me of the issues I had identified. They agreed with all my findings, but were angered about the potential liability they faced due to poor advice they had received from others. They suggested that I write an article warning plan sponsors and other investment fiduciaries of these fiduciary issues, what I like to call “gotchas,” so as to avoid unwanted, and unnecessary, liability exposure. So I have.

Based upon my experience, there are four key fiduciary liability issues that most plans and plan sponsors need to address in the post-Brotherston 401(k) world:

Cost-inefficiency of the plan’s investment options;
Prudence of each individual investment option within the plan;
Legal rules regarding reliance on third-parties; and
Available recourse for poor investment advice provided to a plan.

1. Cost-Inefficiency of Plan’s Investments
I am sometimes contacted by ERISA plaintiff’s attorneys asking about the ERISA litigation strategy I have recommended since the First Circuit’s Brotherston decision. The strategy, which I refer to as BRIC, can also be used by investment fiduciaries to evaluate the legal soundness of their plan/trust.

“B” stands for Brotherston, and the recommendation to incorporate the excellent legal analysis of the application of fiduciary law that the First Circuit provided. Investment fiduciaries would also be wise the heed the court’s suggestion that

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 incurred as a result.(1)

Interestingly enough, John Langbein, the reporter for the committee that drafted the Restatement (Third) of Trusts, had expressed a similar 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 opinions expressed by both the First Circuit and Langbein are further supported by a 2007 article co-authored by K.J. Martijn Cremers and Quinn Curtis. Cremers, dean of the Notre Dame Mendoza School of Business, and Curtis, at that time an associate professor of law at the University of Virginia School of Law, questioned just how much active management “active” funds truly provided and the resulting financial and legal implications of same.

The authors cited a 2007 presentation in which the general counsel of the SEC raised the following issues regarding the high correlation between “active” funds and comparable index funds:

[I]nvestors in some of these [funds] …are paying the costs of active management, but getting instead something that looks a lot like an overpriced index fund. So don’t we need to be asking how to provide investors who choose active management with the information they need, in a form they can use, to determine whether they’re getting the desired bang for their buck.(3)

Following up on that statement, Cremers, creator of the concept of Active Share, and Curtis concluded that

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.(4)

Studies have consistently noted the same inequitable cost-return, i.e., cost-inefficiency, issues with actively managed funds, producing findings such as

99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.(5)
[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.(6)
[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.(7)
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.(8)

With Brotherston placing the burden of proof regarding causation on plans, these consistent findings of cost-inefficiency regarding actively managed funds will make it very difficult for plan sponsors to meet such a burden, As a result, I believe we will see an increase in 401(k) fiduciary prudence litigation and more multi-million dollar settlements.

2. Prudence of each individual investment option within the plan
One of the most common mistakes plan sponsors make is evaluating their plan’s investment options in terms of the portfolio as a whole, instead of evaluating the prudence of each individual investment. This is clearly inconsistent with court decisions involving defined contribution plans and ERISA itself.

The notion of the “portfolio as a whole” concept relative to defined contribution plans has been consistently rejected by the courts.

A fiduciary cannot avoid liability for offering imprudent investments merely by including them alongside a larger menu of prudent investment options. Much as one bad apple spoils the bunch, the fiduciary’s designation of a single imprudent investment offered as part of an otherwise prudent menu of investment choices amounts to a breach of fiduciary duty, both the duty to act as a prudent person would in a similar situation with single-minded devotion to the plan participants and beneficiaries, as well as the duty to act for the exclusive purpose of providing benefits to plan participants and beneficiaries. (9)

Many plan sponsors and plan advisory point to the initial decision in Hecker v. Deere & Co. (Hecker I), as supporting the idea that the prudence of a plan’s investment options is judged by looking to the investments options as a whole, the so called investment menu” defense. (10) What they seem to forget is that the court went back and quickly issued what they deemed a clarification of their first decision after it drew widespread criticism for the suggestion that plans could insulate themselves by simply offering a lot of investment options.(11)

In Hecker II, the court stated that it neither intended to nor did suggest that a plan could avoid liability simply based on the number of fund options offered by the plan. The court expressly rejected any notion that a plan fiduciary “can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them.. The court also noted that such a position “would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives.”

The fallacy of the “plan investment menu” defense was further explained in the DiFelice v. U.S. Airways, Inc. decision, with the court explaining that

Under ERISA, the prudence of investments or classes of investments offered by a plan must be judged individually.” That is, a fiduciary must initially determine, and continue to monitor, the prudence of each investment option available to plan participants. Here the relevant “portfolio” that must be prudent is each available Fund considered on its own, including the Company Fund, not the full menu of Plan funds.(12)

The “R” in my BRIC concept stands for the Restatement (Third) of Trusts (Restatement). SCOTUS recognized that the courts often look to the Restatement for guidance in resolving fiduciary questions.(xx) The Restatement establishes a number of fiduciary standards with regard to a fiduciary’s duty of prudence. Three of the key standards are

a fiduciary has a duty to be cost-conscientious in investing.(13)
a fiduciary has 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.(14)
that due to higher costs and risks associated with actively managed funds, actively managed funds are imprudent unless it can be objectively estimated that the funds will provide a commensurate return for the additional costs and risks incurred, i.e., are cost-efficient.(15)

In determining whether an ERISA fiduciary has breached their fiduciary duty of prudence, the courts assess the fiduciary’s action in terms of both procedural and substantive prudence.(16) In evaluating procedural prudence, the courts look at the methodology tht the fiduciary used, not he eventual results.(17) In evaluating substantive prudence, the courts base their decision on what the fiduciary knew or should have known.(18)

As the previously mentioned studies and comments have shown, most actively managed funds fall short of meeting even one of the Restatement’s requirements for fiduciary prudence.

The “I” in BRIC stands for InvestSense. I created a simple metric, the Active Management Value Ratio (AMVR), that plan sponsors, trustees and attorneys can use to quickly calculate the cost-efficiency of actively managed mutual funds. The AMVR only requires the basic math skills of multiplication, division, addition and subtraction (My Dear Aunt Sally) and requires minimum data inputs, all of which are available for free online.

In conducting a fiduciary prudence audit, InvestSense uses both the AMVR and another proprietary metric, the InvestSense Quotient (IQ). While the AMVR focuses purely on cost-efficiency, the IQ analyzes an actively managed fund on a more qualitative basis, evaluating a fund on efficiency, both in terms of cost and risk management, and consistency of performance.

The AMVR worksheet below shows the results of a forensic analysis between one the ten most commonly used active funds in U.S. 401(k) plan’s and a comparable index fund. Since the active fund’s incremental costs are larger than the fund’s incremental returns, the fund would be characterized as an imprudent fiduciary investment under the Restatement’s prudence guidelines.

The AER column refers to the correlation-adjusted costs for the active funds. As mentioned earlier, the high correlation of returns between many actively managed funds and comparable index funds not only raises the issue of closet indexing and misrepresentation as to the amount of active management provided by a fund, but it also raises the effective costs an investor has to pay. As the graphic shows, the effective cost increases dramatically as the correlation of returns between the funds increases.

At the end of a fiduciary prudence audit, we provide the client with a “cheat sheet” that they can use to calculate the AMVR for themselves. We provide two sets of numbers, One set of numbers is based on the nominal, or publicly stated, annual expense and return numbers. These are the numbers commonly cited by most mutual funds and plan advisers. The second set of numbers are the risk-adjusted return and correlation-adjusted costs numbers. We provide these adjusted numbers so that a plan can see what the plaintiff attorneys often use to evaluate a plan and the potential damages claim. For more information about the AMVR and the calculation process required, click here.

Over the years, the AMVR and the IQ have produced the same findings, namely that the overwhelming majority of actively managed funds are not cost-efficient. As the following graphic shows, the cost-inefficiency becomes even more pronounced in retail funds that charge a front-end load, a commission, just to purchase one of their funds.

The final component of BRIC is correlation of returns. As previously mentioned, actively managed funds that have a high correlation of returns with a comparable index fund raises questions regarding the actual amount of active management received by an investor and the effective costs of same.

The Active Expense Ratio (AER )is a metric often used to calculate the effective annual expense ratio that investor pay in such situtions. Ross Miller, creator of the AER, described the reason that a fund’s publicly stated annual expense may be misleading:

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.(19)

Given the increasing trend of most U.S. domestic equity-based to show a high correlation to comparable index funds. Some have suggested that this trend is an attempt by actively managed funds to reduce any significance variance in returns between active and index funds and the potential loss of investors in their funds.

Whatever the reason, the trend of increasing correlation of return numbers between domestic equity funds and comparable index funds is undeniable. As a result, a strong argument can be made that a failure of plan sponsors and other investment fiduciaries to calculate and consider such correlation- adjusted costs violates their fiduciary duty to make an independent, thorough, and objective investigation and evaluation of all of the investment options within a plan.

3. Legal rules regarding reliance on third-parties
ERISA allows 401(k) plans to seek advice from third-parties, even encourages the practice. However, both ERISA and the courts clearly impose conditions and restrictions on the use of such third-party advice.

First, a plan cannot blindly rely on third-party advice.

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard….The failure to make an independent investigation and evaluation of a particular plan investment is a breach of fiduciary duty. (20)

Our focus in on whether the fiduciary engaged in a reasoned decision-making process, consistent with that of a ‘prudent man acting in [a] like capacity.'(21)

In selecting third-parties, the courts have consistently held that plans must only use third-parties that are experienced, objective and otherwise qualified to provide such services. The objectiveness requirement is often used by the courts to rule that a plan’s reliance on a third-party was not justifiable due to inherent conflicts of interest issues of the third-party.

While ERISA attorneys are well aware of the Liss v. Smith decision, most plan sponsors are not. In that decision, the court held that a plan’s reliance on a commission-based insurance agent was not justifiable, stating that

Blind reliance on a [broker] whose livelihood [is] derived from commissions he is able to garner is the anti-thesis of [a fiduciary’s duty to conduct an] independent investigation.(22)

As Fred Reish, one of America’s most-respected ERISA attorneys, likes to say, “forewarned is forearmed.”

4. Available recourse for poor investment advice provided to a plan.
After I finish a fiduciary prudence audit, the two most common responses are concern over potential liability exposure and whether the company has any legal recourse against the party who provided the poor advice. I always review plan’s advisory as part of my audit, especially with regard to any attempted fiduciary disclaimer clauses. Such disclaimer clauses have become boilerplate in most plan advisor contracts, especially contracts involving large advisory firms and contracts where the advisor is either a broker-dealer, registered investment advisor, or insurance company.

What we are seeing is a new trend of plans suing plan advisor under such common law principles as negligence, fraud ad breach of contract. The argument in such cases is that the plan advisor knew that the client was an ERISA plan and that they paid for a certain level of advice, advice that would meet applicable legal standards. After all, the law generally requires that when one pays someone for a service, the payer is entitled to receive from the person paid services that are commensurate with or greater than the compensation paid.(23)

Plan advisors have generally tried to dismiss such legal actions by claiming that such civil actions are impermissible and that any such disputes are governed by ERISA. However, the courts have consistently ruled that such cases are no different than any other contract dispute and, generally speaking, may be properly bought in separate court action since they do not involve ERISA issues.(24)

Going Forward
I often hear CEOs and plan sponsors dismiss a possible 401(k) fiduciary breach action by saying they will simply claim that they did not know the law and that they did not intent to hurt anyone. If the reader takes nothing away from this article but this, it will justify the time they invested.

A pure heart and an empty head are no defense [to claims of one’s fiduciary duties].”(25)

Anyone contemplating the use of such a strategy should remember the following warning provided by the court in the Fink decision:

The determination of whether an investment was objectively imprudent is made on the basis of what the [fiduciary] knew or should have known, and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate.(emphasis added)(26)

As I explain to prospective clients and ERISA attorneys, the bottom line is that the AMVR helps plan sponsors satisfy the “knew” aspect of the court’s warning, while at the same time providing ERISA attorneys with evidence regarding the “should have known” issue.

The concepts and calculations behind the AMVR are simple, sound and persuasive. In addition to an understanding of the power of the AMVR, the three key takeaways that plan sponsors and other investment fiduciaries will hopefully remember are:

Investment options within a 401(k) plan must be cost-efficient and evaluated individually for prudence.
Plans may seek advice from third-party parties. However, plan sponsors must conduct their own independent, objective and thorough investigation and evaluation of the investment options within their plan. Reliance on any advice from commission-based professionals is not legally justifiable and, thus, offers no protection to plans or plan sponsors.
Regardless of whether a plan’s third-party advisory contract attempts to disclaim any fiduciary liability for the advice that they provide to a 401(k) plan, a plan has the power to attempt to hold a third-party liable for poor advice under common law principles.

While the Brotherston decision technically only applies to the court within First Circuit’s jurisdiction, the soundness of the court’s logic and they fact they relied on basic fiduciary principles leads many to believe that other courts will adopt the First Circuit’s rationale. Again, “forewarned is forearmed.”

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Circuit 2018).
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
3. SEC Speech: The Future of Securities Regulation: Philadelphia, Pennsylvania: October 24, 2007 (Brian G. Cartwright). http://www.sec.gov/news/speech/2007/spch102407bgc.htm
4. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133
5. Laurent Barras, Oliver Scaillet, and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANE 179, 181 (2010)
6. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8ez
7. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P., August 2016.
8. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997)
9. Pfeil v. State Street Bank & Trust Co., 671 F.3d 585, 587, 597-598 (6th Cir. 2012).
10. Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009). (Hecker I)
11. Hecker v. Deere & Co., 569 F.3d 708, 711 (7th Cir. 2009). (Hecker II)
12. DiFelice v. U.S. Airways, 497 F.3d 410, 420 (4th Cir. 2007).
13. RESTATEMENT (THIRD) TRUSTS, (American Law Institute),Section 90, cmt b.
14. RESTATEMENT (THIRD) TRUSTS, (American Law Institute), Section 90, cmt f.
15. RESTATEMENT (THIRD) TRUSTS, (American Law Institute), Section 90, cmt h(2).
16. Fink v. National Sav. & Trust Co., 772 F.2d 951, 957 (D.C.C. 1985).
17. Howard v. Shay, 100 F.3d 1484, 1488 (4th Cir. 1996).
18. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983).
19. 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
20. Fink, supra.
21. DiFelice, supra.
22. Liss v. Smith, 991 F.Supp.2d 297, 300 (S.D.N.Y 1998); Gregg v. Transportation Workers of America Intern., 343 F.3d 833, 841 (6th Cir. 2003).
23. RESTATEMENT OF CONTRACTS, (American Law Institute), Section 205
24. Berlin City Ford, Inc. v. Roberts Planning Group, 864 F. Supp. 292 (D. New Hampshire 1994)
25. Cunningham, supra.
26. Fink, supra.

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, closet index funds, compliance, cost consciousness, cost efficient, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, retirement plans, risk management, wealth management, wealth preservation | Tagged 401k, 401k compliance, 404c, Active Management Value Ratio, AMVR, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, prudence, retirement plans, RIA risk management, risk management, wealth preservation | 2 Comments

4Q 2019 AMVR Cost-Efficiency Analysis

Posted on March 12, 2020 by jwatkins

I apologize for the delay in posting the 4Q 2019 AMVR Cost-Efficiency Analysis. I have been involved in a legal battle involving my investor advocacy/education blog, “CommonSense InvestSense.” Fortunately, the matter has been resolved and the blog is back online.

As you can see, there has been little change in the AMVR grades for the top non-index mutual funds in “Pensions & Investments” annual ranking of the most mutual funds in U.S. DC plans. “P&I does not perform any qualitative analysis of the funds. They simply rank the funds in terms of total investments in the funds in DC plans.

I provide 4 sets of figures so that the readers can choose which figures they wish to use in calculating the Active Management Value Ratio™ (AMVR). In performing a forensic analysis for our clients, we use the most demanding set of figures, correlation-adjusted costs (using Ross Miller’s Active Expense Ratio(, and risk-adjusted return (using Morningstar’s risk-adjusted methodology)

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.

In my opinion, the key takeaways from the 4Q analysis are:

The fact that only two of the six funds were able to produce a positive nominal return.
The fact that only one fund was able to produce a positive incremental return.
All of the funds had a high correlation of return to their benchmark, the Vanguard S&P 500 Index Fund (VIAFX) for teh large-cap blend funds, RWMGX and DODGX, and the Vanguard Growth Index Fund (VIGAX) for the remaining large-cap growth funds.

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.

I believe that these AMVR numbers take on a whole new level importance after the Brotherston. The Restatement emphasizes two two basic fiduciary duties: cost-efficiency and risk management using effective diversification of a portfolio’s investments. With the burden of proof on causation shifting to plan sponsors, and arguable all investment fiduciaries, fiduciaries, who cannot show that their investment choices are cost-efficient face an uphill challenge in any legal action.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, closet index funds, compliance, consumer protection, cost consciousness, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, retirement plans, RIA, RIA Compliance, risk management, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, compliance, ERISA, fiduciary, fiduciary investing, fiduciary law, fiduciary liability, Fiduciary prudence, investment advisers, investment analysis tools, pension plans, prudence, retirement plans, RIA, wealth management, wealth preservation | Leave a comment

“Petition Denied”: Fiduciary Investing After Brotherston

Posted on January 20, 2020 by jwatkins

On January 13, 2020, SCOTUS officially denied Putnam Investment, LLC’s petition for writ of certiorari to review the First Circuit Court of Appeals’ decision in Brotherston v. Putnam Investments, LLC. The First Circuit had ruled that plan sponsors have the burden of proof in ERISA actions once the plan participants prove that the plan’s sponsor breached their fiduciary duties, resulting in financial losses for the plan participants. SCOTUS also ruled that index mutual funds are acceptable for the purpose of establishing the damages suffered by a plan’s participants as a result of the fiduciary breach.

SCOTUS’ decision has caused a lot of concern among plan sponsors and the wealth management industry, as they know, and have known for some time, that in most cases they will not be able to carry that burden of proof. Studies have consistently shown that most actively managed mutual funds are not cost-efficient and, therefore, do not meet the fiduciary prudence standards established by the Restatement (Third) of Trusts. Despite these findings, actively managed funds are still the predominant investment options within most 401(k) and 403(b) plans.

While the First Circuit’s decision is technically only binding within the First Circuit’s jurisdiction, it is reasonable to assume that attorneys and other courts will follow the First Circuit’s well-reasoned and technically correct decision. The challenge for plan sponsors and the wealth management industry will be even harder given the simplicity of establishing a breach of their duties.

The 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.¹ Charles D. Ellis

The breach of fiduciary duty and the damages caused thereby is even more devastating when one factors in the impact of the high correlation of returns that often exists between an actively managed mutual fund and a comparable, less expensive index fund. Since the First Circuit validated the used of index funds in ERISA fiduciary breach actions, it can be argued that attorneys and fiduciaries will need to consider the correlation of returns factor.

One commonly used metric in factoring in the impact of correlation of returns is the Active Expense Ratio (AER) metric. Ross Miller, creator of the AER, explained the value of the metric, stating that

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.²
Ross Miller

I provide forensic investment analysis and litigation support services for fiduciaries attorneys. Being a firm believer in the saying, “a picture is worth a thousand words,” I combined those two concepts to create a metric, the Active Management Value Ratio (AMVR), and a simple and easy to use worksheet to explain the metric.

A fund’s AMVR number is simply its incremental costs divided by its incremental return. Here, the fund’s AMVR number would be zero since the fund provided no positive incremental return. Additional information on the AMVR is available on this blog.

In an interesting twist with regard to the issue of fiduciary liability involving ERISA plans in general, as well as any concerns by plans about having to meet the burden of proof with regard to causation, the Court of Appeals offered ERISA plans the following advice:

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.”³(citations omitted)

Interestingly enough, this was essentially the same advice offered over forty years ago by John Langbein, the reported on the committee that drafted the Restatement (Third) of Trust, with his prediction that

When market [aka 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 vehicles. 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.”⁴

It should be noted that while Brotherston was an ERISA action, the First Circuit and the Solicitor General discussed a fiduciary’s duties regarding the burden of proof on causation in terms of general fiduciary law. Therefore, I would not be surprised to see plaintiffs’ attorneys use the same points and logic in actions involving other investment fiduciaries, such as trustees, investment advisers, and even stockbrokers in some cases, using the decisions in Carras v. Burns⁵ and Follansbee v. Davis, Skagg & Co., Inc.⁶ as applicable authority to impose fiduciary duties on same.

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.

Notes
1. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
2. Ross M. Miller, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol. 5, No. 1, First Quarter 2007. https://ssrn.com/abstract=972173
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
4. Langbein, John H. and Posner, Richard A., “Market Funds and Trust-Investments Law,” (1976), Faculty Scholarship Series Paper 498, http://digitalcommons.law.yale.edu/fss_papers/498.
5. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975).
6. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9^th Cir. 1982).

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, closet index funds, clsoet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, financial planning, investment advisers, investments, pension plans, prudence, retirement plans, risk management, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, fiduciary, fiduciary investing, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, financial planning, investment advisers, investment analysis tools, pension plans, wealth management, wealth preservation | Leave a comment

Putnam Files Responsive Brief In Putnam Investments, LLC v. Brotherston

Posted on December 14, 2019 by jwatkins

“This perverse and harmful holding has extraordinary consequences for the investment management industry, ERISA litigation, and ERISA plans as a whole.”

In its rebuttal brief to the Solicitor General’s amicus brief, Putnam points out the significance of Putnam Investments, LLC v. Brotherston. And they are absolutely correct in their assessment. This case has the potential to be a complete game changer for the ERISA and the investment management industries.

If the First Circuit’s decision is allowed to stand, the case goes back to the district court to complete the trial. Putnam will have the burden of proof as to causation if the plan participants can show both a breach of Putnam’s fiduciary duties and resulting financial losses.

Putnam, in fact the entire ERISA and mutual funds industries, know that they will rarely be able to carry the burden of proof on causation, as studies have consistently shown that very few actively managed funds are cost-efficient, one of basic requirements of prudence under the Restatement (Third) of Trusts, specifically Section 90, comment h(2). My metric, the Active Management Value Ratio metric, confirms those studies when applied to most actively managed funds. That is why so many investment management entities filed amicus briefs with SCOTUS.

In my opinion, Putnam’s arguments have no merit. First, as both the Court of Appeals and the Solicitor General pointed out, the burden proof as to causation is different in civil cases, where the plaintiff has the burden of proof, and trust cases, where the fiduciary has the burden of proof once the beneficiary/plan participant shows a breach of fiduciary duty resulting in damages. The Court of Appeals and the Solicitor General simply objectively stated the applicable law, which can be verified with research. That is hardly evidence of bias.

Second, as the Solicitor General pointed out, Putnam has overstated the extent of the division between the federal courts on the shifting of the burden of proof in trust/ERISA cases. Therefore, there is no merit in Putnam’s argument a to the need to hear this case on that issue, especially since the plan participants were not allowed to present all of their evidence in the proceedings in the district court.

Given the strength of the arguments and the logic contained in both the Court of Appeals’ opinion and the Solicitor General’s amicus brief, I expect SCOTUS to deny the application for certiorari and allow the case to resume in the district court. Knowing the position of Court of Appeals and the Solicitor General about the case in case it were to go back to them on appeal, I would not be surprised to see Putnam settle the case in an attempt to minimize damages.

Posted in 401k, 401k compliance, 401k investments, 403b, Active Management Value Ratio, AMVR, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, investment advisers, investments, pension plans, prudence, RIA, RIA Compliance, risk management, securities compliance, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c compliance, Active Management Value Ratio, AMVR, compliance, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, investment advisers, pension plans, prudence, retirement plans, wealth management | Leave a comment

Putnam Investments, LLC v. Brotherston: The End of “Business as Usual” for 401(k) Plans

Posted on December 7, 2019 by jwatkins

Earlier this year I posted an article on this blog, “Putnam Investments, LLC v. Brotherston: Pivotal Point for 401(k)/403(b) Industries?” The article focused on the potential impact of the case regarding both the general operation of 401(k) plans and legal liability for plans and plan sponsors.

The First Circuit Court of Appeals reversed the district court on a number of its decisions and remanded the case back to the circuit court to continue the trial based on the First Circuit’s rulings.¹The case has been suspended to date, as Putnam applied to the Supreme Court (SCOTUS) for a writ of certiorari, asking the Supreme Court to review the First Circuit’s rulings.

SCOTUS asked the Solicitor General to review the case and provide the Court with an evaluation of the case by filing an amicus brief with the Court. The Solicitor General has recently filed the requested amicus brief with SCOTUS.²The Solicitor General stated that the case presented two issues:

Whether, in an action for fiduciary breach under 29 U.S.C. 1109(a), a fiduciary bears the burden of proving that a loss is not attributable to the fiduciary’s breach once the plaintiff establishes a breach and related plan losses?
Whether comparisons between the returns on a plan’s investment portfolio and the returns on an index- fund portfolio are insufficient as a matter of law to support a finding of loss?3

The Court of Appeals had answered “yes” to the first question and “no” to the second question. The Solicitor General concluded that “[t]he court of appeals correctly decided both questions.”⁴

As a result, the Solicitor General advised the Court not to hear the case. If the Court follows the Solicitor General’s advice, the case will go back to the district court and the trial will resume.

The First Domino – Burden of Proof As to the Causation of Damages
A key aspect of both the Court of Appeals’ decision and the Solicitor General’s amicus brief was their agreement with reference to the difference between the burden of proof on causation in civil cases and trust cases. Given that the Solicitor General liberally quoted from the Court of Appeals’ decision, I will only reference provisions from the Solicitor General’s amicus brief.

The Solicitor General first addressed the significant difference between the burden of proof in civil cases and trust cases:

The “default rule” in ordinary civil litigation when a statute is silent is that “plaintiffs bear the burden of persuasion regarding the essential aspects of their claims.” But “[t]he ordinary default rule, of course, admits of exceptions.” One such exception applies under the law of trusts.

This Court has repeatedly made clear that ERISA’s fiduciary duties are “derived from the common law of trusts.” Accordingly, “[i]n determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts.” Under trust law, “when a beneficiary has succeeded in proving that the trustee has committed a breach of trust and that a related loss has occurred, the burden shifts to the trustee to prove that the loss would have occurred in the absence of the breach.⁵

The Solicitor General then addressed the rational behind the burden-shifting framework in trust cases, specifically in ERISA actions:

Applying trust law’s burden-shifting framework to ERISA fiduciary-breach claims also furthers ERISA’s purposes. In trust law, burden shifting rests on the view that “as between innocent beneficiaries and a defaulting fiduciary, the latter should bear the risk of uncertainty as to the consequences of its breach of duty.”⁶

ERISA likewise seeks to ‘protect the interests of participants in employee benefit plans’ by imposing high standards of conduct on plan fiduciaries. 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.⁷

By contrast, declining to apply trust-law’s burden-shifting framework could create significant barriers to recovery for conceded fiduciary breaches. The 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 [has] recognized… that it is appropriate in some circumstances to shift the burden to establish ‘facts peculiarly within the knowledge of” one party.⁸

The Solicitor General then addressed Putnam’s claim that the Supreme Court should hear the case to resolve the split between the federal Courts of Appeal on the burden of proof as to causation issue, stating that

Petitioners assert that the courts of appeals are ‘deeply divided about which party bears the burden of persuasion regarding causation.’ Although some disagreement exists on that question, the decision below is consistent with decisions of the majority of the courts of appeals that have directly addressed it, and the contrary view is not as widely held as petitioners assert.⁹

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.”¹⁰(citations omitted)

When market [aka 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 vehicles. 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.”¹¹

The Solicitor General then addressed the issue regarding the admissibility of using index funds for the purpose of proving losses in ERISA actions alleging a breach of fiduciary duties.

The court of appeals also correctly concluded that passively managed index funds are not, as a matter of law, improper comparators for determining whether a loss has occurred from an ERISA fiduciary’s breach involving the improper monitoring of actively managed funds….The court noted that “the Restatement specifically identifies as an appropriate comparator for loss calculation purposes ‘return rates of one or more . . suitable index mutual funds or market indexes. …’”¹²

Bottom Line Implications Going Forward
What does all this mean? The case goes back to the district court and the trial continues based upon the Court of Appeals’ rulings. If the plan participants can establish that the plan sponsor breached either their fiduciary duty of loyalty and/or their duty of prudence, resulting in a loss for the plan participants, then the plan sponsor has the burden of proving that such breaches did not cause any of the losses sustained by the plan participants.

On a broader perspective, I personally do not believe that plan sponsors can meet that burden of proof in many cases, for reasons I will discuss later in this post. Furthermore, I believe that the 401(k) industry and mutual fund companies know that they will not be able to meet that burden proof, resulting in liability for breaches of their fiduciary duties, both in the Putnam case and in future 401(k) fiduciary actions.

As both the Court of Appeals and the Solicitor General pointed out, SCOTUS has recognized the Restatement of Trusts (Restatement) as the authoritative source in resolving fiduciary questions. The Restatement includes three key provisions regarding a fiduciary’s duty of prudence:

Section 90, aka The Prudent Investor Rule, comment b, states that cost-consciousness is a fundamental duty in connection with prudent investing;13
Section 90, comment f, states that a fiduciary has a duty to seek the highest rate of return for a given level of cost and risk, or conversely, the lowest level of cost and risk for a given level off return14; and
Section 90, comment h(2), states that due to the higher costs and risks associated with actively managed mutual funds, a fiduciary should only recommend and/or utilize such funds when it can be objectively estimated that the anticipated return from such funds will provide a level of return that will offset such additional costs and risks.15

The predominant invest options in many 401(k) plan continue to be actively managed mutual funds. However, the evidence with regard to the historical performance of actively managed mutual funds shows that the overwhelming majority of actively managed funds are cost-inefficient, not only consistently underperforming comparable passively managed, or index funds, but doing so at a significantly higher price.¹⁶So much for the three fiduciary requirements of prudence set out in the Restatement.

The cost-inefficiency issues associated with actively managed mutual funds become even more egregious when examined more closely in terms of effective return, effective cost, and potential closet index status. In order to effectively evaluate mutual funds, one need to evaluate a fund’s returns on three level: nominal return, load–adjusted return (if applicable), and risk-adjusted return. An actively managed fund’s return at each level is then compared to the returns of a benchmark, usually a comparable index fund.

However analyzing an actively managed fund on returns is only half the due diligence process. As previously mentioned, the evidence with regard to the historical performance and costs of actively managed mutual funds shows that these funds consistently fail to meet both prongs of the Restatement’s cost-efficiency test, especially when examined in terms of their potential classification as closet index funds.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.17
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.18
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.¹⁹
[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.20

There is no precise, universally accepted criteria for designation as a closet index fund. Certain factors between an actively managed fund and a benchmark index are often used in assessing closet index status, including factors such as high correlations of returns, commonly referred to as a fund’s R-squared rating; tracking error; the extent of an actively managed fund’s deviation from an index fund’s returns; and the extent of overlapping of a funds’ portfolio holdings, or ”active share.”

Determining the cost-efficiency of a fund also requires an evaluation of a fund’s stated and effective fees and expenses. In evaluating a fund’s fees and expenses, most investors and fiduciaries only focus on a fund’s annual expense ratio and any sales charges, or loads. However, studies by respected investment experts such as Burton Malkiel²¹, Mark Carhart²², and Roger Edelen²³have concluded that the two most reliable predictors or a fund’s success are it s annual expense ratio and its trading costs.

However, mutual funds are not legally required to disclose their actual trading costs. Trading costs are deducted by a mutual funds as part of a fund’s overall operating expenses and are deducted in calculating a fund’s stated returns.

However, a fund’s trading costs simply have too much potential impact on an investor’s end return to simply ignore. Fortunately, John Bogle, founder of the Vanguard mutual fund family, created a simply metric that can be used as a proxy for a fund’s trading costs. Bogle’s metric simply doubles a fund’s reported turnover and multiplies that number by 0.60. While it is generally acknowledged that Bogle’s metric probably understates a fund’s actual trading costs, it at least allows investors, fiduciaries and attorneys to factor such costs into the due diligence/vetting process.

Cost-Efficiency and the Active Management Value Ratio™ 3.0
Several years ago I created a metric that factors in all of the key criteria set out in the Restatement. InvestSense’s proprietary metric, the Active Management Value Ratio™ (AMVR), is designed to allow investors, fiduciaries, and attorneys to easily evaluate the cost-efficiency, or the relative value, of actively managed mutual funds.

The AMVR is based on the principles set out in the Restatement, as well as the studies of investment icons Charles D. Ellis and Burton G. Malkiel.

Past performance is not helpful in predicting future returns. The two variable that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover.²⁵Burton G. Malkiel

Our example compares the retail shares of a popular actively managed, domestic large cap growth fund, with a comparable large cap growth index fund, the Vanguard Growth Index Fund (VIGRX). The AMVR indicates that the actively managed fund is not cost-efficient, and thus an imprudent investment choice, relative to VIGRX.

In this case, the front-end load fee results in the index fund outperforming the actively managed fund’s five-year performance. Funds that underperform their benchmark do not qualify for an AMVR rating since their underperformance automatically makes them an imprudent investment choice relative to the benchmark.

Another benefit of the AMVR is that it calculates the losses suffered by an investor, both in terms of underperformance and management fees. The AMVR also provides investors, investment fiduciaries and attorneys with a cost-efficiency score, as shown under the “% Fees/% Return” analysis. In this case, using the actively managed fund’s nominal, or stated, expense ratio, 75 percent of the actively managed fund’s expense ratio provides no positive return/benefit for the fund’s investors.

It should be noted that mutual fund companies generally do not normally impose a front-end load on retirement shares. Therefore, the AMVR only calculates the nominal and risk-adjusted return on retirement shares.

Using the fund’s AER-adjusted annual expense ratio to calculate the fund’s implicit return, the combination of the fund’s high AER number and its high R-squared correlation number to the benchmark (98) results in a much higher cost-inefficiency number. It is hard to imagine a financial adviser trying to justify the recommendation of a fund where 96 percent of the fund’s expense provides absolutely no positive incremental return/benefit for an investor.

Calculating the AMVR for retirement shares of a fund essentially uses the same process, the only difference being that retirement shares should never impose any type of load fee, neither a front-end or back-end load. Any fund that does so is not only imprudent vis-à-vis a 401(k) plan participant, but more importantly, would be in violation of ERISA prohibited transaction rules.

The following chart shows an example of a forensic AMVR analysis of the retirement shares of the same two funds without the imposition of a front-end load on the actively managed fund. In this case, the actively managed fund does slightly outperform the benchmark fund by 16 basis points. (A basis point equals 1/100 of 1 percent, or .01 percent, so 100 basis points equals 1 percent.

However, the fund’s incremental cost exceeds the actively managed fund’s incremental returns, resulting in an AMVR number greater than 1.00 (3.43 using the fund’s nominal expense ratio, 27.87 using the fund’s AER-adjusted expense ratio). As a result, the actively managed fund would be deemed to be cost-efficient and an imprudent investment choice.

Financial advisers have always argued that the prudence of their advice should be evaluated on factors other than just cost. The Restatement agrees, pointing out that in assessing the prudence of investment advice, any and all costs of the investment products recommended should be evaluated relative to the value received in exchange for such costs.²⁶

That is exactly what the AMVR does. The AMVR is simply a cost/benefit analysis that compares the incremental costs of an actively managed mutual fund to its incremental return, if any, relative to a comparable index fund.

The beauty of the AMVR is its simplicity. In interpreting a fund’s AMVR scores, an attorney, fiduciary or investor only has to answer two questions:

(1) Does the actively managed mutual fund produce a positive incremental return?
(2) If so, does the fund’s positive incremental return exceed it incremental costs?

If the answer to either of these questions is “no,” then the fund does not qualify as cost-efficient under the Restatement’s guidelines.

Additional information about the AMVR is available throughout this blog.

Closet Indexing and the AMVR
The AMVR factors in Ross Miller’s Active Expense Ratio (AER) metric allows investors and fiduciaries to factor in the ongoing problem of “closet indexing.”²⁷Closet index funds are generally described as actively managed mutual funds that closely track, or “mirror,” the performance of a relevant index or a comparable index fund, yet generally charge a significantly higher annual expense ratio and charge higher overall costs than a comparable index fund.

Closet index funds are often identified through the use of a fund’s R-squared number. Morningstar defines a fund’s R-squared number as “the relationship between a [fund] and its benchmark. It can be thought of as a percentage from 1 to 100,… It is simply a measure of the correlation of the [fund’s] returns to the benchmark’s returns.”²⁸

In our example, adjusting the actively managed fund for its extremely high 5-year (6-28-2013 to 6-28-2018) R-squared number relative to VIGRX, 0.97, results in an AER of 4.64. As a result, the actively managed fund’s AER-adjusted incremental costs essentially accounts for all the fund’s expenses, without providing any commensurate benefit at all for an investor in comparison to VIGRX. Furthermore, most experts would agree that a R-squared of 97 percent alone qualifies an actively managed funds as a closet index fund relative to VIGRX.

For attorneys, the key question involving a financial adviser’s recommendation of and/or the use of closet index funds in providing wealth management services comes down to one question:

Does the selection of a closet index fund breach an ERISA fiduciary’s duties of loyalty and prudence given the combination of the fund’s higher annual expense ratio and high R-squared correlation number, reflecting returns more attributable to the applicable benchmark rather than the fund’s management?

Further evidence of the analytical value of a fund’s AMVR can be seen in InvestSense’s forensic analysis of the “Pensions & Investment” Top Ten Defined Contribution Mutual Funds survey. Each year InvestSense performs an AMVR forensic analysis of the top ten non-index mutual funds on that list to determine the cost-efficiency of those funds. The most recent “Pensions & Investments” Top Ten AMVR forensic analysis (1Q 2019) is available on SlideShare.²⁹The results of the forensic analysis should create some concerns for plan fiduciaries, since the funds analyzed represent the top ten non-index funds currently used in defined contribution plans.

In conducting forensic analyses for pension plans, trusts and other investment fiduciaries, as well as individual investors and attorney we use both the AMVR, a quantitative metric, and the InvestSense Quotient (IQ), a qualitative metric. The IQ analyzes the overall quality of a fund in terms of consistency of performance, and efficiency of performance, both in terms of cost and risk management.

The AMVR and the Suitability Standard
While the discussion herein has focused primarily on the use of the AMVR in connection with current fiduciary standards established under the Restatement and existing law, I would strongly suggest that the same arguments are equally applicable under FINRA’s suitability and “best interests” standards. As FINRA pointed out in FINRA Notice 12-25, the suitability and “best interests” standards are “inextricably intertwined” under FINRA’s regulations.³⁰

The fact that the AMVR shows that many funds are not cost-efficient supports an argument that such funds fail to meet FINRA Rule 2111, the so-called suitability standard. The suitability standard requires that advice provided by any broker must be suitable for at least some investors, as well as for the specific customer involved in a securities transaction. Rule 2111-SM-.01³¹also sets out a “fair dealing” requirements for all of a broker’s transactions and interactions with customers. Investments that are not cost-efficient and/or otherwise cannot be expected to provide a customer with a positive benefit obviously are neither suitable for, “fair dealing” with, nor in the “best interests” of any investor.

Another potential issue is the mischaracterization of funds as “actively“ managed. Such a label is misleading and a possible violation of federal anti-fraud laws in that it suggests a difference between actively managed funds and comparable index funds, while knowing that the “actively” managed funds in question actually have a high correlation of returns to said index funds, while nevertheless charging significantly higher fees and costs than the index funds.

The Second Domino – Increased 401(k) Litigation
If I am correct with regard to my prediction that in most cases plans will not be able to carry their burden of proof regarding causation, it is reasonable to assume that the ERISA plaintiffs’ bar will realize this as well. As a result, it is reasonable to assume that there will justifiably be an increase in the number of 401(k) cases alleging a breach of a plan’s fiduciary duties.

This may, and should, result in more plans hiring ERISA attorneys and other experienced ERISA consultants to conduct fiduciary audits and possibly re-design their plans, where necessary, in an attempt to reduce or eliminate any potential fiduciary liability exposure for both the plan and its fiduciaries going forward..

While such remedial actions can address potential future liability exposure, 401(k) actions allege fiduciary breaches that have already occurred. The applicable statute of limitations in ERISA-related action is three or six years, depending on the facts of the case. As a result, it is imperative that plans take a proactive position in managing their funds as soon as possible in order to minimize future liability exposure.

The Third Domino – Increased Litigation Against Plan Advisers for Bad Advice
Plan advisers often present plans with an advisory contract that contains terms that attempt to disclaim any fiduciary liability for the plan adviser for any advice/ recommendations provided to a plan, arguably leaving the plan and its fiduciaries totally liable for any bad advice provided by the plan adviser.

When 401(k) fiduciary breach actions are filed against a 401(k) or 403(b) plan, many plans learn of the advisory contract’s fiduciary disclaimer provision and mistakenly believe that they have no recourse against the plan adviser and their firm. Fortunately, that is not necessarily true. When justified, plans can often attempt to negate such fiduciary disclaimer clauses by pursuing potential common law claims such as fraud, negligence, and/or breach of contract.

In one of the leading cases upholding such common law claims, the court explained that

“Examining the nature of the suit at issue here, [plaintiff’s] state law negligence claims do not arise from the administration of the plan itself, or the provision of any plan benefits. Likewise, the suit does not involve parties whose relationships are governed by ERISA, such as relations among the plan’s beneficiaries, administrators, or fiduciaries. In short, [plaintiff’s] state claims have nothing to do with the operation of the plan itself. Accordingly, [plaintiff’s] claims [must be allowed to go forward] because they do not relate to an ERISA plan.³²(citations omitted)

Whenever I receive a call from a plan dealing with an advisory contract containing a fiduciary disclaimer clause, I quickly inform that under Section 205 of the Restatement of Contract, implicit in every contract is a duty of fair dealing. Knowingly or negligently providing bad advice, such as recommending cost-inefficient actively managed mutual funds, is not “fair dealing. If the plan adviser is a stockbroker or registered investment adviser, the regulatory bodies that oversee such firms also have similar “fair dealing” and/or “best interest” requirements which may apply to such claims.

Plans and plan fiduciaries should check their plan advisory contracts to determine if the contract includes any fiduciary disclaimer clauses. The clauses are usually buried in the contract, hoping that most plan sponsors will not read that far into the contract , if at all. Fiduciary disclaimer clauses will usually include language along the lines of (1) that the parties mutually acknowledge and agree that the plan adviser is only providing advice/ recommendations and not acting in a fiduciary capacity, and (2) that the plan acknowledges and agrees that the plan has the ultimate responsibility for deciding whether or not to implement the plan adviser’s advice/recommendations.

If the plan is uncertain as to whether their plan has any fiduciary disclaimer clauses or any other questions regarding such clauses, the plan should consult an experienced ERISA attorney. I also recommend to my clients that they ask their plan adviser to document that the recommended funds are cost-efficient and the names of the benchmark funds used in the determining the cost-efficiency of each fund.

I also suggest that the plan ask the adviser to provide them with an AMVR analysis for each recommendation, based on a fund’s nominal numbers and the fund’s risk-adjusted return numbers and AER-adjusted costs. If the plan provider says they cannot, or are not allowed to provide such information, it often indicates that the adviser does not actually know if the funds are cost-efficient. Trust me, they do not know and, as referenced earlier herein, studies have shown the the overwhelming majority of actively managed are not cost-efficient.

Going Forward
In my earlier post, I asked if Putnam Investments, LLC v. Brotherston could be a pivotal decision for the 401(k) and 403(b) industries. The question was based primarily on my experience with InvestSense’s two proprietary metrics, the Active Management Value Ratio™ and the InvestSense Quotient™. My experience with the metrics has corroborated the findings of various academic studies-that the overwhelming majority of actively managed mutual funds are not cost-efficient. Consequently, I do not believe that most 401(k) or 403(b) plans will be able to successfully carry their burden of proof in proving causation, that the plan’s investments did not cause any losses sustained by a plan’s participants.

Since ERISA requires that a 401(k) plan’s investments be prudent, both individually and with regard to the portfolio as a whole, and the Restatement states that the use or recommendation of a cost-inefficient actively managed fund constitutes a breach of fiduciary duties, plans must be proactive to carefully verify and document the cost-efficiency of their plans investment options to avoid potential fiduciary liability exposure.

On a sidenote for current and prospective plan advisers, I believe the Court of Appeals’ decision and discussion provides a blueprint for designing an effective marketing strategy incorporating the AMVR. As I mentioned earlier, I believe that most ERISA plans continue to choose cost-inefficient actively managed mutual funds as the primary investment options for their plans. Plan advisers and those considering becoming plan advisers can point to the developments in the Putnam case and use the AMVR to expose cost-inefficient actively managed mutual funds and solutions for same.

Some plan sponsors have told me that they have simply decided to adopt a plausible denial policy in the event that their plan is challenged in court. If the reader takes anything from this paper, let it be the phrase that is often quoted in ERISA decisions-

a pure heart and an empty heads are not good enough [to defeat a claim alleging a breach of one’s fiduciary duties.]³³(citations omitted)

Note: This post started out as the core for a law review article, which it still may become. I just believe that the case and the time element are too significant, which is why I posted the article. Hopefully the information provided herein makes up for the length.

Dedication: This post is dedicated to Bert Carmody, who championed the AMVR concept from the beginning. When my friend James Holland first notified me of the Solicitor General’s decision, the first thing I thought about was Bert.

I was introduced to Bert by two of our mutual friends, James Holland and Rick Canipe. Bert and I met for a “think tank” session at a local restaurant that lasted over two hours. I love legal theory and Bert loved both the legal theory and the technical expertise involved.

I had initially decided to pick up the tab, but changed my mind when Bert started drawing and taking notes on the restaurant’s linen napkins. When I quickly informed him that I was not paying for that, he laughed and signaled the waitress to come refresh our drinks, and started writing on another napkin. It was the beginning of a wonderful, albeit far too short, friendship.

Bert, James and Rick went different ways than I did with the incremental cost/incremental returns concept, each of us creating effective compliance screening metrics. Bert would have loved to see the First Circuit’s opinion and the Solicitor General’s amicus brief, as they justify all of the points made that day at the restaurant and validate both of the resulting metrics.

Bert passed away several years ago. I miss being able to bounce things off Bert, so now I pester poor James with my ideas and arguments. Pray for James Holland. I know I do.

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018).
2. Amicus Brief of Solicitor General Noel Francisco (hereinafter “Amicus Brief”), available at https://bit.ly/2Yp00xt
3. Amicus Brief, I>
4. Amicus Brief, 7
5. Amicus Brief, 8.
6. Amicus Brief, 10,
7. Amicus Brief, 11,
8. Amicus Brief, 11.
9. Amicus Brief, 12.
10. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
11. Langbein, John H. and Posner, Richard A., “Market Funds and Trust-Investments Law,” (1976), Faculty Scholarship Series Paper 498, http://digitalcommons.law.yale.edu/fss_papers/498.
12. Amicus Brief, 20.
13. Restatement (Third) Trusts, cmt. b (American Law Institute).
14. Restatement (Third) Trusts, cmt. f (American Law Institute).
15. Restatement (Third) Trusts, cmt. h(2) (American Law Institute).
16. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010);
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; Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016; Mark Carhart, On Persistence in Mutual Fund Performance, Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
17. Laurent Barras, Olivier Scaillet and Russ Wermers, supra.
18. Charles D. Ellis, supra.
19. Philip Meyer-Braun, supra.
20. Mark Carhart, supra
21. Malkiel, Burton “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
22. Carhart, supra.
23. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” available at http://www.ssrn.com/ abstract=951367
24. 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
25. Malkiel, Burton “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
26. Restatement (Third) Trusts, cmts. f, h(2), and m (American Law Institute).
27. Ross M. Miller, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol. 5, No. 1, First Quarter 2007. Available at SSRN: https://ssrn.com/abstract=972173
28. https://www.morningstar.com/InvGlossary/r_squared_definition_what_is.aspx
29. https://bit.ly/367BIdJ
30. https://www.finra.org/rules-guidance/notices/12-25
31. https://www.finra.org/rules-guidance/rulebooks/finra-rules/2111
32. Berlin City Ford, Inc. v. Roberts Planning Group, 864 F. Supp. 292 (D.N.H. 1994)
33. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983)

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, best interest, closet index funds, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, Reg BI, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 404c, 404c compliance, Active Management Value Ratio, AMVR, compliance, ERISA, fiduciary, fiduciary investing, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, investment analysis tools, pension plans, prudence, retirement plans, suitability, wealth management | Leave a comment

3 Cases Every Financial Adviser, Investment Adviser and Plan Sponsor Should Know

Posted on November 14, 2019 by jwatkins

Back in my compliance days, I was known for running a tight and tough house. But many of the brokers came to realize that that was my job, and in doing my job I was protecting them as well. As many of my former brokers have gone independent to form their own RIA firms, I have found it rewarding that they have sought me out and hired me as their compliance consultant.

As I have mentioned before, my reason for creating this post was to raise investment fiduciaries’ awareness of existing and developing compliance issues, thereby allowing them to keep their practices clean and allowing them to concentrate fully on serving their clients. I constantly remind my clients of the “core,” three key cases that every investment professional should be aware of and remember – Chase, Levy v. Bessemer Trust, and Johnston v. CIGNA Corp.

After a recent presentation on these cases, someone said I should write a post to let others know about the decisions and their application to actual practices. So, I did.

In re James B. Chase
The Chase decision was a 1997 regulatory enforcement decision involving a broker’s duty in determining the suitability of their investment recommendations.¹ The Securities and Exchange panel stated that in determining a client’s risk tolerance level, a broker/adviser (collectively “adviser”) must determine both a client’s willingness and ability to bear investment risk. While a new account form may indicate a client’s willingness to assume investment risk, other information may indicate that the client’s financial condition is such that they do not have the ability to bear investment risk at all, or only to a limited extent.

What many advisers may not be aware that they personally have a duty to determine the suitability of their investment recommendations before they provide them to a customer. Many advisers believe that if their compliance director approves the trades, everything is fine.

Legally, however, this does not satisfy an adviser’s legal duty to only make suitable recommendations. An adviser must be able to personally evaluate their investment recommendations and ensure that they are suitable for a customer, that they are consistent with both a customer’s willingness and ability to bear the level of investment risk inherent in the adviser’s recommendations.

Furthermore, based on recent trends, I would suggest that advisers also need to determine a client’s need to assume investment risk at all. I continue to see cases where the client’s existing portfolio met their needs before the adviser made any recommendations. This issue seems to come up more in cases where income is a client’s primary consideration.

Those who have heard me speak on this issue are familiar with the story about the widow whose husband had created a well-devised portfolio that would provide her with all of the income she would once he was gone. After the husband’s death, a broker had her fill out a risk tolerance questionnaire.

One of the questions on the risk tolerance questionnaire was whether she had any additional income needs. Naturally, she answered “no.” The risk tolerance questionnaire misinterpreted her answer and recommended completely revising her husband’s perfect portfolio, essentially destroying the needed income investments and replacing them with risky equity-based investments.

One would have hoped that the adviser would have quickly questioned the results and prevented any implementation of the computer’s recommended reallocations. Sadly, in a perfect example of the danger of “black box” planning, the adviser blindly followed the computer’s recommendations, causing significant harm and financial loss for the widow. The case settled out of court, as her husband’s handiwork was perfect and she had no need to assume the investment risk created by the redesigned equity-based portfolio.

Levy v. Bessemer Trust Company
Put simply, investment advisers and other investment fiduciaries cannot simply watch investors lose money and say ”it’s the markets, everyone is losing money.” Plaintiff’s securities attorneys love these types of cases because it’s like “shootin’ fish in a barrel.” All they have to do is pull out the Levy v. Bessemer Trust decision and the adviser has to pull out his checkbook.²

Levy involved a client that was worried about the potential of loss in his portfolio due to the fact that his portfolio had a concentrated position in one stock. Levy’s company had merged with Corning. As a result of the merger, Levy had received a significant amount of Corning stock, so much so that his portfolio was heavily overweighted with Corning stock.

Levy was concerned about the risk exposure posed by the lack of diversification in his overall portfolio due to the Corning stock. When he asked his adviser if there were ways to mitigate any potential loss, the adviser did not discuss the possible use of options or other hedging techniques to protect against downside risk. The client subsequently suffered a significant loss due to the concentrated stock position.

The client sought advice from another adviser who informed the client of the possible use of options, especially European collars, that could have provided the client with the downside protection he had sought. Levy sued the initial adviser for his negligence and misrepresentation in not alerting the Levy to the option to use options to protect the client’s portfolio. In denying the adviser’s motion to dismiss the case, the court ruled that the question of whether an adviser had a duty to at least advise a client of viable loss prevention options presented a valid question for a jury to decide.

The takeaway from Levy is that advisers cannot simply stand by and watch investors suffer significant losses and then blame it on the markets. Levy and other similar decisions have established that investment advisers and other investment fiduciaries have, at a minimum, a legal duty to advise a client of such hedging strategies, both the positive and negative aspects of same, and then let the client decide on whether to use same.

Even if an adviser has discretionary authority over an account, I always recommend that an adviser involve a client in such matters, if for no other reasons than the costs involved in implementing such strategies The adviser should also document both the disclosures that the adviser provided and have the client acknowledge their decision in writing.

Johnston v. CIGNA Corp.
Full disclosure. This is one of all-time favorite cases due to the issues involved and the potential fiduciary and financial planning liability implications as a result of just two sentences.

Johnson and others invested in a couple of investments through a broker employed by defendant CIGNA Corp. In trying to persuade Johnston and the others to purchase the recommended investments, the broker allegedly stated that CIGNA would cover any losses Johnston and the others suffered as a result of the investments.

They did suffer significant losses, CIGNA refused to cover such losses, and this lawsuit resulted. CIGNA filed a motion asking the court to dismiss the action on the grounds that (1) CIGNA was simply a broker, not a fiduciary, in connection with the sales of the investments in question, and (2) the risks inherent in the investments had been fully disclosed in the various sales material given to Johnston and the other purchasers.

With regard to the fiduciary issue, the question is important in that the courts have consistently held that a buyer’s duty of care and investigation is reduced in a fiduciary relationship due to the legal nature and duties involved in such relationships.

As the court noted,

A fiduciary relationship can arise when one party occupies a superior position relative to another. [Johnston’s] claim that [CIGNA], acting as investment advisers and financial planners, created a relationship of trust and confidence and, accordingly, [CIGNA] owed [Johnston] a fiduciary duty. These labels are terms of art defined in the federal securities laws….³

When confronted with the fiduciary issue, brokers and broker-dealers will immediately counter with the argument that they are just brokers, just salesmen, and they do not owe their customers any fiduciary duties. We just went through several years of that debate and the debate still rages.

Interestingly, there are states that hold brokers and broker-dealers to either a full or limited fiduciary standard, based upon state laws and/or state judicial decisions. Furthermore, some courts have indicated that they have no problem imposing a fiduciary duty on a broker and/or broker-dealer when justice and equity demand such measures, particularly when, as the Johnston court stated, one party has a distinct advantage over another.

The courts have clearly established the guidelines for when they will consider imposing a fiduciary duty on a broker. One of the most common justifications cited by the courts for imposing fiduciary duties on a broker is when a broker has effectively taken over an account, so much so that he/she has become the “de facto” manager of the account.

In other cases, the courts have stated that

Usually the broker will have much greater access to financial information than the customer and will have the support of investigative and research facilities. Such a customer will be expected usually to accept the recommendations of the broker or to disassociate himself from that broker and find someone else in whom he has more confidence.

The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.⁴

And in another case, the court announced the applicable guideline as follows:

Control of trading is an essential element of churning. In the absence of an express agreement, control may be inferred from the broker-customer relationship when the customer lacks the ability to manage the account and must take the broker’s word for what is happening…. However, a customer retains control of his account if he has sufficient financial acumen to determine his own best interests and he acquiesces in the broker’s management…. The issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker’s suggestions.⁵

As a result, in my opinion, brokers and broker-dealers are often too quick to dismiss the possibility that they may be legally held to the duties associated with a fiduciary standard. My experience has been that very few investors have the experience and/or understanding to independently and effectively evaluate most investments.

As a CFP® professional for over thirty years, I am intrigued by the court’s judicial recognition that “[f]inancial planners also owe a fiduciary duty to their customers.” That was effectively answered back in 1987 when the Securities and Exchange Commission issued IA-1092..

Given a financial planner’s fiduciary status, a question that I predict will eventually be posed in the courts involves the preparation of asset allocation recommendations as part of a financial plans and/or asset allocation modules. One of the claims that the plaintiffs in Johnston asserted was that that the investments that the defendant recommended to them “did not conform to the financial plans that the defendants had prepared for them.”

What makes this claim potentially significant is that most financial planners use computer programs to generate a plan’s or a modules’s asset allocation and investment recommendations. Such computer programs usually use generic asset indices in generating their investment recommendations.

Such indices include any costs or expenses. Therefore, those matters are not typically factored into the computer program’s assert allocation recommendations. As a result, there are often significant differences between a plan’s or module’s asset allocation representations and the reality of the portfolio and the investments actually used in implementing a plan or module.

In the real world investments obviously do have costs and expenses such as front-end loads, annual expense ratios and trading costs. Costs and expenses of any kind reduce an investor’s end return. In fact, the General Accounting Office has recognized that each additional one-percent in investment fees and expenses reduces an investor’s end-return by approximately 17 percent over a twenty-year period.⁶ As the late John Bogle was fond of saying, “costs matter” and “you get what you don’t pay for.”

All of these conditions have led Nobel laureate William F. Sharpe to state that the use of the two stage asset allocation/portfolio optimization system makes no sense, and that “a far more rational approach uses only one stage, dealing directly with the actual investment vehicles…”⁶The fact that most current asset allocation computer programs do not provide this capability will not be an acceptable excuse for “recommendation-implementation gaps,” as planners and advisers know, or should know, about these inconsistency issues and the harm they can produce for clients.

With the knowledge of the referenced shortcoming in computer generated asset allocation recommendations, the question has been raised as to whether a subsequent implementation based upon such recommendations could possibly violate federal securities laws, a sophisticated form of “bait and switch.” “Bait and switch” schemes violate the anti-fraud provisions of Section 10b of the Securities Act of 1934 and related Rule 10b-5, and/or Section 206 of the Investment Advisors Act of 1940.

Rule 10b-5 provides that

240.10b-5 Employment of manipulative and deceptive devices.
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

So, the potential question going forward would be something along the lines of:

Could the intentional use of computer generated asset allocation plans/modules, with full knowledge of the data input issues and the likely inconsistency between the computer input data and the risk and return characteristics of the actual investments used to actually implement the computer generated recommendations, as well as the eventual actual risk and return, including any loss, generated by the investments purchased in reliance on such plans/modules, constitute a “device, scheme, or artifice to defraud,” a “untrue statement of a material fact,” and/or an “act, practice, or course of business which operates or would operate as a fraud or deceit upon any person” in violation of Section 10b and Rule 10b-5 and/or Section 206 of the Investment Advisors Act of 1940?

I do not know the answer. I do know the issue has been discussed increasingly in certain legal circles, including the potential for litigation. I raise the issue simply to alert planners and advisers to the potential liability issues and to suggest possible consideration of same in adopting and maintaining their their firm’s and their personal liability risk management program.

Noted ERISA attorney Fred Reish is fond of saying “forewarned is forearmed.” One of my favorite quotes is from Aldous Huxley-“facts do not cease to exist because they are ignored.”

Notes
1. In re James B. Chase, NASD National Adjudicatory Council Decision, Complaint C8A990081 (August 15, 2001)
2. Levy v. Bessemer Trust Company, 1997 U.S. Dist. LEXIS 11056 (S.D.N.Y. 1997).
3. Johnston v. CIGNA Corp., 916 F.2d 643 (Colo. App. 1996).
4. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 677 (9^th Cir. 1982).
5. Carras v. Burns, 516 F.2d 251, 258-59 (4th Cir. 1975).
6. W. F. Sharpe, Investors and Markets: Portfolio Choices, Asset Prices and Investment Advice (Princeton, NJ: Princeton University Press, 2006), 206-209

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, asset allocation, closet index funds, compliance, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, RIA, RIA Compliance, risk management, securities compliance, wealth management | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, asset allocation, compliance, fiduciary, fiduciary investing, fiduciary law, fiduciary standard, financial planning, investment advisers, investment analysis tools, pension plans, portfolio optimization, prudence, RIA, RIA compliance, RIA risk management, risk management, securities compliance, suitability, wealth management | Leave a comment

“Fair Dealing”-The Key to Navigating the Suitability, Best Interest and Fiduciary Standards

Posted on October 28, 2019 by jwatkins

Any intelligent fool can make things bigger and more complex… It takes a touch of genius-and a lot of courage to move in the opposite direction. – Albert Einstein

With FINRA’s recent announcement that it will keep its suitability rule and the Department of Labor (DOL) announcing that it will release a new version of their fiduciary standard, investment fiduciaries and non-fiduciary investment advisers will have three separate standards to navigate in addressing their compliance and risk management concerns. The future of the Securities and Exchange Commission’s (SEC) Regulation Best Interest (Reg BI) remains uncertain, as two separate actions, since consolidated, have been filed asking the courts to vacate the regulation.

While navigating the three standards may appear to be a daunting task, I have suggested to my consulting clients that there is a common thread in the three standards that might reduce compliance and risk management concerns to two words-“fair dealing.” A quick review of the two existing standards, suitability and best interest,” and a projected fiduciary rule, given existing industry standards, will help understand my “fair dealing” theory.

Current Standards
FINRA’s current suitability standard is found in Rule 2111(Rule). The Rule essentially sets up a three-part suitability analysis that broker-dealers and registered representatives must conduct before recommending investment products and/or strategies to the public. The two key standards contained in the Rule require that any products and/or strategies must be suitable for both the general public and the specific customer involved.

While the Rule is important, equally important from both a compliance and professional liability standpoint is the Rule’s Supplemental Material, SM-.01, which states:

Implicit in all member and associated person relationships with customers and others is the fundamental responsibility for fair dealing. Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of FINRA rules, with particular emphasis on the requirement to deal fairly with the public. The suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.

The requirement of fair dealing is important to FINRA’s overall mission and purpose. The importance of the requirement of fair dealing, as well as the applicable standards in determining when the standard has been violated, have been consistently set out in numerous FINRA and SEC enforcement decisions.

NASD Rule [SM-2111-.01] imposes on members a “fundamental responsibility for fair dealing,” which is ‘implicit in all [their] relationships’ with customers. As relevant here NASD Rule [SM-2111-.01] provides that “sales efforts must be judged on the basis of whether they can be reasonably said to represent fair treatment for the persons to whom the sales efforts are directed….

The record shows that Epstein’s mutual fund recommendations served his own interests by generating substantial production credits, but did not serve the interests of his customers. Epstein abdicated his responsibility for fair dealing when he put his own self-interest ahead of the interests of his customers.¹

In short, Belden put his own interest before that of his customer. We thus conclude that the securities that Belden recommended to [the customer] were unsuitable in the circumstances of this case. Belden’s conduct also was inconsistent with Conduct Rule 2110, which requires observance of ‘high standards of commercial honor and just and equitable principles of trade.’ ²

This commitment to “fair dealing” and “just and equitable principles of trade” were reinforced in FINRA Regulatory Notice 12-25, when FINRA stated that

In interpreting FINRA’s suitability rule, numerous cases explicitly state that ‘a broker’s recommendations must be consistent with his customers’ best interests.’ The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests…These are all important considerations in analyzing the suitability of a particular recommendation, which is why the suitability rule and the concept that a broker’s recommendation must be consistent with the customer’s best interests are inextricably intertwined.³

FINRA’s statement that suitability and a customer’s best interests are “inextricably intertwined” is a perfect lead-in to an analysis of my “fair dealing” theory and compliance with Reg BI. Reg BI tracked FINRA’s suitability Rule so closely that some labeled Reg BI as a watered down version of the Rule. That is one of the major allegations in the current legal actions seeking the revocation of Reg BI.

The pertinent sections of Reg BI state that

240.15l-1 Regulation Best Interest

(a) Best interest obligation-(1) A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

(2) The best interest obligation in paragraph (a)(1) of this section shall be satisfied if:
(ii) Care obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, and skill to:
(B) Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the financial or other interest of the broker, dealer, or such natural person ahead of the interest of the retail customer;…⁴

Once again, we see “best interest” defined in terms of “fair dealing,” in terms of a broker-dealer or stockbroker not putting their own interests ahead of the interest of the customer.

While no one knows exactly what the DOL’s proposed new fiduciary standard will provide, it is reasonable to assume that the standard will the closely track the fiduciary standards set out in the Restatement (Third) of Trusts (Restatement). After all, the Supreme Court has endorsed the value of the Restatement in determining fiduciary law questions.⁵

Two key fiduciary duties identified by the Restatement are the duties of loyalty (always acting solely in the best interest of a trust’s beneficiaries) and prudence. In defining the duty of care required under Reg BI, the SEC basically adopted the same language used by the Restatement, citing a duty to exercise “reasonable diligence, care and skill.” The only major difference between the Restatement’s “duty of care” language and Reg BI’s language was the SEC’s decision not to include an express duty to be prudent.

Two additional duties regard the “fair dealing” theory. Section 205 of the Restatement of Contracts states that implicit in every contract is a duty on both parties to deal fairly in performing the contract. Another consideration is the fact that a number of states have already passed state fiduciary standards requiring fair dealing/fair treatment for public investors, with additional states considering similar laws.

Analyzing and Applying the “Fair Dealing” Requirement
Regardless of the exact term that is used-“fair dealing,” “fair treatment,” ”best interest,” and/or “high standards of commercial honor and just and equitable principles of trade,’- the essential question that must be asked and answered is simple-was the customer treated fairly? Based upon my legal and securities/RIA compliance backgrounds, three obvious issues come to mind in analyzing and applying the fair dealing requirement:

the recommendation of cost-inefficient mutual funds;
the recommendation of “closet index” mutual funds; and
broker-dealer “preferred provider”/revenue sharing programs.

“Fair Dealing” and Cost-Efficiency
One of the key factors in answering the “fair dealing” question has to be whether the recommended investment is cost-efficient. In analyzing an investment option, Nobel laureate William F. Sharpe has noted 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.’ ⁶

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! ⁷

Building upon these pieces of advice, I created a simple metric, the Active Management Value Ratio™ (AMVR). Now in its third iteration, the AMVR allows investors, investment fiduciaries and ERISA/securities attorneys to easily calculate the cost-efficiency of an actively managed mutual fund using information that is freely available online. Bottom line, the AMVR allows anyone to identify actively managed mutual funds that are cost-inefficient, thereby avoiding unnecessary investment underperformance and unnecessary costs and expenses.

In this example, the expense ratio is expressed in terms of basis points (bps). A basis point is equal to .01 percent. So 100 bps equals 1 percent.

The active fund has incremental costs of 90 basis points and an incremental return of 50 basis points. Since the active fund’s incremental cost exceed its incremental return, the fund is not cost-efficient and would not be a prudent investment.

The active fund’s “% Fee/% Return” numbers provide another indicator that the active fund is not cost-efficient. In this case, 90 percent of the fund’s total expense ratio is only producing approximately 5 percent of the fund’s total return.

The actively managed fund’s AMVR would be 1.8 (.90/.50). This indicates that an investor in the fund would be paying a cost premium of 80 percent relative to the fund’s incremental return. An investment whose costs exceed its returns is never “fair dealing” or in a customer’s “best interest.”

Ideally, investors should look for an AMVR score greater than zero, but less than 1.00. An AMVR less than zero indicates that the actively managed fund failed to provide a positive incremental return relative an index/benchmark fund. An AMVR greater than 1.0 indicates that the fund did provide a positive incremental return. However, the fund’s incremental costs exceeded the fund’s incremental returns, effectively resulting in a loss for an investor.

Furthermore, if we assume that the person who recommended the cost-inefficient actively managed fund received some sort of compensation for their advice, commissions, and/or a fee, while the investor received no relative benefit from the recommendation, then it can be legitimately argued that the adviser in this example put their own interest ahead of the investor’s interests, thereby violating the adviser’s “fair dealing” and “best interest” duties. This would be consistent with the Epstein and Belden decisions and other related decisions.

The “fair dealing” question may prove troublesome for the investment industry and investment fiduciaries with regard to cost-efficiency, as most studies have concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient, with findings such as

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

At the end of each calendar quarter, InvestSense prepares a forensic analysis of the top ten actively managed mutual funds used by U.S. defined contribution plans, based on the annual survey by “Pensions & Investments” of the top 100 mutual funds used by such plans.

The “cheat sheet” provides incremental cost and incremental return data in various forms so that the user can see the impact of the data format chosen. Generally speaking, the investment and pension industries prefer to analyze funds on the basis of the funds’ nominal, or stated, data. Plaintiff ERISA/securities attorneys prefer to use data that factors in a fund’s risk-adjusted returns and a fund’s AER-adjusted incremental costs.

Ross Miller, the creator of the Active Expense Ratio (AER) metric, has stated that by factoring in a fund’s R-squared correlation number, the AER-adjusted incremental cost metric provides an implicit cost of the fund’s active management component.¹³In many cases, once a fund’s R-squared correlation number is factored in, the fund’s AER is significantly higher than the fund’s stated expense, often as much as 400-500 percent higher.

In this example, only three of the top ten non-index funds managed to provide a positive incremental return at all, whether using the fund’s nominal or risk-adjusted return numbers. This adds credence to the findings of the previously mentioned studies.

An analysis of the same funds using our proprietary InvestSense Quotient (IQ) metric is shown below. If a fund fails to provide a positive incremental return, it does not qualify for an IQ score, thus the numerous “NA” entries.

With the IQ metric, the goal is a high score, which is then used on a relative basis to rate the funds. In this example, while three funds qualified for an IQ score when a fund’s nominal returns were used, none of three funds qualified for an IQ score using the funds’ risk-adjusted returns. These results clearly indicate why the plaintiff’s ERISA/ securities bar prefers to use the risk-adjusted/EAR-adjusted combination in litigation when arguing causation and damages, the argument being that the data provides a more realistic analysis.

“Fair Dealing” and “Closet Indexing”
“Closet indexing” is a problem that is gaining increased attention worldwide due to the harmful impact that the practice has on investors. Canada and Australia are the latest countries to acknowledge and address the problem.

Closet indexing refers to the practice whereby an actively managed fund creates a mutual fund designed to closely track, or “mirror,” the performance of a market index or index fund, yet charge investors significantly higher fees than those of a comparable index fund. The practice is presumably based on an actively managed fund’s fear of losing investors if their fund significantly underperforms a comparable, less expensive index fund.

Closet indexing clearly violates a stockbroker’s duties of fair dealing and always acting in a customer’s best interest based on the cost-efficiency issue. Furthermore, questions are increasingly being raised as to whether the practice violates securities laws by misleading investors as to the services that the fund will provide, such representations being made to justify the actively managed fund’s higher fees. Violations of any applicable securities laws would constitute violations of the regulatory “fair dealing” requirement.

“Fair Dealing” and Preferred Provider/Revenue Sharing Programs
Many broker-dealers have adopted “preferred provider” or revenue sharing programs. Under such programs, a mutual fund company will either pay a broker-dealer a fee or agree to share revenue from the broker-dealer’s sale of the fund company’s products in exchange for the broker-dealer granting them access to the broker-dealer’s stockbrokers. The broker-dealer also agrees to limit the number of companies that it will allow to participate in the preferred provider program, thereby limiting the number of investment options that the firm’s stockbrokers can recommend to its customers.

Consumer advocates have been quick to note the obvious conflict-of-interest issues inherent in such programs and the potential inconsistency of such programs with the regulatory bodies’ fair dealing and best interest requirements. For what its worth, SEC Chairman Clayton is on record as saying that firms adopting or maintaining preferred provider and/or revenue sharing program will still be subject to Reg BI’s best interest requirements, with no exemptions.

“Fair Dealing” Compliance and Risk Management Going Forward
There is a saying that says that if you stick your head in the sand, you just provide a larger target for the enemy. While the results of both the AMVR and the IQ metrics usually do not provide beneficial evidence for advocates of active management, to ignore the data would be a mistake.

This is especially true given the fact that the AMVR and IQ metrics and the resulting data are derived not from algorithms and other complex mathematical formulas, but rather from what the late John Bogle referred to as “humble arithmetic,” the same “My Dear Aunt Sally” math we all learned in first grade.

“Fair dealing” is a constant theme in both FINRA and SEC regulations and their regulatory enforcement actions. “Fair dealing” is often used in enforcement actions in connection with defining “best interest.” Whatever the DOL eventually adopts in terms of its new fiduciary standard, “fair dealing” will be a necessary aspect of the standard if the DOL adopts the fiduciary standards followed in the courts, the fiduciary standards established by the Restatement (Third) of Trusts.

Given the fact that the “fair dealing” requirement is a already a common thread in FINRA’s suitability and fair dealing requirements,as well as the SEC’s Reg BI, and is a common element of the fiduciary standards established by the Restatement, it is suggested that the investment industry should objectively review its current business practices in terms of fair dealing in order to reduce any potential liability exposure. Given the overwhelming evidence regarding the general cost-inefficiency of actively managed mutual funds, and the dominance of such funds in U.S pension plans, perhaps that is a good starting for both pension plan and their advisers as well.

Stockbrokers and other financial advisers often recommend actively managed mutual funds. Equally troubling is the fact that financial advisers are often limited to recommending only certain types of investments, i.e., actively managed mutual funds, by virtue of their broker-dealer’s adoption of preferred provider programs.

Given the evidence from both numerous academic studies and the findings of metrics such as the Active Management Value Ratio and the Active Expense Ratio, such funds are often cost-inefficient. If a financial adviser receives compensation for recommending a cost-inefficient mutual fund to a customer or pension fund, does that constitute a situation, where the adviser has put his/her own financial interests ahead of their customer’s best interests? Given the decisions in FINRA and SEC enforcement actions, do such recommendations constitute a clear violation the “fair dealing” and “best interest” requirement of FINRA, the SEC, and the DOL’s eventual fiduciary standard?

Fair dealing, will play a critical role in the future of both the investment and pension industries, in terms of both “best practices” and litigation trends. As a result, investors, investment fiduciaries, investment professionals and ERISA/securities attorneys should begin every investment evaluation with a simple question-would the recommendation to purchase this investment constitute “fair dealing,” would the recommendation be in the “best interest” of the customer?”

To borrow a frequent admonition of Fred Reish, one of the nation’s leading ERISA attorneys “forewarned is forearmed.”

Notes
1. Scott Epstein, Exchange Act Rel. No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan.30, 2009).
2. Wendell D. Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS 1154, at *11 (2003).
3. FINRA Regulatory Notice 12-25.
4. 17 CFR Sections 240.15l-1(a)(1), (2)(ii)(B).
5. Tibble v. Edison International, 135 S. Ct 1823 (2015)
6. Willam F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
7. 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
8. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
9. 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.
10. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
11. Mark Carhart, On Persistence in Mutual Fund Performance, Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
12. Ross M. Miller, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol. 5, No. 1, First Quarter 2007. Available at SSRN: https://ssrn.com/abstract=972173

Posted in 401k, 401k compliance, 401k investments, 403b, 404c compliance, Active Management Value Ratio, AMVR, best interest, closet index funds, compliance, consumer protection, cost consciousness, cost-efficiency, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, fiduciary liability, fiduciary standard, pension plans, Reg BI, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, best interests, DOL fiduciary rule, ERISA, fiduciary, fiduciary investing, fiduciary law, fiduciary standard, FINRA, investment analysis tools, pension plans, Reg BI, retirement plans, risk management, suitability, wealth management, wealth preservation | Leave a comment

Q3 2019 Top Ten 401(k) Mutual Funds “Cheat Sheet”

Posted on October 5, 2019 by jwatkins

At the end of each calendar quarter, InvestSense calculates new Active Management Value Ratio™ (AMVR) data for our clients. We also publish for the public an AMVR analysis of the top ten actively managed mutual funds in U.S. 401(k) plans, based on “Pension and Investments” magazine’s annual survey.

InvestSense recommends to clients that they calculate their AMVR data using the same standard being used increasingly by ERISA plaintiff attorneys in arguing and settling cases, that being Active Expense Ratio (AER) adjusted incremental costs divided by risk adjusted return adjusted incremental returns. In short, the AMVR allows investment fiduciaries, such as 401(k)/403(b) plan sponsors and trustees, and ERISA plaintiffs’ attorney to quantify fiduciary prudence and use the results as evidence.

One reason that ERISA plaintiffs’ attorneys are using the AMVR is the fact that properly calculated and utilized, the AMVR creates questions of fact in a legal action. Since judges can only decide questions of law, not questions of fact, the AMVR may help reduce the number of ERISA cases dismissed summarily by the courts or other legal tribunal. We also provide the simple nominal, or reported, incremental cost and incremental return data on funds in a plan for those willing to take the risk of unnecessary fiduciary liability exposure.

In interpreting the quarterly data, a user should remember to begin by analyzing the data in terms of two simple questions:

1. Did the mutual fund provide a positive incremental return relative to the comparable benchmark that was used by a fiduciary or financial adviser in evaluating the mutual funds in question?

2. If a fund did provide a positive incremental return relative to the comparable benchmark used, was the positive incremental return provided greater than the fund’s incremental costs?

If the answer to either of these questions is “no,” then the Restatement (Third) of Trusts states that it would be an imprudent investment choice. The Supreme Court has recognized the Restatement as the authority in resolving fiduciary and investment prudence issues.

The Restatement’s position becomes even more important when one examines the findings of various studies on the issue of the cost-efficiency of actively managed mutual funds, including

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.¹
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.²
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.³
[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.⁴

I am record as saying that I believe that the issue of cost-efficiency is going to gain greater attention in ERISA litigation going forward, especially if the current Putnam litigation results in pension plans having the burden of proof on the issue of causation in ERISA excessive fees and fiduciary breach actions. The fund companies know, and have known for some time, that their actively managed mutual funds are generally not cost-efficient, especially when many of said funds have R-squared correlation numbers of 90 or above, thereby supporting an argument that they are simply “closet index” funds. Closet index funds, aka “index huggers” and “mirror funds,” are actively managed mutual funds that essentially track the performance of comparable market indices, yet charge investors significantly higher fees and charges for such similar performance.

Going Forward
Once again, the third quarter AMVR “cheat sheet” results serve to remind investment fiduciaries of three key important fiduciary issues:

1. Actively managed mutual funds with high R-squared correlation numbers often indicate potential “closet index” funds. Closet index funds are imprudent by definition.
2. Actively managed mutual funds with high R-squared correlation numbers and high incremental costs typically result in high Active Expense Ratio numbers. Per Ross Miller, the creator of the metric, a fund’s AER number indicates the implicit cost of the fund, as opposed to its stated annual expense ratio.
3. The very nature of actively managed mutual funds, higher management fees and trading costs, usually results in actively managed mutual funds underperforming comparable index funds.

As one of America’s leading ERISA attorneys, Fred Reish, is fond of saying, “forewarned is forearmed.”

Notes
1. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
2. 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.
3. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
4. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE, 52, 57-8 (1997).

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, best interest, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, investment advisers, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, best interests, compliance, ERISA, evidence based investing, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, investment advisers, investment analysis tools, pension plans, wealth management, wealth preservation | Leave a comment

“Think Different” – The Often Overlooked Key Fiduciary Liability “Gotcha” Question

Posted on September 24, 2019 by jwatkins

What is the first thing you consider when selecting investments? There is a familiar saying in the investment industry – “amateur investors focus on investment returns; professional investors focus on investment risk.

Studies have shown that three out of four stocks tend to follow the general trend of the market. Consequently, professional investors know it is not that difficult to make money when the overall market trend is positive.

Secondly, investment professionals understand the opportunity costs inherent in investment losses. Investment losses reduce the amount of an investor’s principal that is available to fully participate in market recoveries. Furthermore, to totally cover investment losses, an investor has to earn more than the loss suffered since the investor’s account will be lower due to the investment loss. For instance, an investor would need a gain of 25 percent.to recover from a 20 percent loss,

As usual, I like to follow Apple’s famous slogan and “think different.” I like to approach wealth management with a “think outside the box” perspective, to create “deliberate disruptiveness” to change things for the better.

The first thing I look for in evaluating a mutual fund is the fund’s R-squared correlation number. As usual, there is a method to the madness.

Addressing the Problem of “Closet indexing”
In my practices, my primary focus is on fiduciary law, more specifically potential breaches of a fiduciary’s duties and strategies to prevent such breaches. The problem of closet indexing is gaining attention worldwide. Canada and Australia are the most recent countries to address the issue.

A mutual fund’s R-squared correlation number is a key factor in determining whether a fund is a potential “closet index” fund. A closet index fund is generally described as an actively managed mutual that has a high correlation of return to a comparable index fund, yet has fees and costs that are significantly higher than those of the index fund. By definition, closet index funds are cost-inefficient and, therefore, legally imprudent.

The legal imprudence of a closet index fund is even more evident when a closet index fund’s annual costs and fees are recalculated factoring in the fund’s R-squared correlation number. The argument is that the higher a fund’s R-squared number, the lower the implicit contribution of an actively managed fund’s management team to a fund’s performance.

The two most commonly used metrics in determining a fund’s closet index status are the Active Expense Ratio (AER) and Active Share. While the two metrics are used for similar purposes, they use distinctly different approaches. The AER metric focuses on the impact of an actively managed fund’s R-squared correlation number relative to the fund’s overall cost-efficiency. Active Share focuses on the overlap between the investment portfolios of an actively managed fund’s investment portfolio and a comparable benchmark fund.

According to Ross Miller, the creator of the AER, the metric indicates the implicit cost of an actively managed fund’s active component. As an actively managed fund’s R-squared correlation number increases (indicating less of a contribution from the fund’s management) and/or the fund’s incremental costs increase, the fund’s AER number increases.

Active Share’s focus on the overlap between the two funds’ investment portfolios is obviously important relative to being labeled a “closet index” fund. However, many have argued that Active Share overlooks the more important issue, that being how effectively a fund’s management team manages the non-overlapping portion of the actively managed fund’s investment portfolio in terms of both performance and cost-efficiency.

Exposing “Closet Index” Funds Using the Active Management Value Ratio™
At the end of each calendar quarter, I use the Active Management Value Ratio™ (AMVR), a proprietary metric, to calculate the cost-efficiency of the top ten actively managed mutual funds in U.S. defined contribution pension plans. The funds are chosen based on “Pensions and Investments” annual report on defined contribution plans..

A key component in calculating a fund’s AMVR is the fund’s AER. Given the fact that more attorneys are factoring in a fund’s AER in calculating damages in ERISA and securities litigation cases, investment fiduciaries and financial advisers should also factor in such numbers in providing recommendations to clients and selecting investment options for pension plans.

In calculating a fund’s AER, I typically use Vanguard index funds for benchmarking purposes. There are those who argue that it is “unfair” to compare Vanguard funds to actively managed funds since the two types of funds operate on different types of business platforms. My response is that legally the “best interest” of the investor/plan participant is/should be the only concern under both ERISA and federal/state securities laws. Therefore, such arguments have absolutely no merit.

As the chart shows, a fund’s high R-squared correlation number, combined with the incremental costs resulting from Vanguard funds’ low cost and fees, often results in significant increases in a fund’s AER and incremental costs relative to a comparable benchmark index mutual fund.

Costs Matter
Regardless of whether the situation involves the “best interest” standard under either the legally accepted fiduciary standard or the SEC’s recently adopted Regulation “Best Interest,” costs have to be considered in recommending an investment to the public or managing a pension plan. There is a direct, negative relationship between a fund’s R-squared correlation number, a fund’s incremental costs, and the fund’s cost-efficiency.

There is no universally agreed upon level of R-squared that designates an actively managed mutual fund as a closet index fund. I use an R-squared correlation number of 90 as my threshold indicator for closet index status. Others avoid the whole closet index debate and simply calculate a mutual fund’s cost-efficiency using the AMVR and answer two simple questions:

(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?

(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?

If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and unsuitable/imprudent and should be avoided.

Based on the chart above and the funds’ risk-adjusted five-year returns, only four of the ten funds even produced a positive risk-adjusted incremental return relative to their benchmark: Fidelity Contrafund, Fidelity Growth Company, T. Rowe Price Blue Chip Growth, and T. Rowe Price Growth Stock. Of those funds, only three produced an AMVR rating less than 1.0, indicating their nominal incremental return exceeded their nominal incremental costs.

For litigation and consulting purposes, InvestSense recommends that attorneys and pension plan sponsors use an AMVR score based on a fund’s AER-adjusted incremental costs and risk-adjusted incremental returns. Using those standards, none of the three referenced funds posted an AMVR of 1.0 or less, indicating that they were cost-efficient over the five-year period analyzed. The respective AMVR scores were Fidelity Growth Company (2.04). T. Rowe Price Blue Chip Growth (3.67), and Fidelity Contrafund (6.83).

Going Forward
The pension plan and mutual fund industries do not like to discuss the issues of correlations of return, closet indexing or cost-efficiency. A quick glance at Morningstar’s data shows that many U.S. equity-based mutual funds have a high R-squared correlation number, resulting in significantly higher implicit annual expense ratios than the funds stated annual expense ratios. As a result, studies have consistently shown that very few actively managed mutual funds are cost-efficient:

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.¹
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.²
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.³
[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.⁴

It is generally agreed that effective diversification within an investment portfolio is a valuable means of risk management and the avoidance of large investment losses. The cornerstone of effective diversification is combining various investments that behave differently under various economic and market conditions, investments that have varying/low correlations of returns.

And yet, inexplicably, ERISA does not require 401(k)/404(c) plans to provide plan participants with correlation data on the investment options in their plan. Without such information, plan participants have a difficult time determining whether they have effectively diversified their plan accounts to reduce the chance of large losses, thereby improving their opportunity to achieve the much touted goal of “retirement readiness.”

For more information about the Active Management Value Ratio™ and the calculation process required, visit the following blogs:

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, evidence based investing, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, pension plans, prudence, Reg BI, retirement plans, SEC, securities compliance, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, ERISA, evidence based investing, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, investment analysis tools, pension plans, prudence, retirement plans, risk management, securities compliance, suitability, wealth management, wealth preservation | Leave a comment