The Prudent Investment Fiduciary Rules

“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

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.

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.”

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

The Future is Now: SCOTUS and Putnam Investments, LLC v. Brotherston

Posted on September 7, 2019 by jwatkins

SCOTUS has yet to decide whether to hear the case of Putnam Investments, LLC v. Brotherston. I continue to argue that the ultimate decision in this case could have a significant impact on the future of the 401(k) industry and the ability of plan participants to have a meaningful opportunity to work towards their goal of “retirement readiness.”

As the Supreme Court’s blog, www.scotusblog.com, points out, the case involves the following issues:

(1) Whether an ERISA plaintiff bears the burden of proving that “losses to the plan result[ed] from” a fiduciary breach, as the U.S. Courts of Appeals for the 2nd, 6th, 7th, 9th, 10th and 11th Circuits have held, or whether ERISA defendants bear the burden of disproving loss causation, as the U.S. Court of Appeals for the 1st Circuit concluded, joining the U.S. Courts of Appeals for the 4th, 5th and 8th Circuits; and (2) whether, as the U.S. Court of Appeals for the 1st Circuit concluded, showing that particular investment options did not perform as well as a set of index funds, selected by the plaintiffs with the benefit of hindsight, suffices as a matter of law to establish “losses to the plan.

To me the first question is the more important of the two, primarily because under ERISA and basic fiduciary law, prudence is based on the process used by a fiduciary in selecting and monitoring a plan’s investment options, not their ultimate performance.

The “burden of proof” question is the key issue, as I believe that plans and other 401k related industries would be hard pressed to carry that burden of proof in connection with most of the current actively managed mutual funds. And yet, if SCOTUS agrees to hear the case and upholds the First Circuit’s decision, or SCOTUS decides not to hear the case, leaving the First Circuit’s decision as the final word in the case, that would be the formidable challenge facing pension plans.

Why do I say “formidable challenge?”

Exhibit A, from Nobel laureate William F. Sharpe:

[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.¹

So how would one carry the burden of proof on the question of causation? SCOTUS has provided an answer to that question.

Exhibit B, from SCOTUS

ERISA is essentially a codification of the Restatement (Third) of Trusts (Restatement). SCOTUS has recognized that the Restatement is a legitimate resource for the courts in resolving fiduciary questions, especially those involving ERISA.²

The Restatement states that actively managed mutual funds are imprudent unless they are also cost-efficient.³

So, what would be an appropriate test for meeting the burden of proof as to causation, or, more specifically, the cost-efficiency of an actively managed mutual fund?

Exhibit C, from Charles D. Ellis:

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!⁴

As mentioned earlier, studies that have been conducted using such comparisons have consistently found that the overwhelming majority of actively managed mutual funds are not cost efficient, and therefore imprudent. (Exhibits D-G)

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.⁵
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.⁶
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.⁷
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.⁸

As Ellis suggests, the actual calculation process required to evaluate the cost-efficiency of an actively managed mutual fund need not be complicated. In fact, using the Restatement and the findings of studies by Ellis and Burton Malkiel, I created a simple metric, the Active Management Value Ratio™ (AMVR), that uses simple, what Bogle referred to as “humble arithmetic,” to calculate the cost-efficiency of an actively managed mutual fund.⁹

People are constantly asking me what SCOTUS is going to do. Obviously, I do not know. Personally, I do not think that SCOTUS wants to hear the case, as I believe that the First Circuit’s decision was both logically and technically correct. I believe that is why we have yet to hear a decision on whether SCOTUS will hear the case. Plus, they have already agree to hear several ERISA related cases during their next term.

I believe SCOTUS may eventually feel compelled to hear the case in order to resolve the existing conflict between the federal appellate courts on this issue. Again, just my opinion. Employees’ ERISA rights are simply too important to depend on whatever jurisdiction in which they happen to reside.

Bottom line is that while the 401k industry and so many pension plans “talk a good game” about “retirement readiness” and wanting to help their employees achieve such a goal, the fact that actively managed mutual funds are still the predominant investment option in so many 403(k) and 403(b) plans effectively renders “retirement readiness” a cruel hoax, at least in terms of providing plan participants with a meaningful opportunity to maximize their retirement savings. As the saying goes, “actions speak louder than words.” “Cost-inefficient” and “wealth maximization” are mutually exclusive. Always have been, always will be.

Whatever SCOTUS’ ultimate decision is, I for one believe the integrity of ERISA in requiring that employees be given a meaningful opportunity to work toward “retirement readiness” hangs in the balance.

Notes
1. Willam F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
2. Tibble v. Edison International, 135 S. Ct 1823 (2015)
3. Restatement (Third) Trusts, Section 90, cmt. h(2) (American Law Institute).
4. 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
5. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
6. 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.
7. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
8. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE, 52, 57-8 (1997).
9. https://iainsight.wordpress.com/2018/01/17/the-active-management-value-metric-3-0-investment-returns-and-wealth-preservation-for-fiduciaries-and-plan-fiduciaries/

This article is for informational purposes only, and is not designed or 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.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, best interest, 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, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, compliance, DOL fiduciary rule, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, investment analysis tools, pension plans, retirement plans, wealth management, wealth preservation | Leave a comment

Investopedia Top 100 Most Influential Financial Advisor Honor

Posted on September 7, 2019 by jwatkins

Honored to be named by Investopedia as one of the Top 100 Financial Advisors for 2019. Unlike a lot of other “top” lists, Investopedia bases its selection largely on criteria such as contributions to online media to educate investors on timely topics such as wealth preservation, wealth preservation and Investor self-protection strategies.

Additional information on the Investopedia Top 100 is available at https://bit.ly/31GZrzi.

Posted in Active Management Value Ratio, AMVR, consumer protection, fiduciary law, fiduciary standard, investment advisers, securities compliance, wealth management, wealth preservation | Tagged Active Management Value Ratio, AMVR, fiduciary, fiduciary investing, fiduciary standard, investment advisers, investment analysis tools, prudence, wealth management, wealth preservation | Leave a comment

ERISA Litigation’s “Next Big Thing?”

Posted on July 6, 2019 by jwatkins

I have been receiving a number of requests to perform forensic analyses on ERISA plans that include one or more variable annuities as investment options within the plan. Most of these plans are ERISA 403(b) plans due to the fact that the entities are private entities, as opposed to public/government entities that are exempted from ERISA coverage.

While there are many prudence and cost-efficiency related issues relating to variable annuities overall, an emerging issue involves the plan sponsor’s ability to carry out its fiduciary duties under ERISA. As SCOTUS noted in the Tibble decision

In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts….Under trust law, a trustee has a continuing duty to monitor trust investments and remove imprudent ones.

Variable annuities usually include numerous sub-accounts as investment options. This increases the odds of finding sub-accounts that are not prudent and need to be removed.

The issue – I am not aware of any variable annuities that permit owners, or plan sponsors, to actually remove an imprudent sub-account from a variable annuity that is part of the annuity’s investment menu. Based upon my experience as a compliance director and ERISA/ securities attorney, the typical response from the variable annuity issuer would be that the overall menu of options is fine, just do not invest in the imprudent sub-accounts.

And there it is, the old “menu of investment options” defense so often misunderstood and misapplied by attorneys and judges. Judges and attorneys have often cited the Hecker v. Deere I decision in support of the “menu of options” argument.

For some reason, the court’s subsequent decision in Hecker v. Deere II is often conveniently overlooked by judges and attorneys, even though most of the legal community agrees that the court’s second decision effectively reversed the court’s first decision. Enlightened courts have quickly pointed out the practical impact of both cases and have consistently rejected the “menu of options” defense.

In footnote 8 of the DiFelice v. U. S. Airways decision, the court explained why “each individual investment” must be the applicable standard in defined contribution cases. With DC plans, a plan participant carries the financial risk of imprudent investments, although the plan has the exclusive power to choose the plan’s available investment options.

Drinker Biddle issued an excellent white paper that sets out the definitive standard, stating that

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.

Which brings us back to the original question. Unless and until a variable annuity allows a plan sponsor to remove an imprudent investment sub-account offered within a variable annuity offered as an investment option within an ERISA plan, how does a plan sponsor avoid a breach of their fiduciary duty to make such changes in compliance with ERISA?

As a plaintiff’s attorney, thjs would seem to be a perfect example of the proverbial “low hanging fruit,” with no viable option for the plan’s failure to meet its fiduciary duties. It has been suggested to me that any attempt to correct the problem by totally replacing the variable annuity could have potentially significant tax implications as well, even given the fact that the plan is given favorable tax treatment. Since I am not a tax attorney, I will leave that issue to the tax attorneys.

Is the plan sponsor’s inability to remove imprudent investment sub-accounts from variable annuities within an ERISA plan a breach of their fiduciary duties? The elements certainly seem to be there to make a valid argument in favor of finding a breach, to make the variable annuity issue potentially ERISA litigation’s “next big thing.” Time will tell.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, Annuities, best interest, compliance, consumer protection, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Annuities, best interests, compliance, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, wealth management, wealth preservation | Leave a comment

The “Hidden” Message in Reg BI

Posted on June 28, 2019 by jwatkins

Like many others, I was eager to review the final version of the SEC’s Reg BI. As an attorney, I was anxious to see whether “prudence” was still expressly set out in Reg BI’s Care Obligation. As many had predicted, the SEC removed the term from the final version of the regulation and offered a disingenuous excuse for not including “prudence” in the final version of the regulation.

Had “prudence” been left in Reg BI’s final version, it would have had disastrous consequences for the variable annuity industry. Moshe Milevsky’s famous study, “The Titanic Option,”¹essentially showed that variable annuities will never be able to pass any true fiduciary standard due to the inequitable nature of the “inverse pricing” methodology used by most variable annuity issuers in calculating a variable annuity’s annual M&E fees.

I am on record as stating that I believe that Reg BI will be vacated by the courts if actions are filed contesting the regulation. My opinion is based largely on the fact that several former SEC economists wrote a scathing review of the Reg BI. The courts often give significant weight to the opinions of former executives within a governmental agency.

My opinion is also based on the fact that the SEC did not define “best interest,” the key concept behind the regulation. While Chairman Clayton offered what I consider to be yet another disingenuous explanation for not defining “best interest,” I do believe that various key SEC and NASD/FINRA enforcement decisions that offered insights into the term “best interest,” such as the Scott Epstein²and Wendell D. Belden³decisions, could be used to identify “best interest” violations.

The final issue that I have with Reg BI is the fact that, in my opinion, it is totally inconsistent with the SEC’s mission statement-to protect investors-and unnecessarily protective of Wall Street’s interests at investors’ expense. The courts have consistently stated that the purpose of securities laws is to protect investors, not brokers.

In Hirshberg & Norris v. SEC, the court dealt with an analogous situation where the appellee broker-dealer essentially argued that the federal securities laws and regulations were enacted to protect broker-dealers rather than the investing public. The court quickly rejected the appellant’s argument, stating that

To accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protections of the broker-dealer rather than the protection of the public….On the contrary, it has long been recognized by the federal courts that the investing and usually naïve public needs special protection in this specialized field. We believe that the Securities Act and the Securities Exchange Act were designed to prevent, among other things, just such practices and business methods as have been shown to have been indulged in by the petitioner in this case.⁴

Time will tell whether Reg BI can successfully run the judicial gauntlet.

Reg BI’s “Hidden Agenda”
In reading through Reg BI, I did find the SEC’s frequent reference to the importance of “efficient” advice and strategies interesting, especially the need to factor in the costs of such advice and strategies.

A rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes expected utility. From the discussion above, an efficient investment strategy may depend on the investor’s utility from consumption, including: (4) the cost to the investor of implementing the strategy.⁵

The efficiency of a recommendation to a retail customer may depend on: (1) the menu of securities transactions and investment strategies the broker-dealer or its associated persons considers and makes available to the retail customer; (2) the return distribution and the costs of these securities transactions and strategies;…⁶

An inefficient recommendation may lead to various results for the retail customer, including inferior investment outcomes, such as risk-adjusted expected returns that are lower relative to other similar investments or investment strategies.⁷

Reg BI’s acknowledgment of the importance of cost-efficiency in terms of investment recommendations is consistent with the Restatement (Third) of Trust’s position regarding cost-efficient in investing. Section 90, comment h(2) essentially states that the recommendation of cost-inefficient actively managed mutual funds is imprudent.

Several years ago I created a metric, the Active Management Value Ratio (AMVR). The AMVR is based on the research of investment icons such as Charles D. Ellis and Burton L. Malkiel. The AMVR allows investors, investment fiduciaries and attorneys to evaluate the cost-efficiency of actively managed mutual funds. Further information about the AMVR and the calculation process, click here.

Going Forward
Whether Reg BI survives judicial scrutiny or not, financial “advisers” of all types need to recognize the importance of investment costs and the potential liability issues associated with same. Costs matter.

With Reg BIs’ recognition of the importance of factoring in cost-efficiency, one has to wonder if the cost-efficiency issue will include the consideration of the growing issue of closet index/shadow index funds. Canada and Australia have recently recognized the closet indexing issue and are considering new regulations to address the problem.

Based on recent information provided by the Morningstar Investment Research Center, domestic U.S. large-cap funds have an average expense ratio of 106 basis points and average trading costs of 73 basis points, using the funds’ average turnover ratio of 61 percent and John Bogle turnover/trading cost conversion metric. So these funds essentially start out 180 basis points in the hole compared to comparable passive/index funds.

The only way that actively managed funds can hope to make up this difference in costs is through higher returns. However, research has shown that many domestic funds, especially large-cap funds, have shown a trend of high R-squared correlation numbers in order to reduce the potential loss of customers due to significant differences in returns from comparable passive/index funds. So by “hugging” the indices, the actively managed funds may reduce variances in returns, but the significant difference in fees remains, effectively reducing investors’ returns.

Costs and cost-efficiency matter. Both the Restatement (Third) of Trusts and now Reg BI acknowledge that fact. At some point, financial advisers need to do the same and adjust their practices accordingly, or continue to face increasing liability exposure.

Notes
1. Moshe A. Milevsky and Steven E. Posner, “The Titanic Option: Valuation of the Guaranteed Death Benefit in Variable Annuities and Mutual Funds,” J. of Risk and Insurance, Vol. 68, No. 1 (2001)
2. Scott Epstein, Exchange Act Release 34-59328 (2009)
3. Wendell D. Belden, Exchange Act Release 34-47859 (2003)
4. Hirshberg & Norris v. SEC, 177 F.2d 228, 233 (1949)
5. Regulation Best Interest, Exchange Act Release 34-86031, 378 (2019)
6. Regulation Best Interest, Exchange Act Release 34-86031, 380 (2019)
7. Regulation Best Interest, Exchange Act Release 34-86031, 383-84 (2019)

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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.

Posted in 401k, 403b, Active Management Value Ratio, AMVR, best interest, closet index funds, compliance, cost consciousness, cost efficient, cost-efficiency, evidence based investing, fiduciary compliance, Fiduciary prudence, investment advisers, investments, Reg BI, SEC, wealth management, wealth preservation | Tagged Active Management Value Ratio, AMVR, best interests, evidence based investing, investment advisers, Reg BI, risk management, suitability, wealth management | Leave a comment

Designing a “Win-Win” 401(k)/403(b) Defined Contribution Plan

Posted on June 6, 2019 by jwatkins

As a forensic ERISA attorney. I use forensic analysis to demonstrate effective risk management strategies to pension plans. I also design liability-driven, “win-win,” 401(k) and 403(b) plans (hereinafter “401(k) plans”). “Win-win” 401(k) plans are plans that provide plan participants with a meaningful opportunity to work toward “retirement readiness,” while at the same minimizing the potential fiduciary liability of the plan and the plan fiduciaries.

The 401(k) Litigation Landscape
The 401(k) landscape has seen an increase in the amount of litigation alleging improper management of 401(k) plans. Most legal actions involving such plans have alleged excessive fees and/or a breach of the plan’s fiduciary duties with regard to the selection and/or monitoring of the plan’s investment options.

I am on record as saying that I believe that 401(k) excessive fee/fiduciary breach cases are not going to end anytime soon. My opinion is based on my experience auditing and analyzing 401(k) plans. Most plans I have seen are simply not ERISA compliant, for reasons I will address in this white paper.

As a result, I believe it is more important than ever for plans and plan fiduciaries to become more proactive in ensuring that their plans are ERISA compliant. Whether this simply requires a better system of selecting and monitoring a plan’s investment options, or designing and implementing a “win-win” plan, taking a more proactive position in managing a plan can help both plan participants and plan fiduciaries.

Creating a “Win-Win” 401(k)/430(b) Plan
I provide ERISA consulting services to 401(k) plans and ERISA attorneys. Whenever a potential ERISA client contacts me for the first time, I always ask two questions:

How many investment options are within the plan?
How many of the investment options are actively managed mutual funds?

Those two simple questions provide a wealth of information with regard to potential fiduciary liability exposure for a 401(k) plan and plan fiduciaries.

1. Number of Investment Options – Less is More
Most 401(k) plans that I have reviewed have mistakenly adopted the “more is better” approach in designing their plans. However, in the ERISA defined contribution arena, the number of investment options offered within a plan simply increases the potential fiduciary liability exposure for both the plan and the plan fiduciaries.

What some ERISA fiduciaries do not realize is that there are two separate and distinctly different fiduciary prudence standards for defined benefit and defined contribution plans. The fiduciary prudence standard for defined benefit plans is “the portfolio as a whole.” The fiduciary prudence standard for defined contribution plans is “each individual investment.”¹

The rationale behind the difference is simple. In defined benefit plans, the plans carry the burden of investment risk. The plan has to make the required payments to the plan participants, regardless of the performance of the plan’s portfolio.

In defined contribution plans, the plan has the potential liability to shift the burden of investment risk to the plan participants. Since the plan is still responsible for selecting a defined contribution plan’s investment options, each individual investment needs to be prudent. As one court explained,

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.

This is so because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine with a company stock fund, could theoretically, in combination, create a prudent portfolio.² (emphasis added)

The “each investment” prudence standard for defined contribution obviously makes a “less is more” approach more prudent for a defined contribution plan, as the odds of non-compliance go up with each additional investment option. Simple statistics.

Advisers and plan sponsors often tell me that ERISA requires them to offer a large number of funds. But exactly what does ERISA require?

That plan sponsors manage the plan “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.³
That plan sponsors diversify the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.⁴

So far, ERISA Section 404 does not provide any real specifics about any quantitative requirement regarding mutual funds and a plan sponsor’s duty of prudence. Many defined contribution plans decide to elect Section 404(c) status in an attempt to shift investment risk to plan participants. Section 404(c) sets out approximately twenty requirements in order for a plan to qualify for the protections provided by the Section, among them that a plan provide participants with “an opportunity to choose, from a broad range of investment alternatives.”⁵

The Section then goes on to discuss the “broad range of investment alternatives” requirement:

A plan offers a broad range of investment alternatives only if the available investment alternatives are sufficient to provide the participant or beneficiary with a reasonable opportunity to:

(A) Materially affect the potential return on amounts in his individual account with respect to which he is permitted to exercise control and the degree of risk to which such amounts are subject;⁶

(B) Choose from at least three investment alternatives:

(1) Each of which is diversified;

(2) Each of which has materially different risk and return characteristics;

(3) Which in the aggregate enable the participant or beneficiary by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant or beneficiary; and

(4) Each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant’s or beneficiary’s portfolio;⁷

(C) Diversify the investment of that portion of his individual account with respect to which he is permitted to exercise control so as to minimize the risk of large losses….⁸

So with regard to ERISA’s quantitative requirements for 401(k)/404(c) funds, ERISA expressly only requires a minimum of three funds. ERISA does require that the funds selected meet additional qualitative requirements, which we will address in the next section. But for right now, a plan could theoretically comply with both ERISA Sections 404(a) and 404(c) using just three funds.

In one of my earlier books, I suggested a format for a simple 401(k)/403(b) plan using just three diversified index funds. While I still believe that a legally compliant three index fund 401(k) plan is possible, I believe a five index funds plan is more practical for a fund focusing on legal compliance, simplicity and “retirement readiness” effectiveness for plan participants.

The bottom line for plan sponsors and plan service providers is that ERISA does not require an army of funds in order to be ERISA compliant. In fact, a simpler plan offering a lower number of investment options is arguably in the plan participants’ best interests, as it makes the entire 401(k) participation process less intimidating, thereby avoiding the so-called “paralysis by analysis” concern.

However, the issue of quantitative prudence is just one aspect of designing a prudent “win-win” 401(k) plan. Plan designers also need to focus on ERISA’s qualitative requirements. Two dominant themes throughout ERISA Section 404 are risk management, more specifically the avoidance of large losses, and cost-control/cost-efficiency

2. Risk Management, Diversification and Fiduciary Prudence
In terms of risk management, the Department of Labor and the courts have adopted Modern Portfolio Theory (MPT) as the method of assessing fiduciary prudence under ERISA. While MPT has drawn criticism for a number of valid reasons, MPT’s core concept, the value of effective diversification in avoiding large losses, is fundamentally sound.

Some plans and plan sponsor have attempted to justify an overabundance of investment options within a plan based on their belief that effective diversification requires that a large number of investment options offered within a plan. However, Nobel Laureate Harry Markowitz, the creator of MPT, has clearly refuted that belief, stating that

It is not enough to invest in many securities. It is necessary to avoid investing in securities with high [correlations]among themselves….Effective diversification depends not only on the number of assets in a trust portfolio but also on the ways and degrees in which their responses to economic events tend to reinforce, cancel or neutralize one another.⁹

Furthermore, as the Restatement points out, effective diversification is a two-step process. Effective diversification requires both horizontal diversification (across asset classes) and vertical diversification (within asset classes).

Unfortunately, it has become increasingly harder to find equity-based funds mutual funds that offer the level of correlations of return necessary to effectively diversify a plan’s investment options, both in terms of domestic and international funds. But that does not relieve a plan’s fiduciaries of their duty of prudence in designing and monitoring their plan and its investment options.

3. Actively Managed Mutual Funds, Cost-Efficiency and Fiduciary Prudence
ERISA is essentially a codification of the Restatement (Third) of Trusts (Restatement). SCOTUS has recognized that the Restatement is a legitimate resource for the courts in resolving fiduciary questions, especially those involving ERISA.¹⁰ The Restatement states that actively managed mutual funds are not prudent unless they are also cost-efficient.¹¹

Most current 401(k) plans are still heavily dominated by actively managed mutual funds as their investment options. As mentioned earlier, various studies by academia and well-respected investment experts have consistently concluded that actively managed mutual funds are not cost-efficient, and therefore not prudent investment options.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.¹²
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.¹³
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.¹⁴
[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.¹⁵

The challenge for actively managed mutual funds is one described by the late Jack Bogle as “humble arithmetic.” Actively managed mutual funds typically have significantly higher expense ratios and higher turnover/trading costs than comparable index funds.

Therefore, in order to cover such costs and compete with comparable, less expensive index funds, the actively managed funds must outperform the index funds. However, studies have shown that many actively managed funds have adapted a “closet” or “shadow” indexing strategy in order to prevent significant variances in returns, which could result in a loss of customers.

Closet indexing is generally defined as an actively managed mutual fund advertising that it actively manages the fund’s assets, supposedly to provide better performance. In reality, closet indexing essentially guarantees that an actively managed fund will provide returns that are similar to, or often less than, those of a comparable index fund.

So, in essence, the actively managed fund owner has simply purchased an over-expensive, underperforming index fund. When forensic analysis is applied to such funds to factor in the actively managed fund’s R-squared/correlation of return number, the negative impact on an investor is even worse. The negative impact on a fund’s end-return obviously increases the potential fiduciary liability exposure for a plan and the plan’s fiduciaries.

Interestingly, very few courts decisions have focused on the relationship between cost-inefficient performance and fiduciary prudence. Instead, recent court decisions dismissing 401(k) excessive fees/breach of fiduciary actions have cited a litany of theories to support their decisions, including

the difference in business platforms between actively managed funds and passively managed index funds (“apples to oranges”);
the “menu” or number of investment options offered by a plan;
the supposed legal acceptability of a range of fund expense ratios; and
the number of plans offering a specific fund.

If we accept the stated purpose of ERISA, to protect plan participants, and thus their ability to work toward “retirement readiness,” then all of the referenced theories are totally irrelevant. The only concern and question in 401(k) breach of fiduciary duty litigation should be whether an investment option in a 401(k) plan provides the plan’s participants with the best opportunity for carrying out ERISA’s stated purpose.

The Active Management Value Ratio™ 3.0
Recognizing the inherent compliance challenges involved with 401(k) plans , I created a metric, the Active Management Value Ratio™ (AMVR). The AMVR is based upon the research and investment management concepts of Nobel Laureate William D. Sharpe and investment icons Charles D. Ellis and Burton G. Malkiel. Both Sharpe and Ellis advocate the analysis of actively managed mutual funds by comparing such funds with comparable index funds.

Malkiel’s research found that a fund’s expense ratio and its trading costs are the most reliable predictors of a fund’s future performance. There are those who argue that factoring in a fund’s trading costs is misleading since trading costs are deducted as part of a fund’s operating expenses in calculating a fund’s performance.

While technically true, the law does not require that a fund specifically disclose the fund’s actual trading costs. This prevents a plan sponsor and plan participants from including a material fact in the selection of funds for the plan and their personal 401(k) accounts.

For example, assume a plan sponsor or plan participant is choosing between two funds with similar returns. However, one of the funds has a turnover rate that is significantly higher than that of the comparable index fund. All things being equal, the fund with the much lower turnover ratio is obviously the more cost-efficient option, and thus the more prudent investment choice.

Therefore, it can be legitimately argued that the fiduciary duty of prudence requires that a fund’s turnover/trading costs, or some acceptable proxy for such costs, be separated out of a fund’s operating costs and factored into a plan’s investment selection process. The fact that an actively managed fund’s turnover/trading costs are often significantly higher than the fund’s annual expense ratios only strengthens this argument.

For those reasons, the AMVR calculates an actively managed fund’s AMVR score based on both an expense ratio-only basis and a combined “expense ratio+trading costs” basis so that plans and ERISA attorneys can decide for themselves as to which analysis to use in their fiduciary prudence analyses. I supplement AMVR calculations with two additional proprietary metrics, the Cost–Efficiency Quotient (CEQ) and the Fiduciary Prudence Score. The Fiduciary Prudence Score provides an overall evaluation of an actively managed mutual fund’s efficiency, in terms of both risk management and cost-control, and the fund’s consistency of performance.

The AMVR calculation process is simple, requiring only the basic mathematic skills everyone learned in elementary school, “My Dear Aunt Sally”-multiplication, division, addition and subtraction. The AMVR requires a minimum amount of data, most of which is freely available online at sites such as Morningstar, Marketwatch and Yahoo! Finance. For more information about the AMVR and the calculation process required, click here. For an example of a typical AMVR report, click here.

As mentioned earlier, the evidence clearly shows that the overwhelming majority of actively managed mutual funds are not cost-efficient relative to comparable index funds. Cost-inefficient investments waste plan participants’ money. As the Uniform Prudent Investor Act states, “Wasting beneficiaries’ money is imprudent.”¹⁶

Going Forward
There are no signs that the level of 401(k) excessive fees/breach of fiduciary duty litigation is going to slow down anytime soon. In fact, as the information in this white paper has shown, there is every reason to believe that the level of litigation may actually increase.

This would be especially true if SCOTUS agrees to hear the Brotherston case and rules that pension plans have the burden of proof regarding causation in 401(k) litigation. As discussed herein, plans would seemingly be hard-pressed to successfully carry that burden of proof on most actively managed funds.

When I discuss the need for plans to design “win-win” 401(k) plans, many plan sponsors will indicate that they are not concerned about being sued or any potential liability because their plan is too small and/or their employees are happy with their plan and would never sue the company.

That may be; however, most 401(k) litigation is begun by former employees. Furthermore, under ERISA, so-called “alternate payees” have the same legal rights as the plan participants, including the right to sue a plan. The most common forms of alternate payees under ERISA are heirs and ex-spouses, who often acquire an interest in a plan as a result of a property settlement.

As many probate and divorce attorneys are quickly learning, a failure to properly evaluate and factor any 401(k) plan interests into probate or divorce proceedings may constitute legal malpractice. Consequently, it would not be surprising to see an increase in 401(k) litigation involving alternate payees’ interests in the near future.

While this white paper has focused on 401(k) plans and plan sponsors, the points made herein are equally applicable to plan service providers. Over the past year or so we have seen more ERISA-related complaints include plan service providers as party defendants.

Many plan sponsors mistakenly believe that the inclusion of a fiduciary disclaimer clause in their advisory contract insulates them from any liability whatsoever for the advice they provide to a 401(k) plan. Plan service providers are now learning that fiduciary disclaimer clause notwithstanding, they can still be sued by plans and plan participants for bad advice under common law principles such as negligence and breach of contract.

In conclusion, I often read stories defining the “perfect” 401(k)/403(b) plan in terms of the plan’s rate of participation, rate of retention and level of deferral/contribution. To me, that seems like “putting the cart before the horse.” What good are high participation rates and the like if at the end of the day the plan is writing a multi-million dollar check to settle a 401(k) fiduciary breach action?

Perhaps it is because I am an attorney, but it seems to me that the “perfect” 401(k)/ 403(b) plan is one that is designed to create a “win-win” situation for all parties involved with the plan – one that provides plan participants with a meaningful opportunity to work toward achieving “retirement readiness,” while protecting plan sponsors and other plan fiduciaries against unnecessary and unwanted fiduciary liability. Until a 401(k)/403(b) plan’s house is in order in terms of ERISA compliance, adding or retaining plan participants would seem to just be increasing the potential liability for the plan and the plan’s fiduciaries.

Notes
1. DiFelice v. U.S. Airways, 497 F.3d 410, 423 and fn. 8.
2. DiFelice.
3. 29 U.S.C.A Section 1104(a)(1)(B).
4. 29 U.S.C.A Section 1104(a)(1)(C).
5. 29 CFR § 2550.404c-1(b)(1).
6. 29 CFR § 2550.404c-1(b)(3)(i)(A).
7. 29 CFR § 2550.404c-1(b)(3)(i)(B)(1)-(4).
8. 29 CFR § 2550.404c-1(b)(3)(i)(C).
9. Harry M. Markowitz, Portfolio Selection, 2nd Ed. (Cambridge, MA: Basil Blackwood & Sons, Inc., 1991), 5-6.
10. Tibble v. Edison International, 135 S. Ct 1823 (2015).
11. Restatement (Third) Trusts, Section 90, cmt. h(2) (American Law Institute).
12 Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
13. 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.
14. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
15. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE, 52, 57-8 (1997).
16. UPIA, Section 7 (Introduction).

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, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, Active Management Value Ratio, AMVR, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, prudence, retirement plans, risk management, wealth management | Leave a comment

“Whoa Nelly”*-Reg BI and That Other “F” Word

Posted on May 7, 2019 by jwatkins

*Yes, I am old, Yes, I used to love listening to the late Keith Jackson call college football games. I miss his “whoa Nelly” calls.

As the debate over the SEC’s proposed Regulation Best Interest (Reg BI) rages on, people have increasingly asked me what I think will happen. The SEC is obviously going to propose Reg BI in some form. I expect various legal actions to be filed attempting to stop the implementation. In the end. I expect at least one court to rule that Reg BI violates the SEC’s express mission statement, to protect and promote investors’ interests, and is therefore unenforceable. Just my opinion.

Lot of moving parts behind that opinion, but all supported by existing law. First, the SEC’s stated purpose is to enact rules and regulations that protect investors, not broker-dealers. Reg BI adopts a number of positions that arguably advance the interests of broker-dealers and their representatives at the cost of investors.

The clearest example of this is Reg BI’s adoption of a disclosure rule regarding conflicts of interest rather than a strong absolute prohibition of selling when conflicts of interest exist. Making matters even worse is the failure of the SEC to offer and require a clear and understandable standardized format for such disclosures of conflicts of interests.

Another obvious problem with Reg BI is the SEC’s to define the core concept, best interests. While one could argue that such an oversight was deliberate to further protect the investment industry, I would suggest that there are two potential ways that investors may be able to overcome such tactics.

At least for the present time, FINRA’s rules would still apply. Often overlooked is FINRA’s requirement with regard to the other “F” word-“fair dealing.” Fortunately, NASD/FINRA and SEC enforcement decisions provide valuable guidance in defining fair dealing and what constitutes a violation of the requirement.

The Scott Epstein enforcement decision (Exchange Act Release No. 34-59328) is the decision most cited in connection with FINRA’s fair trading/fair treatment requirement (FINRA Rule 2111, Supplementary Material -.01). The panel noted that FINRA and the SEC have consistently stated that a registered representative’s “recommendations must be consistent with his customer’s best interests.”

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.

OK, so we have the rule. But what does it mean and what constitutes a “fair dealing” violation by a broker-dealer or stockbroker? Epstein was accused of engaging in “switching,” or recommending the sale and subsequent purchases of mutual funds for the primary purpose of generating commissions for him and his broker-dealer. In ruling that Epstein was guilty of all charges, the SEC panel justified its decision by stating that

Epstein’s 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.

So, the fair dealing requirement incorporates the same “best interest” standard, one based on broker/adviser’s putting his/her financial interests ahead of the customer’s financial interests. Seems simple enough, but how would one prove this.

Anyone who follows me on social media or on one of my blogs knows that I am a staunch advocate of using cost-efficiency to prove securities violations involving fair dealing, suitability and/or a duty of prudence. After all, Sections 90 of the Restatement (Third) of Trusts, otherwise known as the Prudent Investor Rule, establishes several prudence standards.

Since broker-dealers and stockbrokers often recommend actively managed funds, the key comment to Section 90 is comment h(2), which essentially states that recommending or using actively managed mutual funds is imprudent unless the funds are cost-efficient, that is their anticipated returns cover the fund’s extra costs and risks. As the Comment to Section 7 of the Uniform Prudent Investor Act states, “wasting beneficiaries’ money is imprudent.”

Based on the research of numerous noted and well-respected investment experts, the evidence overwhelmingly states that most actively managed mutual funds are cost-inefficient, that they fail to cover their investment costs.

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

This would certainly seem to make the justification of a recommendation of an actively managed mutual fund more questionable unless the financial adviser can show that the fund(s) in question are cost-efficient relative to other comparable investment options, including comparable index funds.

There are those that suggest that comparing actively managed funds to less expensive index funds is inherently unfair. However, if we accept that the guiding principle is the protection of investors and putting their financial best interests first, then the only thing that matters is the comparative cost-efficiency of the funds under consideration.

The concept of comparing actively managed funds to comparable index funds has the support of two well-respected investment icons, Nobel Laureate William S. Sharpe and Charles D. Ellis.

‘[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’⁵

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!⁶

By adopting cost-efficiency as the preliminary and primary standard in addressing both FINRA’s fair trading rule and the prudence under Reg BI’s duty of care, the court and the parties would only have to answer one simple two-part question:

At the time that the financial adviser selected a particular actively managed fund to recommend:
(a) was the actively managed mutual fund cost-efficient in comparison to other comparable available funds, including index funds, and
(b) did the actively managed mutual fund further the SEC mission statement of properly protecting investors’ best interests?”

If an actively managed fund is cost-inefficient relative to a comparable index fund, or if a comparable index fund was not even considered, I am not sure how one can argue in good faith that the actively managed fund is in any customer’s best interests Since financial advisers typically receive commissions in connection with sales of actively managed funds, you would be looking at an Epstein-like situation, where the financial adviser would profit financially, while the customer would actually be losing money relative to comparable cost-efficient investment options.

At the end of the day, we hold these truths to be self-evident:

prudent investors do not knowingly invest in cost-inefficient investments, and
recommending cost-inefficient investments to customers is not fair dealing/fair treatment.

Going Forward
As I stated earlier, if the SEC adopts Reg BI as currently written, I do not believe that it will withstand judicial scrutiny. The obvious issue that I would expect opponents of Reg BI to address is why the SEC did not just adopt the fiduciary standard set out in the Investment Advisor Act of 1940. I would provide the protection investors need and provide one uniform standard.

The SEC has tried to justify the adoption of a much lenient suitability standard on the grounds of wanting to provide investors with a choice of how they receive investment advice. With all due respect, that argument is simply “disingenuous double talk.” If I was a judge in any of these cases challenging Reg BI, I would quickly point out to the counsel that the choice of a standard of prudence in no way prohibits the business model chosen by the investment industry. It simply requires a certain level of conduct from broker-dealers and financial advisers in carrying out their business model.

The SEC’s mission statement makes their primary mission the protection of investors. In opting for a suitability standard, the SEC has deliberately chosen the weaker of two options. Again, if I were a judge hearing one of the promised challenges to Reg BI, I am asking the SEC why the less protective suitability standard was really chosen, as it definitely seems to favor the investment industry at the expense of public investors.

Another issue that I would address is the noticeable absence of any express fair dealing require such as set out in FINRA’s rules. The SEC would probably answer that such a requirement is implicit in the definition of “best interests,” but then again that should raised the issue of why Reg BI does not define “best interest” at all.

The absence of an express fair dealing requirement in Reg BI is also troubling given FINRA’s statement that it might just adopt Reg BI as well. What is unclear is whether that FINRA would eliminate its express fair dealing requirement as part of such a move, arguably eliminating a key investor protection measure.

If Reg BI were to survive all legal challenges, the question would be whether the plaintiff’s bar would argue fair dealing and prudence based upon a cost-efficient standard. Given the evidence cited herein, the adoption of such a standard would seemingly simplify the argument of such legal actions. The only question would be whether an actively managed fund’s incremental costs exceed the fund’s incremental returns relative to a comparable index fund. The strategy would also seemingly impose an extremely difficult evidentiary burden on the investment industry, given the extra costs and risks typically associated with actively managed funds relative to index funds.

Chairman Clayton has recently announced that the release of Reg BI may be sooner than later. Actual implementation would obviously be significantly delayed if the promised challenges to Reg BI do occur, especially given the expected appeals by the losing party. Something leads me to believe that these cases are going to be “doozeys” for legal eagles.

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)
5. Willam F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm
6. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c

Posted in AMVR, best interest, consumer protection, cost consciousness, cost efficient, cost-efficiency, fiduciary compliance, prudence, Reg BI, SEC, securities, securities compliance | Tagged best interests, evidence based investing, prudence, securities compliance, suitability, wealth management | Leave a comment

Simple and Sound Advice from Jack Bogle…Again

Posted on May 5, 2019 by jwatkins

Sound advice from Mr. Bogle…again. Several years ago I suggested the concept of EZ 401(k) plans in my book, “What Plan Sponsors and Plan Participants REALLY Need to Know.” ERISA only requires three broadly diversified funds. Following Mr. Bogle’s advice would greatly reduce compliance costs and potential liability exposure for 401(k) and 403(b) plans.

https://www.yahoo.com/finance/news/vanguard-founder-jack-bogle-apos-194408395.html

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, closet index funds, cost consciousness, cost efficient, cost-efficiency, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, pension plans, prudence, retirement plans, wealth management, wealth preservation | Tagged 401k, 401k compliance, 403b, 404c, 404c compliance, ERISA, fiduciary, fiduciary investing, fiduciary law, Fiduciary prudence, fiduciary standard, pension plans, wealth management | Leave a comment