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

Posted on December 7, 2019 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

ERISA likewise seeks to ‘protect the interests of participants in employee benefit plans’ by imposing high standards of conduct on plan fiduciaries. Applying trust law’s burden-shifting framework, which can serve to deter ERISA fiduciaries from engaging in wrongful conduct, thus advances ERISA’s protective purposes.7

By contrast, declining to apply trust-law’s burden-shifting framework could create significant barriers to recovery for conceded fiduciary breaches.  The fiduciary is in the best position to provide information about how it would have made investment decisions in light of the objectives of the particular plan and the characteristics of plan participants. Indeed, this Court [has] recognized… that it is appropriate in some circumstances to shift the burden to establish ‘facts peculiarly within the knowledge of” one party.8

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

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

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

Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”10  (citations omitted)

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

When market [aka index] funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.”11

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

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

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

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

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

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

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

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

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

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.17
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.18
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.19
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.20

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

Determining the cost-efficiency of a fund also requires an evaluation of a fund’s stated and effective fees and expenses. In evaluating a fund’s fees and expenses, most investors and fiduciaries only focus on a fund’s annual expense ratio and any sales charges, or loads. However, studies by respected investment experts such as Burton Malkiel21,  Mark Carhart22, and Roger Edelen23 have concluded that the two most reliable predictors or a fund’s success are it s annual expense ratio and its trading costs.

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

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

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

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

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.24
Charles D. Ellis

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


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

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

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

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

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

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

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

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

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

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

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

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

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

Additional information about the AMVR is available throughout this blog.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018).
2. Amicus Brief of Solicitor General Noel Francisco (hereinafter “Amicus Brief”), available at https://bit.ly/2Yp00xt
3. Amicus Brief,  I>
4. Amicus Brief, 7
5. Amicus Brief, 8.
6. Amicus Brief, 10,
7. Amicus Brief, 11,
8. Amicus Brief, 11.
9. Amicus Brief, 12.
10. Brotherston v. Putnam Investments, LLC, 907 F.3d 17, 39 (1st Cir. 2018).
11. Langbein, John H. and Posner, Richard A., “Market Funds and Trust-Investments Law,” (1976), Faculty Scholarship Series Paper 498, http://digitalcommons.law.yale.edu/fss_papers/498.
12. Amicus Brief, 20.
13. Restatement (Third) Trusts, cmt. b (American Law Institute).
14. Restatement (Third) Trusts, cmt. f (American Law Institute).
15. Restatement (Third) Trusts, cmt. h(2) (American Law Institute).
16. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010);
Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e;  Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016; Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
17. Laurent Barras, Olivier Scaillet and Russ Wermers, supra.
18. Charles D. Ellis, supra.
19. Philip Meyer-Braun, supra.
20. Mark Carhart, supra
21. Malkiel, Burton  “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
22. Carhart, supra.
23. Roger M. Edelen, Richard B. Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” available at http://www.ssrn.com/ abstract=951367
24. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”               available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
25. Malkiel, Burton  “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
26. Restatement (Third) Trusts, cmts. f, h(2), and m (American Law Institute).
27. Ross M. Miller, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol. 5, No. 1, First Quarter 2007. Available at SSRN: https://ssrn.com/abstract=972173
28. https://www.morningstar.com/InvGlossary/r_squared_definition_what_is.aspx
29. https://bit.ly/367BIdJ
30. https://www.finra.org/rules-guidance/notices/12-25
31. https://www.finra.org/rules-guidance/rulebooks/finra-rules/2111
32. Berlin City Ford, Inc. v. Roberts Planning Group, 864 F. Supp. 292 (D.N.H. 1994)
33. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983)

© Copyright 2019 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual 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, closet index funds, compliance, consumer protection, cost consciousness, cost efficient, cost-efficiency, ERISA, ERISA litigation, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, Reg BI, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , | Leave a comment

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

Posted on November 14, 2019 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

As the court noted,

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

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

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

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

In other cases, the courts have stated that

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

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

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

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

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

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

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

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

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

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

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

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

Rule 10b-5 provides that

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

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

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

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

in connection with the purchase or sale of any security.

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

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

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

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

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

© Copyright 2019 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual 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, asset allocation, closet index funds, compliance, fiduciary compliance, fiduciary law, fiduciary liability, Fiduciary prudence, fiduciary standard, investment advisers, investments, pension plans, prudence, RIA, RIA Compliance, risk management, securities compliance, wealth management | Tagged , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

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

Posted on October 28, 2019 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

The pertinent sections of Reg BI state that

240.15l-1 Regulation Best Interest

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

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

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

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

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

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

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

  1. the recommendation of cost-inefficient mutual funds;
  2. the recommendation of “closet index” mutual funds; and
  3. 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.13  In 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

© Copyright 2019 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual 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 , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

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

Posted on October 5, 2019 by jwatkins

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

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

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

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

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

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

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

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

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.1
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.2
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.3
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.4

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

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

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

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

Notes
1. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
2. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e.
3. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
4. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).

© Copyright 2019 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual 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, 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 , , , , , , , , , , , , , , , , , , , , | 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:

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).

© Copyright 2019 The Watkins Law Firm. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual 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, 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 , , , , , , , , , , , , , , , , , , , , , , | 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/

© Copyright 2019 The Watkins Law Firm. All rights reserved.

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 , , , , , , , , , , , , , , , , , , | 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 , , , , , , , , , | 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.

© Copyright 2019 The Watkins Law Firm. All rights reserved.

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, 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 , , , , , , , , , , , , , , , , , , | 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,”1 essentially 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 Epstein2 and Wendell D. Belden3  decisions, 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)

Copyright © 2019 The Watkins Law Firm. All rights reserved.

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 , , , , , , , , | 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).

© Copyright 2019 The Watkins Law Firm. All rights reserved.

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, 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 , , , , , , , , , , , , , , , , , | Leave a comment