And Now the Fiduciary Radar Shifts to …

Posted on April 11, 2016 by jwatkins

Now that the DOL has released its new fiduciary rule, advisers are wondering what could be “the next big thing” drawing upon the new rule. Canada has recently announced that it would conduct a sweeping investigation of the abusive marketing of “closet index” mutual funds. When one does a quick cost/benefit analysis of such funds, it is easy to see why litigation involving the marketing of such funds could easily be on the radar involving both civil and regulatory litigation. It would hard to envision a product that better meets the definition of “low hanging fruit” from a litigation and liability standpoint.

Professor Ross Miller crated a proprietary metric, the Active Expense Ratio, which calculates the effective annual expense fee for mutual funds with a high correlation of return score to an underlying market index, i.e., a high r-squared score. His findings were that such funds often had an effective annual fee significantly higher than the fund’s stated annual fee, often at least 4-5 times higher.

I created a similar metric, the Active Management Fee Factor (AMFF) , that produces a similar effective annual fee using some extra cost factors. The AMFF is generally very close to Miller’s AER, albeit slightly lower.

With the new DOL fiduciary rules, adviser need to be aware of the fiduciary rule’s emphasis on “best interests” and the challenges all advisers, in both the ERISA and non-ERISA context, will have in successfully defending fiduciary breach claims involving closet index funds.

To review I wrote earlier on the legal liability issues involved with closet index funds, click here.

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The 401(k)/404(c) Plan Sponsor’s Achilles Heels Redux

Posted on March 28, 2016 by jwatkins

With the effective date for the DOL’s new fiduciary standard getting closer, I have been receiving questions and calls from plans and fellow attorneys regarding the various obligations under the new standard. For that reason, I am re-posting an updated version of an article I posted earlier this year.

401(k)/404(c) plan sponsors need to realize that the primary reason that plans are being successfully sued involves a plan sponsor’s fiduciary duty that will not be changed due to the DOL’s announcement, a duty that plan sponsors need to address to “bulletproof” their plans. In far too many cases, liability is based primarily on a plan sponsor’s failure to properly perform the personal investigation and evaluation of a plan’s investment options.

ERISA requires that a plan sponsor make an independent investigation and evaluation of the merits of both the investment (1) and any and all service providers(2) chosen by a plan. In determining whether a plan sponsor properly fulfilled their fiduciary duty to investigate and evaluate,

[T]he determination of whether an investment was objectively imprudent is made on the basis of what the [fiduciary] knew or should have known; and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate.(3) (emphasis added)

This fiduciary duty to conduct an independent investigation and evaluation of a plan’s investment options is a plan sponsor’s first “Achilles heel.” In applying the “objectively prudence” standard, the court have held that

a decision is “objectively prudent” if “a hypothetical prudent fiduciary would have made the same decision anyway.” (4) (emphasis added)

Plan sponsors and plan service providers often try to justify questionable investment choices by relying on modern portfolio theory (MPT), the idea that investments in an investment portfolio should be evaluated individually, but in the context of the portfolio as a while. While that argument may be applicable with regard to defined benefit plans, where the employer is essentially selecting one investment portfolio which will applicable to all plan participants, the courts have rejected the MPT argument when defined contribution plans are involved.(5) As the DiFelice court pointed out with regard to defined contribution plans

Here the relevant ‘portfolio’ that must be considered is each available fund considered on its own…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 another investment option], could have theoretically, in combination, create a prudent portfolio.

The case cited by the district court in support of its heavy reliance on modern portfolio theory involves a plaintiff challenging the prudence of one investment, contained in a monolithic, fiduciary-selected portfolio. [In that case], …the fiduciary himself  consciously coupled risk y securities with safer ones to construct one ready-made portfolio for participants….Here, in contrast, modern portfolio theory alone cannot protect [the plan sponsor]…just because it also offered other investment choices that made a diversified portfolio theoretically possible.(6)

While many plan sponsors are experts at the services their company provides, many lack the knowledge, expertise and experience needed to properly evaluate and select investment options. In such cases, the plan sponsor’s fiduciary obligations require them to hire independent professional advisers.(7)

What many plan sponsors do not realize, their second “Achilles heel,” is that they cannot blindly rely on any advice provided by a third party such as a service provider or any other professional adviser.(8) The plan sponsor still has a fiduciary duty to independently “review, evaluate and understand” the third-party advice.

The plan sponsor’s Achilles heel is made more vulnerable by the fact that a plan sponsor is not legally entitled to rely on the advice of a third-party unless the third-party is “independent and impartial.”(9) As the court pointed out in the Gregg decision, parties who do, or can, receive compensation from or produce compensation for other related third parties, such as stockbrokers and insurance agents, do not meet the impartiality requirements. This simple requirement has ensnared more than one plan sponsor and will undoubtedly ensnare others since very few plan sponsors or service providers are aware of the “independent and impartial requirement.

So, a plan sponsor’s duty to investigate, evaluate and select a plan’s investment options applies whether a plan sponsor attempts to do so independently or on the basis of advice provided by a truly “independent and impartial” third-party. And as the Supreme Court recently pointed out,

[A plan sponsor’s] duties apply not only in making investments but also in monitoring and reviewing investments, which is to be done in a manner that is reasonable and appropriate to the particular investments, courses of action, and strategies involved…. In short, under trust law, a [plan sponsor] has a continuing duty of some kind to monitor investments and remove imprudent ones.(10)

The takeaway from these decisions is that plan sponsors need to be able to properly investigate and evaluate a plan’s investment options. And the numerous successful cases that have been filed, and will be filed, against 401(k) and 404(c) plans strongly suggests that many plan sponsors lack the ability to perform this vital fiduciary duty.

It has been argued that requiring a plan sponsor to perform a service that it is not suited for is inequitable and not in the best interests of the plan participants and beneficiaries. Proponents of that position argue that plan sponsors should be able to retain and completely rely on the advice of third-party experts on such duties.

Yet, experience has clearly shown that competing, and conflicting, best interests of such third-parties does not necessarily ensure that the best interests of a plan’s participants and beneficiaries are not served by reliance on a plan’s third-party advisers. Plan sponsors are often unaware that their contracts with third-party providers include “escape” clauses that effectively negate any fiduciary duties and/or liabilities that the third-party would otherwise have to a plan and its participants, leaving the plan sponsor potentially exposed to complete and personal liability for any issues that arise under the plan.

People often ask me why I publicly released my metric, the Active Management Value Ratio™ 2.0 (AMVR). This is exactly why I did so, to provide a simple means for plan sponsors to perform a simple initial evaluation of actively managed mutual funds, as they are the type of funds commonly found in most plans. While there are other aspects of a plan’s prospective or current investment options that will always need to be investigated and evaluated, the AMVR is a simple cost/benefit analysis that is based on sound, proven principles and is an appropriate due diligence technique with regard to an investment’s cost efficiency relative to a fund’s return.

I believe that most plan sponsors truly want to do the right thing, but simply lack the knowledge, expertise, and experience to do so. History has clearly shown that third-party advisers have actual or potential conflicts of interest that prevent them from providing truly independent impartial advice to a plan or its participants. That is the very reason the DOL is revising ERISA’s current provisions to hopefully better protect plans and plan participants and beneficiaries.

But plan sponsors need to understand that the new DOL fiduciary standards will not relieve them of their personal ongoing fiduciary duty to independently investigate, evaluate and monitor a plan’s investments options, even when a third-party expert, such as a 3(21) or 3(38) fiduciary, is retained. The importance of understanding how to properly evaluate a fund’s prospective and actual investment options cannot be overstated. As one court stated

 [I]f fiduciaries imprudently evaluate, select, and monitor a plan’s investment options, or do so for any purpose other than the best interest of the plan, they breach their fiduciary duties. (11)

The new fiduciary standard that the DOL will introduce provides an opportunity for truly independent and impartial third-party advisers to demonstrate their value-added proposition to plan sponsors. Plan sponsors that retain the services of third-party experts should select only those experts that are willing to assume a fiduciary status and both advise and educate both the plan and the plan’s participants on the appropriate evaluation of investment options, thereby promoting a true win-win situation for both the plan, its participants and the third-party adviser.

Notes

1. U.S. v. Mason Tenders Dist. Council of Greater New York, 909 F.Supp. 882. 887 (S.D.N.Y. 1995); Liss v. Smith, 991 F. Supp. 278, 298 (S.D.N.Y. 1998); Fink v. National Sav. and Trust Co., 772 F.2d 951, 957 (D.C.C. 1984).
2. Liss, at 300.
3. Fink, at 962.
4. Tatum v. RJR Pension Investment Committee, 761 F.3d 346 (4th Cir. 2014)
5. DiFelice v. U.S. Airways, 497 F.3d 410, 423 and fn. 8.
6. DiFelice, at 423
7. Mason Tenders, at 886; Liss, at 296.
8. Howard v. Shay, 100 F.3d 1484, 1488 (9th Cir. 1996); Donovan v. Mazzola, 716 F.2d 1226, 1234 (9th Cir. 1983 ); Donovan v. Bierwirth, 680 F.2d 263, 272-73 (2d Cir. 1982).
9. Gregg v. Transportation Workers of America Intern., 343 F.3d 833, 841 (6th Cir. 2003).
10. Tibble v. Edison International, 135 S.Ct. 1823, 1828-29 (2015).
11. In re Regions Morgan Keegan ERISA Litigation, 692 F.Supp.2d 944, 957 (W.D. Tenn. 2010).

© Copyright 2016 InvestSense, LLC. 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 adviser should be sought

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What the New DOL Fiduciary Standard Will and Will Not Do

Posted on March 14, 2016 by jwatkins

As many of you may know, I released my new book on fiduciary law last week. I was immediately flooded with emails asking me why I would release the book before the DOL’s announcement.

There is so much misinformation and conflicting information about the potential impact of the DOL’s new fiduciary standard, that it is easy to understand the confusion. But whatever the DOL announces, it is only going to change the applicability of fiduciary law to the parties involved in ERISA and possibly other pension plans. The DOL’s announcement is not going to change the long standing principles of fiduciary law, as set out primarily in the Restatement (Third) of Trust, the Restatement of Agency, and the various legal and regulatory decisions that have helped develop and fine tune basic fiduciary law.

The purpose of my writing and releasing my book on fiduciary law was to provide a means for people to learn and understand basic fiduciary law, especially those who might have to deal with fiduciary law for the first time as a result of the DOL’s announcement. Far too many times I see fiduciaries such as investment advisers and ERISA plan sponsors try to avoid liability by saying that they meant no harm or that they were unaware of the applicable legal standards. And each time the court or the regulators references the famous quote from Donovan v. Cunningham, “a pure heart and an empty head are not defenses to a claim of the breach of one’s fiduciary duties.” I often believe that every fiduciary should have that saying tattooed on their arm.

Fiduciary law, especially under ERISA, is to enforced on a purely objective basis. Subjectivity has no place in determining whether a breach of fiduciary duty occurred. People often ask me what is the best way to get a better understanding of fiduciary law. Aside from the obvious answer, my short book, I tell people that they should take the time to read Section 90 of the Restatement (Third) of Trusts, otherwise known as the Prudent Investor, both the section’s black letter law and all of the comments. Yes, it is dull and boring, but it is the authority. Second, I tell people to read the Enron decision in its entirety, as the court handed down an excellent analysis of fiduciary law under both ERISA and the Restatement (Third) of Trusts. It’s over 100 pages long and you may have to take several breaks. but it is one of the best analyses of fiduciary you will ever read.

 

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“The Prudent Investment Adviser Rule™: Risk and Liability Management for Investment Fiduciaries”

Posted on March 8, 2016 by jwatkins

With the pending release of the Department of Labor’s new fiduciary standard, I am happy to announce that my new book and ebook, “The Prudent Investment Adviser Rule™: Risk and Liability Management for Investment Fiduciaries,: are now available at amazon.com.

I have always given my consulting clients a copy of the book to help them better understand the applicable laws and better protect themselves and their practices against unwanted and unnecessary liability exposure. The book also contains passages from key legal decision to clarify common errors and the steps necessary to avoid same.

Many people have questioned the timing of the release of the books before the DOL announces its new rules. The DOL’s new standards are not expected to change existing substantive fiduciary law, only to expand the applicability of same. Therefore the books are meant to help all investment fiduciaries, e.g., investment advisers, pension plan sponsors, trustees, and stockbrokers, better understand what their true legal obligations are to clients.

If the DOL does make some earth shattering to existing fiduciary law, I will obviously release an appropriate press release updating everyone the change.

 

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Outsourcing: Panacea or Placebo?

Posted on March 8, 2016 by jwatkins

Outsourcing has become a buzzword in the investment advisory industry. I have had many RIA firms tell me that they have outsourced bot their compliance and wealth management functions, allowing them to concentrate solely on marketing and  gathering assets. In the words of noted ESPN football analyst Lee Corso… not so fast my friend.

Outsourcing may be an appropriate and strategy if one lacks the ability to perform the function being outsourced. However, the idea that the entity outsourcing the function has no ongoing responsibility is completely wrong, and leaves the outsourcing to all kinds of serious legal consequences.

With regard to the outsourcing of compliance duties, regulators have made it clear that entities who outsource their compliance duties still have a duty to monitor such third-parties and remain ultimately liable for their firm’s compliance with all applicable rules and regulations. Back in the 90’s, the NASD addressed this issues with regard to the popular OSJ system used by most indie broker-dealers, where one OSJ may have the responsibility of supervising 100 or more registered representatives in various offices. The NASD addressed these issue in Notice to Members 99-45, which essentially required indie broker-dealers to make drastic revisions in their supervisory programs to provide more meaningful field supervision of their brokers.

Two of the primary concerns with regard to the outsourcing of compliance duties has to do with the qualifications and experience of the third-party to whom the compliance duties are being outsourced and the lack of on-site supervision by the third-party. The qualifications and experience issue speaks for itself. The fact that most third-party compliance providers are not actually on-site has always raised concerns as to just how effective their compliance oversight can be, especially if they are providing such services to a large number of firms and brokers.

Outsourcing of wealth management responsibilities raises a number of potential issues, including possible double-dipping and quality control monitoring and supervision. Double-dipping refers to a situation where an investment advisory firm represents and contracts with a client to personally mange their asses, but instead outsources the actual management to a third-party.

Given the fact that the advisory firm is not actually managing the client’s assets, the advisory firm should reduce its fee accordingly to account for the actual management by the third-party. An obvious way for the advisory firm to address this issue is the modify their advisory contract to specify exactly what services they are, and are not, providing. Failure to do so could result in liability based on various grounds, including fraud, breach of fiduciary duty, and breach of contract.

Another issue with regard to outsourcing of wealth management duties has to do with the advisory firm’s fiduciary duty to provide ongoing monitoring of the third-party to whom the wealth management services were outsourced and, if necessary, to replace the third-party and, if necessary, to sue the third-party for damages. These ongoing duties are based primarily on the fact that clients generally select fiduciaries on the trust that they have in the person or entity. As a result, the law, while allowing outsourcing, requires the original fiduciary to keep ultimate responsibility for the management of the client’s account.

So to answer the original question, in many ways outsourcing is nothing more than a placebo since the advisory firm still has ultimate responsibility for proving ongoing services to ensure that the account is properly handled and, if not, the advisory firm can be held liable for violations of their fiduciary duty. If a client contracts directly with a third-party wealth management firm, then the advisory firm may not be liable for mismanagement by the third-party, but could still possibly be held liable for their recommendation of the third-party based on a failure to properly conduct due diligence on the third-party.

Both the NASD and FINRA have both recognized the potential  issues with outsourcing. In NASD Notice to Members 05-48 and FINRA Regulatory Notice 11-48, the regulators addressed such issues. FINRA proposed a new rule, Rule 3190, to set out the requirement for the outsourcing of legal responsibilities. While the Rule has never been enacted and investment advisers and their advisory representatives may not be subject to FINRA, the Notices provide useful guidelines for investment advises of issues to address to avoid unnecessary liability exposure.

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2016 So Far and the Levy Decision

Posted on March 4, 2016 by jwatkins

I recently posted an article on my blogs about the fact that not everyone is losing money in 2016. I had several people respond negatively, some rudely so, suggesting that I did not understand the cyclical nature of the stock market. Not only do I understand the cyclical nature of the market, I also understand the legal decisions that have dealt with the cyclical nature of the stock market and have addressed the legal obligations of investment advisers and other investment fiduciaries in light of said cyclical nature.

Recently we have seen a number of mutual funds begin to offer so-called low volatility mutual funds for investors who have become skittish due the increased volatility in the U.S. stock markets. These low volatility funds basically overweight less volatile sectors in the stock market in hopes of reducing the fund’s overall volatility. In exchange for reduced volatility, investors need to understand that they are potentially giving up some upside return that is often provided by historically more volatile sectors, such as technology, in bull markets.

One such fund, the S&P 500 Low Volatility High Dividend Index Fund (SP5LVHD), has a YTD return of 7.11% (through 3-3-2016) versus a 3.35% loss on the S&P 500 Index. The fund’s return is probably a testament to both its low volatility orientation and the impact that dividends have historically on total market returns. According to Standards & Poors, since 1926, the income from dividends has accounted for approximately 33% of the S&P 500 Index’s total returns. More recently, during the twenty-five year period of 1989-2014, dividends accounted for approximately 50% of the S&P 500 Index’s total return.

Does that every investor should invest in low volatility mutual funds and/or the S&P 500 Low Volatility High Dividend Index? Not at all. Obviously depends on a client’s personal investment parameters and needs. The funds were mentioned to illustrate possible considerations for investors in light of adverse market indicators.

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

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. When he asked his adviser if there were ways to mitigate his potential loss, the adviser did not discuss the possible use of options 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 collars, that could have provided the client with the downside protection he had sought. The client sued the initial adviser for his misrepresentation and negligence in not alerting the client 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. Whether an advisers likes or dislikes a particular strategy that could provide a client with downside protection, Levy and other similar decisions have established that investment advisers and other invest-ment fiduciaries have, at a minimum, a legal duty to advise a client of such strategies, both the positive and negative aspects of same, and then let the client decide on whether to use same. The adviser should also document both the disclosures that the adviser provided and have the client acknowledge their decision in writing.

I have already had a couple of advisers call me telling me that some of their clients were upset over the 2016 losses and mentioning legal action against them. As I have said on numerous occasions, the decision to own one’s own RIA firm includes the duty to learn and stay current with all applicable legal and compliance standards. Under 94-44, a broker-dealer only has a legal obligation to monitor and supervise their registered representatives that also serve as investment adviser representatives (IAs). As the court pointed out in Levy, if you hold yourself out to the public as an IA, you are representing that you have the special knowledge associated with such a position.

Many people are predicting a down year for the U.S. stock markets. While no one can predict the future, advisers should consider whether to discuss available investment strategies that could provide clients with downside protection. For some clients, especially older and risk averse clients, low volatility mutual funds, including the S&P 500 Low Volatility High Dividend Index fund might be a viable option for at least a portion of their portfolio.

Note: The Levy decision is available at 1997 U.S. Dist. LEXIS 11056. A discussion of the case is available online at http://corporate.findlaw.com/litigation-disputes/s-amp-p-index-too-speculative-to-prove-lost-profits-against.html

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401K Mutual Funds Fail Fiduciary Prudence Test

Posted on January 18, 2016 by jwatkins

Our recent analysis of the top ten mutual funds in 401(k) plans revealed that 7 of the 10 funds failed to pass our simple fiduciary prudence test. The funds were evaluated based on their five-year performance between 2011-2015. The findings should alert both 401(k) sponsors and plan participants to the possible implications, both in terms of prudent investing and potential liability issues.

The results of the test can be found at http://bit.ly/1OBD8xI

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, compliance, evidence based investing, fiduciary compliance, fiduciary law, investments, pension plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , | Leave a comment

Some Common RIA Mistakes That Regulators Are Focusing On in 2016

Posted on January 11, 2016 by jwatkins

Going to start the new year with a rather brief, but important, post. The regulators have announced their intent to perform more RIA audits in 2016. Some recent cases have highlighted issues that do not regularly receive the amount of attention as some other RIA/fiduciary issues.

There have been several cases recently involving the misrepresentation of an adviser’s AUM. Any type of misrepresentation by an adviser would be a violation of Section 206 of the Advisers Act of 1940. While AUM is always subject to fluctuation due to market pricing, withdrawals, distributions and clients leaving, significant variations in AUM are always going to draw the attention of regulators. Significant increases in AUM also raise a red flag. As long as you can properly document your AUM claims, you should have no problem.

Another area that regulators have been focusing on is variances between an adviser’s advisory contract and an adviser’s Form ADV/Disclosure Document. The information provided within these documents should always be consistent. Since the advisory contract actually defines the relationship between an adviser and their client, it will usually be the controlling document unless enforcement of same would be inequitable to a client. This is consistent with the general rule of law that documents will generally be construed against the party who drafted the document.

Along those same lines, language in a contract that attempts to have a client waive rights owed to them by their adviser are void as against public policy. This would also be construed as a violation of the adviser’s fiduciary duty of loyalty, a duty to always put a client’s interests first. This is one reason why I generally advise my consulting clients not to include an arbitration agreement in their advisory contracts. A good securities attorney will jump on that alleging the issues I just discussed.

Asking a client to waive the important rights and advantages possible in trying a case in court, especially the right to conduct meaningful discovery, as opposed to the questionable arbitration process is clearly not in a client’s best interests. Not all my clients follow my suggestion since their broker insists that they include a binding arbitration clause. That’s their choice, but if they own their own RIA, I remind them of that and that they, not their B-D, will be liable if the decisions go against them.

Finally, be sure that you are not misrepresenting the true identity of the investment advisory firm. Simply put, the registered RIA is the name shown on the certificate a firm receives when it registers, not any assumed or fictitious name, i.e., dba name, the firm is using publicly. Contracts executed using only a fictitious name are generally void since there is actually no entity with that name. In such cases, advisers will be required to return any and all money received pursuant to the fraudulent advisory contract.

The proper identification of the advisory firm often comes up involving dually registered representatives who who are offering advisory services through their B-D’s proprietary RIA firm. For some reason, the reps do not want to use the B-D’s RIA’s registered name, but want to use their own fictitious name, presumable to impress prospective clients.

A good compliance department would catch this and ensure proper identification of registered advisory firm, such as “B-D Advisers dba Greatest Investment Adviser in the World,” on all advisory contracts. And yet every year, I run across advisory contracts that are executed using only the GIAW name, subjecting them to possible revocation and substantial fines and other monetary penalties.

Offenders often try to justify the violation by saying that their business cards indicate that advisory services are offered through their B-D. But a business card is generally not considered part of the advisory contract and the “four corners”rule is usually applied to contracts,  meaning that only that which is within the four corners of a page will be considered as part of the contract.

Since the 2015 year-end performance numbers are out, I will be updating the sample of the ERISA Forensic Fiduciary Prudence Analysis sometime this week. I will post a notice on the blog once I have posted the update on SlideShare.

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Combining the Active Management Value Ratio 2.0™ and the Active Expense Ratio – A More Meaningful Evaluation of Fiduciary Prudence

Posted on December 30, 2015 by jwatkins

“The two variables that do the best job in predicting [a mutual fund’s] performance are expense ratios and turnover.”- Burton Malkiel, “A Random Walk Down Wall Street”

Registered investment advisers and their representatives are fiduciaries. The courts have consistently held that a fiduciary’s duties are “the highest standard of care at law or equity,” requiring that the adviser’s advice be truly disinterested. As legendary Justice Benjamin Cardoza stated, a fiduciary must act not simply with “honesty alone, but the punctillo of an honor the most sensitive….”

Fiduciary law is based primarily on common law trust and agency principles. While there are some differences between fiduciary duties under common law and ERISA, the duties are similar in many ways, especially the focus on cost control and risk management through effective diversification. This post will focus on cost control/efficiency, while the next post will focus on a fiduciary’s duties regarding effective risk management.

A fiduciary has a duty to control costs and avoid unnecessary expenses. As most fiduciaries are well aware, the issue of excessive fees has been, and continues to be, the subject of numerous multi-million dollar ERISA lawsuits and settlements.

InvestSense, LLC introduced its own metric, the Active Management Value Ratio 2.0™ (AMVR), which provides a means for evaluating the cost efficiency of actively managed mutual funds. The AMVR is a simple cost/benefit analysis that compares an actively managed fund’s incremental cost to its incremental return. More information about the AMVR and the calculation methodology, can be found in the white paper, “Management Value Ratio 2.0™ on this site and here.

The AMVR uses an actively managed fund’s stated annual expense ratio in calculating the fund’s incremental costs. However, given the fact that more funds are closement ely tracking their relevant benchmark, the actual contribution attributable to active management is reduced. Therefore, a fund’s stated annual expense ratio can understate the effective/implied cost of the active component of a mutual fund, and thus the overall effective cost of an actively managed fund.

The Active Expense Ratio (AER), a metric created by Professor Ross Miller of the University of New York, addresses this very issue. Like the AMVR, the AER is relatively simple to calculate, requiring very little information, all of which is freely available online at sites such as morningstar.com and yahoo.finance.com.

The first step in calculating an actively managed fund’s AER is to calculate the “active weight” (AWt) of the fund. The calculation simply requires the fund’s R-squared rating. Morningstar defines R-squared as the “measurement of the relationship between a portfolio and its benchmark….An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark….Conversely, a low R-squared indicates that very few of the portfolio’s movements can be explained by movements in its benchmark index.”

Using a fund’s R-squared rating, a fund’s AWt is calculated by using the equation

AWt = SQRT(1-R-squared)/[SQRT(R-squared) + SQRT(1-R-squared)]

AER is simply a fund’s incremental costs divided by the fund’s AWt (IC/AWt). The fund’s incremental costs are calculated as part of the AMVR calculation, making the calculation of AER that much easier.

The majority of domestic equity-based mutual funds currently have R-squared ratings above 90, with many domestic large-cap funds having an R-squared rating above 95. InvestSense uses 90 as the minimum R-squared rating for classification as a “closet index” fund. So using that number as a fund’s R-squared rating, 1.00 as the fund’s stated expense ratio, and 0.72 as the fund’s incremental costs, the resulting AER would be

AWt = SQRT(0.10)/(SQRT(0.10) + SQRT(0.90) = 0.3162/0.3162 + 0.9486 = 0.2499

AER = Fund’s stated expense ratio + (Fund’s incremental cost/AWt) = 1.00 + (0.72/ 0.2490) = 3.88

So, the actively managed fund’s effective annual expense ratio would be 3.88, or almost 300% higher that its stated annual expense ratio. The significant difference in expense ratios makes it extremely hard to successfully argue that the actively managed fund is cost efficient and a prudent choice, especially once the fund’s AMVR score is re-calculated using the fund’s AER. Bottom line, the higher a fund’s R-squared rating and/or the higher the fund’s incremental costs, the higher the fund’s AER and resulting effective expense ratio, and thus the less prudent the fund becomes.

A recent study by noted finance professors Eugene Fama, a Nobel laureate, and Kenneth French found that only the top 3 percent of active fund managers provided returns in excess of their fund’s costs. That number will likely be further reduced when a fund’s AER rating is incorporated into the calculation of the fund’s AMVR score.

Given the recent trend of a high correlation of returns between U.S. domestic equity funds and a resulting higher percentage of “closet index” funds, calculating a fund’s AMVR using its AER rating is both valuable and justifiable, as it provides a better perspective of the fiduciary prudence of a fund. Fiduciaries that recommend actively managed mutual funds that fail to provide investors with a commensurate return for the higher costs associated with actively managed funds face the risk of a breach of fiduciary claim.

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, evidence based investing, fiduciary compliance, fiduciary law, investments, pension plans, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , | Leave a comment

ERISA, Fiduciary Duty and the Art of Skinnydipping

Posted on November 19, 2015 by jwatkins

Only when the tide goes out do you discover who’s been swimming naked. – Warren Buffett

As followers of this blog know, I normally post once a month. However, I am making an exception due to the importance of the subject matter.

This morning I met with a prominent law firm and performed a forensic fiduciary liability audit on their firm 401(k) plan. When I reviewed my findings with the firm’s managing partner and the head of their 401(k) investment committee to review my findings, they were clearly shocked by my projections as to their current liability exposure. After I went over the key data, they were mad, very mad, but they realized I was right and are dedicated to correcting the problems.

If you are a registered investment adviser, you are overlooking one of the greatest potential work opportunities if you are not helping 401(k)/404(c) plans. Fred Reish, one of the nation’s top ERISA attorneys, identified the opportunity with his observation that

our experience is that very few plans actually comply with 404(c). It is probable that most (perhaps as high as 90%) 401(k) plans do not comply with 404(c) and, as a result, the fiduciaries of those plans are personally responsible for the prudence of the investment decisions made by participants.

Compare Reish’s 90 percent figure with a recent study that reported that 94.6 percent of the 401(k)/404(c) plan sponsors surveyed believed that they were compliant with applicable 401(k)/404(c) regulations.

And it’s not just plan sponsors who simply do not truly understand the investment obligations of ERISA fiduciaries and the proper way to evaluate investment options. The Supreme Court’s recent decision in Tibble v.Edison International  clearly established an ERISA fiduciary’s ongoing duty to monitor a plan’s investment options and remove any unsuitable investment options within a plan. But before the SCOTUS ruling, the Ninth Circuit clearly indicated its lack of understanding regarding the fiduciary duties under ERISA’s prudent man standard when it denied Tibble’s claims with regard to the plan’s imprudent selection of the plan’s investment option, stating that

Nor is the particular expense ratio range out of the ordinary enough to make the funds imprudent…and there were roughly forty mutual funds to choose from.(1)

To be fair, the Ninth Circuit is not the only court to take such an indefensible position. But you would think that courts would educate themselves on the appropriate method to evaluate the prudence, or lack thereof, of investment options.

Stockbrokers and financial advisers who rely on commissions often object when the issue of fees on actively managed mutual funds is brought up , responding that the relative performance of a fund should also be considered. And they are right. Unfortunately, the well-documented consistent under-performance of actively managed mutual funds completely undercuts their arguments.

ERISA states that plan sponsors and other plan fiduciaries cannot simply accept the advice provided by third-parties such as stockbrokers, as there are obvious potential conflict of interest issues which can, and often do, impact the quality of such advice. As the Ninth Circuit properly pointed out in dismissing Edison’s blind reliance on their investment consultant,

HFS is its consultant, not the fiduciary. [Plans are required to] make certain that reliance on the expert’s advice is reasonably justified under the circumstances….Just as fiduciaries cannot blindly rely on counsel, …a firm in Edison’s position cannot reflexively and uncritically adopt investment recommendations.(2)

In applying ERISA’s fiduciary’s duties, the courts have consistently held that plan sponsors and other plan fiduciaries must conduct their own thorough and objective analysis of potential investment options for a plan. The courts have emphasized the importance of a plan sponsor’s independent investigation, stating that

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.(3)

The failure to make an independent investigation and evaluation of a potential plan investment is a breach of fiduciary duty.(4)

And there it is, the opportunity for registered investment advisers. The law imposes a duty on plan sponsors to conduct a thorough, objective and independent investigation of potential plan investment options.  The problem is that, to put it bluntly, most plan sponsors have absolutely no understanding as to how to properly conduct such an investigation and therefore, the evidence suggests that, in many cases, thtey do not do so, hoping that they will not get caught.

My father once told me that putting your head in the sand and trying to ignore a problem simply provides your opponents a bigger target. Once I do a fiduciary liability audit and discuss my findings with the plan’s fiduciaries, I often get a response along the lines that their employees are not going to sue the company because they fear losing their jobs.

What plan sponsors do not seem to understand is that those employees eventually become former employees. Most of the current 401(k) excessive fees and breach of fiduciary duty cases are being filed by former employees. Divorcing spouses and the heirs of former employees are increasingly filing actions against 401(k)/404(c) plans. After all, they have nothing to lose and most plans will either settle or lose the cases since, as Reish points out, the majority of such plans are non-compliant.

I often hear investment advisers complain that they simply cannot get a foot in the door to even talk with 401(k)/404(c) plans. I have never had that problem. I ask for fifteen minutes and then I simply tell them how many funds are imprudent and show them the plan’s, as well as their personal, projected current liability. After that, they are more than willing to talk. After all, “money talks.”

Plan fiduciaries hear adviser after adviser tell them they can provide better advice than the plan’s current adviser, so the fiduciaries dismiss such promotion. My suggestion – show the plan’s sponsor and other plan fiduciaries how the plan’s current configuration might hit them personally in their wallets, (remember, plan fiduciaries face unlimited personal liability, including punitive damages, for a breach of their fiduciary duties) and all of a sudden they have all the time in the world to listen to you since you can back up your numbers. Sometimes they’ll even order lunch for everyone.

No one knows for sure when another correction or bear market is going to occur. However, history has shown that the markets are cyclical and bear markets are going to occur, often when least expected. History has also shown that the markets often react to sudden world events. Given the current state of world affairs, a serious market downturn or even a bear market may occur much sooner than expected. And when such events occur, you can be sure that there will be those who look to their 404(k)/404(c) plan now that more people have heard about the multi-million dollar settlements involving such plans and the fact that so many plans and plan fiduciaries will not be able to successfully defend actions against them.

The opportunities are out there. The large multi-national corporations may not want to listen, but there are plenty of local law firms and medical firms that need your services…they just do not know it yet. Based upon my experience as a compliance director, doctors and lawyers are often bad investors. If you make the proper presentation (fiduciary duty to put their interests first, then the identification of imprudent investments and projected potential liability, then a reminder that a loss is not necessary to find one guilt of a breach of one’s fiduciary duties), you should be on your way to a new client.

Notes

  1. Tibble v. Edison International, 711 F.3d 1061, 1083 (9th Cir. 2013)
  2. Tibble, at 1083
  3. Fink v. Nat’l Savs. & Trust Co., 772 F.2d 951, 957 (D.C. Cir. 1985)
  4. U.S. v. Mason Tenders Dist Council of Greater NY, 909 F. Supp. 882, 887 (S.D.N.Y. 1995)

 

 

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, compliance, evidence based investing, fiduciary compliance, fiduciary law, investments, pension plans, retirement plans, RIA, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , | Leave a comment