Has Schwab Opened Pandora’s Box for RIAs? – Part Two

Posted on March 13, 2013 by jwatkins

In a recent post, I suggested that the recent court decision upholding Schwab’s class action waiver in customer’s contracts could have potential liability implications for RIAs and other fiduciaries that recommend or use Schwab, or for that matter any other broker-dealer who adopts such a provision, as a custodian for their clients’ accounts.

Ron Rhoades, someone for whom I have the utmost respect, was kind enough to respond with an excellent analysis discussing points and counter-points to some of my comments. Full disclosure requires me to admit that I had personally notified Mr. Rhoades of my post in hopes that he would respond with his usual expertise. He did not disappoint. Mr Rhoades response can be seen at http://scholarfp.blogspot.com/2013/03/schwabs-forced-customer-waiver-of-right.html

First, a few housekeeping details. As expected, I received quite a few nastygrams.  Despite allegations to the contrary, my post was not meant as an attack on Schwab. Quite the opposite. Schwab is doing what any good business would do, enacting risk management programs to protect their business.

RIAs and other fiduciaries would do well to heed Schwab’s message. In my opinion, the number one mistake that RIAs and other fiduciaries make is failing to implement an effective risk management program for their own businesses. RIAs can have all the manuals and other compliance materials required by the ’40 Act or their state’s applicable regulations.  But unless they have implemented and followed an effective risk management program for their RIA, all it takes is one legal action to effectively dismantle their business, especially since a private legal action is often followed by a regulatory audit.

Schwab is taking a prudent action to try to protect their business.  However, unless a customer signs Schwab’s agreement, Schwab owes them no duty, fiduciary or otherwise.  Given current laws and legal decisions, Schwab, as a broker-dealer, would generally not be deemed a fiduciary to a client that signs their agreement with the class action waiver provision.

On the other hand, RIAs and other fiduciaries who might recommend or use Schwab, or any other broker-dealer who adopts a similar class action waiver requirement, would already be in a fiduciary relationship with their client, and thus would have concerns that Schwab would not. While I am not advocating that RIAs and other fiduciaries not do business with Schwab or other broker-dealers that may adopt the class action waiver policy, the fact that Schwab and RIAs and other fiduciaries are in significantly different positions as far as potential liability exposure simply cannot, and should not, be ignored by RIAs and other fiduciaries.

As I mentioned in my earlier post, I think the likelihood of a finding of a fiduciary would increase in large part on the benefits that an RIA or other fiduciary received from the broker-dealer. As a former compliance director, both RIA compliance and general compliance, broker-dealers generally provide registered representatives and RIA affiliates with various forms of benefits.

In terms of the class action waiver issue, it could be argued that the receipt of such benefits could constitute a breach of the fiduciary duty of loyalty and an impermissible conflict of interest. A fiduciary’s duties impose an even higher duty on the fiduciary and allegations of breaches of such duties are closely scrutinized, with little, or no, margin of error.  Famed jurist Benjamin Cardozo clearly explained the high standard for fiduciaries in his landmark decision in Meinhard v. Salmon, when he stated that

A [fiduciary] is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctillo of an honor the most sensitive, is then the standard of behavior….

Mr. Rhoades has suggested that RIAs should provide greater disclosure if they should choose to do business with a broker-dealer that requires customers to agree to the class action waiver. While I am certainly an advocate for greater transparency in the financial services industry, I am not sure that greater disclosure would prevent a finding of a breach of fiduciary duty.

My opinion is based primarily on the unyielding attitude that the courts take towards protecting the public and enforcing the well-established duties of a fiduciary.  A breach of fiduciary duty claim can be upheld even if the alleged breach did not result in any actual harm to a client, as court will often base their decision on not allowing an otherwise offending fiduciary to avoid liability due to fortuitous circumstances.

The courts are even more vigilant when an alleged breach of fiduciary duties involves a conflict of interests involving a fiduciary’s financial self interests.  As noted by the court in Hughes v. Securities and Exchange Commission, when one both provides financial advice and sells investments products, there is an inherent conflict of interests. Given this conflict, the court stated that the courts will review such cases in order to ensure that the public is not taken advantage of or otherwise harmed.

In light of these judicial positions, I am not sure that any extent of disclosure will save an act that otherwise constitutes a breach of one’s fiduciary duties. Fiduciary duties are essentially absolute, a message reinforced by the “pure hearts, empty head” quote.

From a risk management perspective, the best course of action would be simply to avoid engaging in any actions which could be interpreted as a breach of one’s fiduciary duty, any actions in which a question could arise as to whether the fiduciary’s actions were in the client’s best interest. One of my client asked me if it would permissible to have a client sign a waiver to protect against such potential liability. The simple answer…no. After all, that’s the whole issue here, asking a client to waive a significant legal right. Furthermore, any RIA that asks a client to waive a legal right could be prosecuted for fraud under Section 206 of the ‘Act.

If you compare my original post and Mr. Rhoades response, I think you will find that our opinions are not that different.  We both support the idea that the class action waiver provision could have potentially significant liability implications for RIAs and other fiduciaries given the different standards of legal liability review for the parties.  I think we both agree that RIAs and other fiduciaries need to be more conscious of the importance of designing effective risk management programs for the RIA and other fiduciary practices.

When I joined LinkedIn, it was with the hope that the site would provide interesting posts and conversations that would benefit both myself and fellow professionals in managing their practices and better serving their clients. I know that I have enjoyed this discussion with Mr. Rhoades. As I mentioned earlier, I have always respected him and his expertise, and continue to do so.

Selah.

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Has Schwab Opened Pandora’ Box for RIAs?

Posted on March 11, 2013 by jwatkins

Schwab’s recent victory upholding its class action waiver provision in its customer contracts raises a number of potential issues for fiduciaries, especially since most B/D’s can be expected to follow suit with similar provisions if Schwab’s waiver provision withstands the anticipated appellate review.  In most cases, broker-dealers (B/D’s) are not held to a fiduciary standard, so actions that they take may not raise the same fiduciary concerns that such actions may raise for RIAs.

After the Schwab decision was announced, I had a number of clients call me and ask me what, if any, ramifications would it have on them. Many of the callers suggested that anything Schwab did should not have any ramifications on them since they could not control Schwab’s actions. While this is certainly true, it does not follow that RIAs and other fiduciaries can ignore potential implications of the class action waiver.

Fiduciary law is based primarily on trust law and agency law.  The fact that RIAs are fiduciaries is clearly established by law. As fiduciaries, RIAs owe their clients a duty of loyalty, a duty to always put the clients interests first and to disclose any actual or potential conflicts of interest.

RIAs routinely maintain relationships with B/D’s. In some cases, RIAs receive soft dollar benefits from B/D’s in exchange for the RIA’s recommending that the client open or maintain a custodial account with the B/D. These soft dollar arrangements often involve the B/D providing an RIA with research and/or money for office provisions.

The right to participate in a class action is a potentially important legal right for many investors.  Class actions have long been criticized on many fronts, including the potential to bring frivolous lawsuits and using leverage to force defendants to settle actions rather than bear the financial burden such actions often create.

As a trial attorney, I feel compelled to point out that in many cases, class actions are the only realistic opportunity that those whose rights have truly been violated have to seek redress for such wrongs.  The costs of litigation can effectively prevent some victims from pursuing claims unless they can pursue a class action.

Like it or not, the law says that there shall be a right for every wrong, whether in law or equity. As is often the case, people do not care about inequitable treatment  or unjust laws until and unless it involves them or their family. Professional prejudices aside, denying the public access to the legal system flies in the face of fundamental rights guaranteed by the Constitution.

OK, I’m off the soap box.  Back to the issue at hand, the potential implications of a class action waiver provision in B/D customer contracts.  In my opinion, an RIA that knowingly recommends that clients open or maintain an account with a B/D that requires that customers waive their legal rights, including an important legal right such as the right to participate in class actions, may very have violated their fiduciary duties. The situation should definitely concern RIAs.

I can already hear the argument that “I’m not an attorney, so I cannot give legal advice.” With all due respect, that is not the point.  Giving up a legal right is an important issue. Both federal and state RIA laws prohibit any advisory contract that requires a client to give up any legal right. RIAs can put in certain clauses that address a client’s legal rights. However, any RIA that chooses to do so must include “clear and conspicuous” language stating that such language is not meant as a waiver of a client’s legal rights.

Supporters of the waiver provision will argue that a client can simply choose not to open an account with a B/D that requires a class action waiver provision or, if their RIA only works with B/D’s that use such a provision, the client can find another RIA. Is that really what RIAs want?  RIAs work so hard to find clients and develop strong client relationships as it is.

If the Schwab provision is upheld on appeal, it is reasonable to assume that other B/D’s will adopt similar provisions in order to protect themselves.  If so, would clients really have a choice? Common sense would suggest that a few B/D’s would not follow suit for marketing purposes and to grow their own business, but due diligence review may raise other fiduciary issues for RIAs and/or clients. Would it be in an RIA’s best interests to work with more than one B/D, one of whom would be a B/D that does not require clients to waive their legal rights?

To me, the strongest case against RIAs who recommend B/D’s that adopt the class action waiver provision would be situations where the RIAs receives some sort of benefit from the B/D, such as common soft dollar benefits like research and money for office needs.  Schwab has their popular annual IMPACT conference.  an argument can be made that any RIA that recommends that their clients agree to the class action waiver and also receive any sort of discount on travel, lodging, etc. in connection with such a conference has violated their fiduciary duty to their clients, both in terms of the “exclusive interests” rule and the conflict of interests rule.

I obviously do not know how the Schwab case will be resolved.  My point is that RIAs and other fiduciaries need to monitor such cases and re-examine what, if any impact, such cases could have for them with regard to their obligations as a fiduciary.  As I always remind my clients, ignorance of the law is no excuse and, to quote my favorite fiduciary quote from the courts, “a pure heart and an empty head are no defense” to a breach of fiduciary claim.

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Gifts and Conflicts of Interest

Posted on February 26, 2013 by jwatkins

I received a call yesterday from an RIA firm that had been providing magazine subscriptions and other gifts to clients that referred new clients to the firm.  The managing member of the RIA firm said that he had attended a seminar at one of the industry’s bigger conventions and the speaker had suggested such an incentive program and had assured them that it was OK as long as no actual money involved.

OK, short answer, don’t go there.  This is an issue that has been debated, as the Advisor’s Act talk in terms of prohibitions of gifts of money.  In an early decision, the SEC implied that the prohibition extended to both money and non-money gifts where same was clearly in exchange for the referral.

Occasional gifts of sports or theater tickets should be fine as long as there is no demonstrable pattern of such gifts that could be construed as compensation for referrals. RIAs often send a gift card or a similar gift to clients on their birthday.  As long as the gift is not excessive ( in excess of $100), such gestures are arguably valid business expenses to thank clients.

The real issue with regard to any form of compensation to clients in exchange for referrals has to do with actual or potential conflicts of interest and disclosure of same.  This is a slippery slope and could possibly depend on the actual facts of the case.  In cases where this practice is involved, I have always argued that the failure to disclose is a violation of the Advisor’s Act if the practice is not disclosed at all in both the RIA’s Form ADV and specifically in writing to the potential client. RIAs should remember that full disclosure is one  of the primary duties under the Act.

One of my ongoing concerns is that many consultants do not take the time to research legal decisions and enforcement actions to fully inform themselves of applicable legal and regulatory standards.  Knowledge of the Advisor’s Act and the relevant regulations is absolutely necessary. However, failing to research all sources of relevant compliance information can result in serious consequences for both the RIA and the consultant.

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“The 401(k)/403(b) Investment Manual”

Posted on February 26, 2013 by jwatkins

My new book, “The 410(k)/403(b) Investment Manual” is now available from both Amazon and CreatSpace. The manual is intended to provide both plan participants and plan sponsors with valuable information to allow them to properly evaluate the investment options within their retirement plans, information which should be provided to participants and sponsors, but often is not due to conflict of interests issues.

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, compliance, fiduciary compliance, fiduciary law, investments, retirement plans, RIA | Tagged , , , , , , , , , , , , | Leave a comment

Your RIA, Their Money!

Posted on February 8, 2013 by jwatkins

As an RIA consultant, I continue to be amazed at those firms who do not take the time to properly inform themselves about the regulatory and liability aspects of engaging in RIA activity. Ignorance and/or good intentions are simply not enough.

First, it’s your RIA. You are responsible for ensuring that your RIA is in compliance with all regulatory and legal requirements. Far to often RIA firms tell me that their broker-dealer will tell them whatever they need to know.

Under NTM 95-44, the only responsibility that a broker-dealer has to RIAs owned by their registered representatives is to monitor and supervise their representatives training activity.  Broker-dealers are not going to engage in activity that could create unnecessary liability exposure when they are legally required to do so.

Another common mistake I see RIAs make is not understanding their legal obligations to their clients.  As a securities attorney I repeatedly see the multi-color pie charts with recommendations to invest in numerous asset categories.  When questioned about the quality of their advice, they attempt to defend their asset allocation  recommendations based upon the popularity of their software program. I, in turn, open Dr. Markowitz’s seminal work, “Portfolio Selection,” to page six and ask them to read the section at the bottom of the page.

RIAs cannot guarantee the performance of their recommendations and are not legally required to do so. But their recommendations must be prudent and in the client’s best interests.  If a client wants to pursue an ultra-conservative strategy, it’s their right to do so.

Yes, they may be exposing themselves to risks such as purchasing power risk, and you should advise them of such risks, but unless what they are proposing to do is illegal, it’s their right to do so. Just be sure to document what your recommendations were and that you advised the client of such risks. And if what they are proposing to do is illegal and/or clearly exceeds the suitability guidelines for the client,  the RIA clearly cannot participate in such conduct. Yes, you may lose the account, but better to keep your licenses.

And finally, on the topic of suitability, every RIA should read and re-read the James B. Chase decision. The Chase decision discusses the two-prong test used in assessing suitability – the client’s willingness to accept risk and the client’s ability to bear investment risk. And be forewarned, a new prong to the suitability test is gradually appearing, that being the client’s need to accept investment risk at all.

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Secrets to a Successful 401(k) Plan

Posted on January 5, 2013 by jwatkins

Over the holidays I was catching-up on my reading. One of the articles I came across involved a debate over which metric was more effective in assessing the success of a defined contribution plan, a plan’s rate of participation or a plan’s deferral rates.  While I realize that the article was not discussing “success” in terms of legal success, I still found the article’s premise interesting.

Given the recent legal developments involving pension plans and the increase in cases involving plans either being held liable or settling cases, I think any discussion of a plan’s success must include an evaluation of its ability to create a true “win-win” situation for both the plan participants and the plan itself so as to avoid legal liability issues.

The Department of Labor is expected to release new fiduciary standards sometime in 2013, with the general consensus being much more stringent requirements.  Even without the new DOL standards, ERISA already requires plans and plan fiduciaries to meet various duties, including the fiduciary duty of loyalty and the duty of prudence.

The fiduciary duty of prudence requires plans and plan fiduciaries to always out the interests of the plan participants and their beneficiaries first. The duty of prudence consists of various responsibilities, including the duty to avoid unnecessary expenses and the duty to provide participants with a selection of investment options that allows them to minimize the risk of significant losses and “sufficient information to allow plan participants to make an informed decision.”

I recently released a white paper on the Active Management Value Ratio,  proprietary metric that allows investors and fiduciaries to analyze the cost efficiency of actively managed funds.  The white paper clearly shows that a number of the leading mutual funds used by pension plans are not cost efficient, in some cases even reducing a plan participant’s return. It could be argued that such inefficiency could constitute a breach of fiduciary duty, clearly not a sign of a successful plan.

Plans and their fiduciaries are required to provide plan participants with a sufficient selection of investment options to reduce the risk of large losses and sufficient information to evaluate such investment options and make informed investment decisions. In short, in most cases this simply is not happening.

In  most cases plans are primarily an assortment of expensive, highly correlated equity-based mutual funds that unnecessarily expose plans and plan fiduciaries to unlimited personal liability. Furthermore, in many cases plans fail to provide plan participants with all of the information they need to make informed decisions, resulting in liability exposure for both the plan and its fiduciaries.

Many plans and plan fiduciaries mistakenly believe that they do not face any personal liability by virtue of their mistaken belief that they have complied with ERISA Section 404(c). However, Fred Reish, one of the nation’s leading ERISA attorneys, has testified that over his twenty plus years of ERISA practice, he has never seen a plan properly comply with all of Section 404(c)’s requirements. Consequently, there are a lot of plans and plan fiduciaries that do not realize the risk exposure that they actually have.

In determining whether a defined contribution plan is a “success,” I would suggest that a more meaningful analysis would be whether the plan presents a true win-win situation for both the plan participant and the plan and its fiduciaries by complying with all of the fiduciary requirement required under ERISA and applicable legal decisions, which in turn would reduce any potential lioability exposure for both the plan and its fiduciaries.

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Seeing Is Believing: Marketing to Plan Sponsors

Posted on November 5, 2012 by jwatkins

One of the most common questions I get is from advisor is how to convince plan sponsors that they need to review their plan for potential compliance issues.  When I ask plan sponsors what it takes to get their attention, the usual response I receive is credibility and both an offer and an  ability to present evidence to support the need to make changes in the plan.

Turns out that a lot of plan sponsors are just like most of us.  Don’t waste my time with a bunch of abstract gobbledygook or self-serving opinions. Show me the money!

Most advisors approach plan sponsors with various abstract arguments as to why changes need to be made in their plans. The problem with this type of approach is that studies have shown that people are more visually oriented.  That is why most attorneys try to always reinforce testimony at trial with supporting visual aids. Advisors would be wise to adopt a similar approach in dealing with plan sponsors.

When I meet with a plan sponsor, I always provide the plan sponsor with both the Active Management Value Ratio and the InvestSense Ratio calculations for the plan’s investment options.  These are two proprietary formulas that InvestSense has developed.  The formulas are relatively simple, yet very persuasive and have proven to effective in resolving legal actions.  While advisors cannot duplicate the results from our proprietary formulas, advisors need to realize the importance of visual evidence in trying to work with plan sponsors.

I can tell the plan sponsor that there are serious compliance and liability concerns that need to be addressed. However, by providing a plan sponsor with a tangible document with meaningful numbers, it gives the plan sponsor not only something that they can wrap their arms around, but also something that they can use to document their due diligence and support their decision in case questions of liability arise.

Advisors trying to work with plan sponsors also need to understand the importance of cognitive biases.  Remember, plan sponsors believe that they are doing things right. Therefore, they can be expected to view most opinions to the contrary with skepticism. Again, another reason for supporting documentation.

Appearance of authority and “anchoring” are two of the most common cognitive biases that advisors face in dealing with any potential customer. Appearance of authority refers to a situation where a customer believes that someone is knowledgeable on a subject simply because of their title or employer. This appearance of authority usually results in a level of trust that can be hard to reverse, even in the face of overwhelming evidence, as most people tend to want to trust other people. This desire to trust others often leads to anchoring, or the tendency to resist change and hold on to personal perceptions and beliefs, no matter how strong the evidence is to the contrary.

Once again, mere oral presentations are unlikely to overcome a plan sponsor’s cognitive biases.  One of the major problems in overcoming cognitive biases is that most people are unaware that they may have such biases.  In my opinion, the best way to handle such biases is simply to use the “touchy feely’ approach, providing the plan sponsor with a tangible document that they can privately review and then use to question the plan’s current consultant.

The bottom line is that mere rhetoric is unlikely to be enough to convince a plan sponsor to listen to your presentation or make any changes.  Advisors attempting to work with plan sponsors need to develop legitimate presentations that emphasize visual persuasion in the form of supporting documentation and other forms of visual material that plan sponsors can easily understand and use.

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Fiduciaries, We Ain’t No Stinkin’ Fiduciaries: Help for Fiduciaries and Unsuspecting Fiduciaries

Posted on September 4, 2012 by jwatkins


As a securities attorney that represents investors and provides consulting and compliance services to RIA firms, I can honestly say that one of the most common problems I encounter with RIA firms is a failure to develop an effective risk management system for the firm. In some cases this oversight is due to a misperception that a broker-dealer will provide the RIA firm with whatever compliance information the RIA firm needs to know.  In other cases, the oversight is due to a reliance on a non-legally trained compliance consultant and, thus, a failure to monitor applicable court and regulatory decisions.

Yes, I am an attorney, but the previous statement is not meant to be a self-serving statement.  When I represent an investor in a case against a stockbroker, one of the first things I do is analyze the case to determine whether I can make a good faith argument that the broker was acting in a fiduciary capacity and therefore the more stringent fiduciary standard, not the suitability standard, is the applicable liability standard. 

When faced with litigation, brokers and their broker-dealers are usually quick to produce new account forms and argue that the account was marked “non-discretionary,” thereby preventing the broker from being deemed a fiduciary.  In other cases, the old “two-hats” argument is advanced to deny a broker’s fiduciary status.

However, to quote Lee Corso of ESPN, “not so fast my friend.” The U. S. Supreme Court decision in the Capital Gains decision established that all investment advisers are fiduciaries.  As for the “two hats” argument, the courts have stated that when a financial adviser acts simultaneously in the dual capacity of investment adviser and of broker and dealer,

“conflicting interests must necessarily arise. When they arise, the law has consistently stepped in to provide safeguards in the form of prescribed and stringent standards of conduct on the part of the fiduciary…’in this conflict of interest, the law wisely interposes. It acts not on the possibility, that, in some cases, the sense of that duty may prevail over the motives of self-interest, but it provides against the possibility in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.’”1

FINRA recently released Regulatory Notice 12-25 regarding the suitability obligations of brokers and broker-dealers.  One of the questions addressed in the Notice was a broker’s duty to always act in the best interests of the client.  Some argued that this position would force brokers to adhere to the fiduciary standard of care rather than the more common suitability standard for brokers.  FINRA rebuffed the brokers’ arguments and referenced several legal decisions and regulatory decisions that had previously mandated that brokers always act in a client’s best interests, effectively shooting down the “two hats” argument again.

As a former compliance officer, I always enjoyed squaring off with the brokers and advisers over the “non-discretionary” issue.  Short and simple – the “non-discretionary” issue is only one of the issues that the courts and regulators consider in deciding whether the fiduciary standard will be used in determining the issue of liability.  Both the courts and the regulators make their evaluations based on substance, not style. 

The key question is whether or not the broker controlled the account, regardless of how the account was labeled. If the broker is found to have controlled the account, then the applicable standard of care will generally be the fiduciary standard.

If a broker is formally given discretionary authority to buy and sell for the account of his customer, he clearly controls it.  Short of that, the account may be in the broker’s control if his customer is unable to evaluate his recommendations and to exercise an independent judgment. 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.2

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.3

So there are various methods an attorney can use to get the courts or regulators to hold a financial adviser to the higher “best interests of the client” fiduciary standard.  Fortunately for RIA firms, there are several relatively simple steps they can take to reduce any potential liability exposure.

First, develop and follow an established due diligence process and document both the process and enforcement of the process. 

Brokers [and investment advisers] are ‘under a duty to investigate, and their violation of that duty brings them within the term ‘willful’ in the Exchange Act. [A broker or adviser] cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant. He must analyze sales literature and must not blindly accept recommendations made therein.4

Second, review and verify any financial plans or asset allocation/return projections.  Most asset allocation/portfolio optimization software programs are relatively unstable and easily susceptible to errors.  When I take a case I reverse engineer any plans or projections that were used in connection with the investor, with special emphasis on those areas that are most vulnerable to errors.

With regard to asset allocation recommendations, the two most areas of concern for advisers should be the quality of any risk tolerance questionnaire and the viability of the input data used in any asset allocation/portfolio optimization software program, particularly the risk and return assumptions used for the various assets or asset categories. Seemingly insignificant errors in the input data can result in significant errors in the recommendations produced.

Third, ensure that any recommendations made meet the applicable standards of care.  Address all three prongs of the risk tolerance equation – willingness to accept investment risk, ability to bear investment risk, and need to accept investment risk. With regard to suitability, assess both the issues of qualitative suitability and quantitative suitability. With regard to cost, perform some form of meaningful cost benefit analysis.  Document both the RIA firm’s process and findings in all of these areas and be prepared to produce them as part of a regulatory audit or a civil litigation.

I have previously written about a cost-benefit analysis process that I use during fiduciary audits and litigation, a formula that I refer to as the Active Management Value Ratio.  Another popular cost-benefit formula is the Active Expense Ratio.  The key is to use some sort of meaningful analysis to show that an investor is getting true value in any investment or investment strategy being recommended.

In summary, when I speak to attorneys or financial advisers about RIA risk management, I tell them to focus on the three C’s – correlation of returns, consistency of advice, and cost-benefit analysis. The three C’s cover the basic fiduciary duties – correlation (duty to diversify to minimize the risk of larger losses), consistency (duty of loyalty), and cost-benefit (duty to control costs and avoid unnecessary costs).  Since an experienced securities attorney is going to focus on those areas in order to win their case, the prudent RIA firm will be proactive and develop  and enforce  an effective risk management program that includes a due diligence process to effectively reduces potential liability exposure in those areas.

                                                               Notes

1. Hughes v. S.E.C., 174 F.2d 969 (D.C.C. 1949)
2. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673 (9th Cir. 1982)
3. Carras v. Burns, 516 F.2d 251 (4th Cir. 1975)
4. Hanley v. S.E.C., 415 F.2d 589 (2d. Cir. 1969)

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The Active Management Value Ratio™- Revealing the Undisclosed Cost of Actively Managed Mutual Funds

Posted on August 6, 2012 by jwatkins

Despite overwhelming evidence that actively managed mutual funds generally under-perform passively managed index funds, the evidence indicates that most investors continue to purchase and hold actively managed funds.  Even when an actively managed fund does outperform its relevant index, the margin is usually slim, often measuring less than 1 percent.  That 1 percent advantage may disappear entirely when the actively managed fund’s annual fees are factored in.

In analyzing the prudence of actively managed mutual funds, I use a proprietary formula, the Active Management Value Ratio™ (AMVR), to determine the cost effectiveness of an actively managed mutual fund. In short, most actively managed mutual funds simply are not cost efficient.

Most investors only think of mutual fund fees in terms of the annual expense fee quoted in ads and prospectuses.  What most investors do not realize is that in breaking down an actively managed mutual fund’s annual fee into its active and passive components, the active component usually exceeds the passive component by a wide margin.

Most investors expect to see a reasonable relationship between the fees they pay and the returns they receive. However, that is usually not the case when it comes to actively managed mutual funds, where it is not unusual to see the portion of the annual fee allocatable to active management, often 60-70 percent of the fund’s annual return, providing only 25-30 percent of the fund’s annual return.

When we apply the AMVR, we often find that the fund’s active fee component either significantly reduces or totally removes the active management component’s contribution to the fund’s overall return. In some cases, the active management component of the fund may actually end up costing an investor money.

These imbalances are also reflected in measurements such as a fund’s active expense ratio (AER).  The AER was developed by Professor Ross Miller of the State University of New York.  Dr. Miller’s study found that due to the fee issues associated with actively managed mutual funds, the effective annual expense ratio for such funds was often significantly higher, often 5-6 times greater, than the fund’s stated annual expense ratio.

Investors often see a stated fee of 1 percent and just dismiss it as being only 1 percent. What investors fail to see is the cumulative impact of fees.  According to a study done by the General Accounting Office, over a twenty year period, each 1 percent of investment fees reduces an investor’s ending return by approximately 17 percent.  So, if you are paying an investment adviser an annual management fee of 1 percent and paying annual 401(k) fees of 1 percent, goodbye 34 percent of your end-return.

This is why variable annuities are such a bad investment decision. If your investment adviser recommends that you purchase a variable annuity (generally imposing an annual fee of 2 percent) and recommends that you retain him to manage the variable annuity for you for an annual fee of 1 percent, goodbye 51 percent of your end-return. Add to that the fact that variable annuity issuers base their annual fee on the accumulated value of the annuity rather than on their actual legal obligation to you, an investor’s best course of action is to just say “no” to variable annuities.  (Please see our white paper under “Variable Annuities” for a more detailed analysis on variable annuities and the questionable and often misleading marketing tricks used to sell them.)

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Is ERISA Section 408(b)(2) the New 401(k) Fiduciary’s Achilles’ Heel

Posted on June 25, 2012 by jwatkins

On July 1st, the disclosure requirements of ERISA 408(b)(2) go into effect with regard to plan providers and plan sponsors.  Disclosure requirements between plan sponsors and plan participants are scheduled to go into effect at the end of August.

Plan sponsors are already complaining that 408(b)(2)’s lack of a uniform system of disclosure is resulting in disclosures that are often hard to find and often cryptic, far from 408(b)(2)’s goal.  Such evasive tactics will only make the plan sponsor’s disclosure duties more difficult.

Plan sponsors should also note the special requirements for dealing with plan providers who fail to provide the required disclosure under 408(b)(2).  In such circumstances, the plan sponsor has a duty to request the required disclosure from the plan provider.  If the plan provider fails to make the required disclosure within 90 days, the plan sponsor is required to dismiss the plan provider and retain the services of a new plan provider.

408(b)(2) imposes greater responsibilities on plan fiduciaries to properly evaluate the fees being charged under the plan.  Failure to properly evaluate such fees can result in liability for both the plan and the plan’s fiduciaries. 

This responsibility and potential liability poses special questions with regard to actively managed mutual funds. Despite overwhelming evidence that actively managed mutual funds generally underperform passively managed index funds, most investment options offered by 401(k) plans are actively managed mutual funds. 

What many plan fiduciaries fail to understand is that a properly conducted cost-benefit analysis of such actively managed mutual funds may result in a breach of fiduciary claim, regardless of whether or not the inclusion of such fund resulted in a financial loss to the plan participants.  During a recent fiduciary audit, I analyzed the plan’s twenty mutual fund investment options using the Active Management Value Ratio (AMVR), a proprietary formula that I use to determine the cost effectiveness of an actively managed mutual fund.  My analysis indicated that three of the funds were prudent in terms of cost effectiveness and performance, five of the funds provided marginal benefits from active management, and twelve of the funds provided no benefit at all from active management.

In analyzing the active management component of a fund’s overall fee, I found situations such as 74 percent of a fund’s overall fee producing over 100 percent of the fund’s return, 88 percent of the fee fund’s overall fee producing 22 percent of the fund’s return, and numerous examples where the active component of a fund’s overall fee was producing a negative return.

When I presented the results of my analysis to the plan sponsor’s investment committee, I got the “OMG” response I often get.  The “OMG” response is usually followed with the “why didn’t someone explain this to us” question.  The usual answer is that the plan provider either employed the old 3(21) fiduciary trick, confusing the plan sponsor as to the plan provider’s fiduciary duties, or ignored conflict of interest issues, since alerting the plan sponsor to these active management cost-benefit conflict of interest issues would probably have resulted in the plan provider not getting the account.

With 408(b)(2), plan sponsors must be alert to such issues and perform a full and proper analysis of the cost issues inherent in their plan.  One of a fiduciary’s duties under ERISA is to avoid any unnecessary expenses and costs.  With the new disclosures required under ERISA Section 408(b)(2), plan sponsors and plan fiduciaries have a greater responsibility to properly review and evaluate a mutual fund’s fees.  Simply looking at a  funds stated expense fee does not provide the analysis required under ERISA to protect the plan and its participants, especially with regard to the generally higher fees charged by actively managed funds. 

If actively managed mutual funds are chosen as investment options offered within a retirement plan, the plan fiduciaries should evaluate the potential costs of the funds’ active management upon a participant’s return. The failure to recognize the potential impact of such costs and properly evaluate same should not be overlooked. Plan fiduciaries should heed the courts’ warnings that a fiduciary’s failure to personally perform a proper investigation and analysis of a plan’s investment options constitutes a breach of one’s fiduciary duty.

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