By: Frank Armstrong
By: Frank Armstrong, CFP, AIFA
Several high profile class action law suits are now winding their way through the Federal Courts alleging high costs, sustained underperformance, and failure to properly disclose and account for revenue sharing and other “under the table” payments in pension and 401(k) plans. The Fiduciaries have only themselves to blame. These issues should never have been on the table.
All relevant fiduciary standards including the 1974 Employee Retirement Income Security Act (ERISA), the 1994 Uniform Prudent Investor Act (UPIA), the 1997 Uniform Management of Public Employee Retirement Systems Act (MPERS) and the 2006 Uniform Prudent Management of Institutional Funds Act, and Restatement 3rd of Trusts (Prudent Investor Rule) have embedded language suggesting that Passive Investment Strategies such as Index Funds, Asset Class Funds, and Exchange Traded Funds (ETF) should be the appropriate implementation of a fund’s investment policy. Fiduciaries ignore this at their peril.
The direction to consider passive strategies as the default implementation is so explicit that it provides considerable “safe harbor” for fiduciaries. In our view, index funds, asset allocation funds, and Exchange Traded Funds mean never having to say you are sorry.
While active strategies are not specifically prohibited, the burden of proof required to justify an active strategy is very high and probably impossible to meet in practical terms. The Reporter for the Restatement elaborates on this in the fourth generalization concerning prudent investment: “To the extent an investment strategy involves extra management, tax, and transaction costs or a departure from an efficiently diversified portfolio, that strategy should be justifiable in terms of special circumstances or opportunities or in terms of a realistically evaluated prospect of enhanced return [from the strategy]. The Reporter goes on to say: “The greater the trustee’s departure from one of the valid passive strategies, the greater is likely to be the burden of justification [for selecting the proposed active strategy] and also of continuous monitoring [of it].”
“Failure to diversify on a reasonable basis in order to reduce uncompensated risk is ordinarily a violation of both the duty of caution and the duties of care and skill.”
That’s why Commentary to Section 227 of the Restatement 3rd of Trusts (Prudent Investor Rule) cautions: “Because market pricing cannot be expected to recognize and reward a particular investor’s failure to diversify, a trustee’s acceptance of [uncompensated] risk cannot, without more, be justified on grounds of enhancing expected return.”
It’s very difficult to read this Commentary and not get the point that fiduciaries must prefer passive strategies from a risk management perspective. Our experience and the overwhelming academic research indicate that active management strategies are a highly effective method of increasing risk while reducing returns. Active investors can reliably expect to reduce their returns by 1-2% per year while bearing a significant load of uncompensated risk. Over the lifetime of a pension participant or trust account, this is a significant sustained underperformance which places the fiduciaries squarely in the crosshairs of the plaintiff’s bar.
Index funds offer “pure market exposure” with minimum uncompensated risk which should be the objective of every fiduciary.
The overwhelming evidence shows that actively managed accounts cannot reliably add value when compared to an unmanaged index. While 20 to 30 percent may beat the index in any particular time frame, winners in one period are no more likely to outperform during subsequent periods than mere random chance might indicate. Actively managed funds tend to underperform by an amount of their additional expense. The relationship between costs and underperformance is hard wired.
Stated another way, actively managed funds have a one in five to one in three chance of beating an index, but the average underperformance is 1-2% per year. That’s a suckers bet that reliably generates personal liability for the fiduciary.
The index fund is expected to track the index upon which it is based very closely, and suffers from only a tiny cost drag relative to its actively managed competitors, virtually eliminating the threat of underperformance. (A few index funds are able to exceed their indexes due to a combination of trading advantages, income from securities lending, and superior reconstitution strategy.)
Overall, benchmarking the performance of a passive strategy is straightforward, tracking error should be trivial, and in any given market performance should mirror the appropriate index.
“Wasting beneficiaries’ money is imprudent” reads a blunt warning in Commentary to section 7 of the Uniform Prudent Investor Act. From that perspective, institutional class passive strategies offer the fiduciary excellent cost control.
“In investing and managing trust assets, a trustee may only incur costs that are appropriate and reasonable in relation to the assets, overall investment strategy, purposes, and other circumstances of the trust.” While the fiduciary is not obligated to provide the lowest cost product available, he must be prepared to justify the additional cost.
It should be noted that salesmen often blow off the question of cost by explaining that their recommendations fall well within industry standards. However, industry standards are a license to steal, and are in no way the appropriate benchmark for fiduciaries. In the pending Wal-Mart case, plaintiffs argued that the appropriate standard for cost was the Vanguard Admiral Shares and that retail, actively managed fund costs were excessive providing no additional value. It certainly would be hard to justify an additional 1% or more per year of costs over and above that benchmark.
Appropriate fee disclosure is a high priority of pending legislation, Department of Labor enforcement, and the plaintiff’s bar. In the Wal-Mart case, plaintiffs argue that Merrill Lynch (the custodian) received undisclosed fee sharing payments from the retail funds for which there was no corresponding benefit or services provided.
Most institutional class passive funds do not provide any fee sharing to custodians or pension administrators. In that case, custodians and administrators charge a fully disclosed fee to cover their services, and the issue of under the cover payments from the fund managers disappears. (A few index funds offer pension shares which provide fully disclosed payments to TPAs to cover their services. Where TPAs provide an offset to their costs and fully disclose the payments, no fiduciary breach should be implied. However, the total costs of administration must still be reasonable.)
Fiduciaries that utilize passive strategies can effectively, efficiently, and economically implement their investment policy. The fiduciaries tasks of monitoring and oversight are greatly simplified. Due diligence, cost control, risk control, underperformance and fee disclosure almost disappear as potential issues for litigation. Any other choice exposes them to unnecessary personal and corporate liability. All of these advantages combine to make the passive approach the default choice for fiduciaries and the benchmark against which alternative strategies will be judged.