In Part 2 of this series, I explored the distinctions between arms-length (sales) and fiduciary (advisory) relationships, the fiduciary principle, several of the public policy rationales for the imposition of fiduciary duties, and briefly touched upon the various fiduciary duties that exist.
This Part 3 explores the impact of fees and costs upon investment returns, and the relationship of academic insights in this area to the fiduciary's duty to control costs.
The following is a sad tale, as are so many tales of individual investors today.
About Mary Doe and Her "Wealth Manager."
Mary Doe (a real person, although name is changed for confidentiality reasons), once an executive for a Fortune 500 company, had retired a decade before. Upon retirement, Mary Doe did all the right things. She asked around – family and friends – for financial advisors to interview. She interviewed several. In the end, she chose one of the largest “wealth management” firms and a team of “financial advisors” with fancy titles, such as “Senior VP – Wealth Management.” She received the firm’s Form ADV Part II (now known as Part 2A), and she was recommended a broad variety of investments.
“How much do I pay in fees?” – Mary inquired (both initially, and several times thereafter) of her financial advisors. “0.85% each year” was the answer, with no elaboration and no caveats.
Mary Doe was happy. She was, in fact, represented by “investment advisers” bound to act in her best interests, so she understood. Yet, it did not seem her portfolio was growing as fast as the overall market, especially in recent years. With Mary Doe’s consent I reviewed her monthly portfolio statement and reported back to her the results of my analysis.
Mary Doe's Portfolio Analysis Reveals High Fees, Costs & Additional Compensation.
Over the course of the two days available to me to undertake the analysis of Mary Doe's portfolio, I poured through the monthly statement, nearly 60 pages. As I undertook my analysis, I reviewed the large firm’s current Form ADV, Part 2A. I searched the web (including at times the SEC’s Edgar database) and reviewed an additional 40 other disclosure documents, including fund prospectuses, statements of additional information, a variable annuity prospectus, and occasional fund annual reports. I also obtained summary data from Morningstar. What did I discern?
Advisory Fees. Most of Mary Doe’s portfolio was distributed among two IRA accounts – both managed under investment advisory programs. (This is where the 0.85% annual investment advisory fee was assessed.) Mary also had two "brokerage" accounts with this dual registrant firm (i.e., both as a broker-dealer and as an investment adviser), which were also reflected in her consolidated monthly statement. Upon my inquiry to her, Mary Doe did not understand the distinctions.
12b-1 Fees. I discerned that the dual registrant firm and its advisors were receiving way more compensation than the 0.85% annual amount they stated to Mary Doe. They received “revenue-sharing payments” in the form of 12b-1 fees. One mutual fund in the brokerage account had a 12b-1 fee of 1% annually. While I cannot be certain that all of these 12b-1 fees were passed on by the funds to the broker-dealer firm, a frequently quoted statistic is that 80% of 12b-1 fees are, in fact, paid to broker-dealers.
12b-1 Fees. I discerned that the dual registrant firm and its advisors were receiving way more compensation than the 0.85% annual amount they stated to Mary Doe. They received “revenue-sharing payments” in the form of 12b-1 fees. One mutual fund in the brokerage account had a 12b-1 fee of 1% annually. While I cannot be certain that all of these 12b-1 fees were passed on by the funds to the broker-dealer firm, a frequently quoted statistic is that 80% of 12b-1 fees are, in fact, paid to broker-dealers.
Shelf Space Payments. Other revenue sharing payments noted in the funds’ prospectuses, including payments for shelf space. These are payments by fund complexes for “preferred marketing opportunities,” often paid by the fund’s manager from a portion of the management fees charged by the fund's investment advisor. The existence of such payments provides a disincentive to the fund’s manager to not lower management fees, even as economies of scale are achieved as the size of the fund increases. Form ADV Part 2A of the dual registrant firm noted that the firm “receives other compensation from certain distributors or advisors of mutual funds” and that “revenue sharing compensation will not be rebated or credited” to its clients.
Sales Prizes. I also discerned that many of the mutual funds provided “additional compensation to registered representatives of dealers in the form of travel expenses, meals, and lodging associated with training and educational meetings sponsored.” Whether these particular benefits were actually received by these particular "financial advisors" is not known, although such practices remain fairly common in the broker-dealer industry.
Soft Dollar Payments. Also, for trading of securities within the fund, many of the funds paid brokerage commissions back to the dual registrant firm at which Mary Doe held her investment advisory accounts. The generally high portfolio turnover of these funds resulted in a relatively high amount of brokerage commissions (and other transaction costs within the funds, such as principal mark-ups and mark-downs, bid-asked spreads, market impact costs, and opportunity costs due to delayed or canceled trades). Additionally, the amount of brokerage commissions in many of the funds was higher than would be expected, due to the payment of higher brokerage commissions by the funds in return for research from the broker-dealer firm – a practice known as payment of “soft dollars.”
Proprietary Fund. The dual registrant also had Mary Doe invest in one of its proprietary funds. Of course, this fund had high fees and costs, as well. I could not discern if any of the management or other fees were rebated to the client.
"Total Fees and Costs." In summary, I found that Mary Doe was paying about 2.3% (and possibly much more) in “total fees and costs.” Given the size of Mary Doe's portfolio, the amount of total fees and costs she incurred was nearly double what I would have deemed reasonable.
Tax-Inefficient Portfoiio Design and Products. Other problems were present. The overall portfolio was not designed in a manner for long-term tax-efficiency. The location of assets, as between taxable and tax-deferred accounts, did not appear to reflect any long-term tax minimization strategy. Mutual funds held in taxable accounts were not designed for tax efficiency.
No Investment Policy. In the review of the investment portfolio I did not ascertain any overall strategy. Perhaps the overall investment strategy is contained in a separate document. Probably not, however, as Form ADV, Part 2A of the dual registrant firm expressly excluded from the investment advisory programs in which Mary Doe was enrolled. Furthermore, within the portfolio was an emphasis on individual stock selection, or “active management.” The strategic asset allocation was also insufficient to support Mary Doe's current 3.5% rate of withdrawal.
I wish I could state that Mary Doe's case was an isolated occurrence. Unfortunately, the lack of training and skill observed, the relentless pursuit of additional compensation at the firm level and/or at the adviser level, and the negative impact upon individual investor returns, remains common today.
Mary Doe's Reactions.
As I conferred with Mary Doe, and as she expressed herself to others, over the next few days, Mary made the following statements:
I wish I could state that Mary Doe's case was an isolated occurrence. Unfortunately, the lack of training and skill observed, the relentless pursuit of additional compensation at the firm level and/or at the adviser level, and the negative impact upon individual investor returns, remains common today.
Mary Doe's Reactions.
As I conferred with Mary Doe, and as she expressed herself to others, over the next few days, Mary made the following statements:
- “I feel … betrayed.”
- “I trusted my financial advisors. I thought they were looking out after my best interests. I was wrong.”
- “I trusted my financial advisors. They were supposed to be honest with me. I asked them direct questions. At no time did they explain to me that either they or their firm received additional fees.”
- “Don’t let what happened to me keep happening to others. It’s up to all of you … make certain each and every financial advisor out there acts in the best interests of their clients.”
The Cost-Benefit Analysis Required for Professional Advice.
Often in the world of professional services paying higher fees can result in a better outcome. For example, if you were purchasing a $10m company, would you want to be represented by a large firm's senior partner, who had done similar transactions hundreds of times, for $800 an hour (with lower hourly fees billed by junior partners and associates working on the transaction), or would you want to be represented by a general practitioner attorney who, in addition to drafting wills, handling divorce cases, preparing deeds, would handle the transaction for a much lower hourly fee (perhaps $300 an hour)? Speaking as an attorney-at-law, who in my prior legal practice participated in such transactions, and who has seen the distinctions, if I were purchasing a $10m company it would be no contest - I would want to be represented by the senior partner and his firm every single time. Because the likelihood of "doing it right" and "achieving better results" (in tax structures, negotiations, etc.) is far more likely when the attorney with greater expertise and experience is engaged.
But, in the world of investing, higher fees don't usually translate to higher returns. Rather, they more often than not result in lower net returns to the investor, especially over the long term, nearly always.
This is not to say that some investment advisers who provide financial and investment advice to retail consumers don't provide value-added services. Some do. They apply insights from academic research in the design of an investment strategy. They undertake careful due diligence and select low-cost investment products for implementation. They reduce client's tax liabilities through various financial planning techniques, proper structure of investment portfolio, and the use of tax-efficient investments where appropriate. And they add value through the delivery of financial planning services, guiding clients toward the accomplishment of their lifetime goals.
But each service provided - financial or investment advisory - deserves its own cost-benefit analysis. Simply because a financial planning service can be provided, such as the formulation of a comprehensive financial plan, does not mean that every client would be benefitted by same. Some clients possess very discrete or limited financial planning needs and would be better served by an hour or two of advice. Other clients may require initial guidance in the most basic of financial matters - the need to plan personal expenditures, live below their means, and save - before other advice is provided. Some clients may only need one-time advice, while others may need annual "check-ups" to keep them on course, and while still others (with far more complicated planning needs) may require frequent communication and advice. For this reason, it is important to not "oversell" the need for "comprehensive financial planning" or "ongoing investment advice." Clients should only pay for services where the benefits to the client exceed the fees and costs incurred.
I've encountered only a few individual consumers, out of hundreds if not thousands that I've encountered in my professional career, who possessed both the knowledge and discipline and common sense to be able to successfully manage their own portfolios. This sounds like a recipe where financial and investment advisors are sorely needed by the vast majority of the public. And they are. But, sadly, I believe that the majority of "financial planners" and "investment advisers" (or whatever titles may be utilized) are not providing services in a expert manner, and for professional-level fees, that survive a cost-benefit analysis.
Professional financial and investment advisers with high expertise and ethics deserve a high degree of compensation. Those who truly possess expertise and apply such expertise for the benefit of the client deserve professional-level compensation. That compensation should be similar in amount to the compensation experienced and knowledgeable attorneys or CPAs would receive. For it takes many years of education, training, and experience to become an outstanding financial and/or investment adviser, and the effort to attain and maintain such a high level of professional competence and ethics should be justly rewarded.
But compensation must remain reasonable at all times. Excessive compensation is prohibited. As discussed in a prior blog post in this series, the fiduciary standard imposes restrictions upon conduct.
As Mary Doe's situation reveals, it is extremely difficult for consumers to discern who is truly skilled, who really understands and adheres to the obligations flowing from their fiduciary status, and what level of compensation is appropriate. Disclosures don't work to cure this vast disparity in knowledge and power. In fact, disclosures, when undertaken by an advisor, may even lead to worse advice. Given the inability of disclosures (and other regulatory restrictions) to constrain greed, fiduciary status is appropriately applied to the relationship between advisor and client. And those acquiring fiduciary status must understand, as experts, the connection between investment fees and costs and investor returns, and then act appropriately.
The Academic Research: Higher Investment-Related Fees = Lower Returns.
Academic research generally supports the conclusion that higher-fee, actively managed mutual
funds are bested, on average, by low-cost (and often passively managed) mutual funds and other pooled investment vehicles.
Sharpe (1966)[1]
and Jensen (1968)[2]
first showed that the average mutual fund underperformed relative to their
indexes.
“Eugene Fama, William Sharpe and Jack
Treynor were some of the first researchers to note the apparent lack of skill
by mutual fund managers. Economist Michael Jensen provided his view in 1967,
that “mutual funds were on average not able to predict security prices well
enough to outperform a buy-the-market-and-hold policy, but also that there is
very little evidence that any individual fund was able to do significantly
better than that which we expected from mere random chance.”[3]
Actively managed funds tend to
underperform their benchmarks after adjusting for expenses, and the probability
of earning a positive risk-adjusted return is inversely related to expense
ratios. (Haslem et al., 2008).[4]
Although a small number of early
studies find that mutual funds having a common objective (e.g., growth)
outperform passive benchmark portfolios, Elton, Gruber, and Blake (1996)[5]
argue that most of these studies would reach the opposite conclusion if
survivorship bias and/or adjustments for risk were properly taken into account.
Expense ratios and turnover are
negatively correlated with return. (Carhart, 1997[6];
Dellva & Olson, 1998[7];
O’Neal, 2004).
Sales loads (commissions on the sale of mutual fund shares) are also negatively associated
with fund performance (Carhart, 1997[8];
Dellva & Olson, 1998[9]).
Load funds underperform no-load funds
by an estimated 80 basis points (bps) per year (Carhart, 1997).[10]
Transaction costs also decrease the
potential benefit of active management (Carhart, 1997).[11]
Opportunity costs exist due to cash
holdings by funds. Hence, part of this underperformance is because actively
managed mutual funds have higher liquidity needs for frequent purchases and
redemptions. (O’Neal, 2004).
Lower performing fund have higher
fees, and high-quality funds do not charge comparatively higher fees. (Gil-Bazo
& Ruiz-Verdu, 2008).[12]
Mutual funds on average underperform
benchmarks by approximately the amount of fees and expenses. (Fama and French,
2008).[13]
After correcting for false
discoveries in positive alpha, lucky mutual fund managers, most funds do not
deliver positive alpha net expenses. Skilled managers are disappearing, finding
skilled managers in 1996 but almost none by 2006.[14]
Evidence collected over an extended
period on the performance of (open-ended) mutual funds in the US (Jensen, 1968[15];
Malkiel, 1995[16];
Wermers et al., 2010)[17]
and unit trusts and open-ended investment companies (OEICs) in the UK (Blake
and Timmermann, 1998[18];
Lunde et al., 1999)[19]
has found that on average a fund manager cannot outperform the market benchmark
and that any outperformance is more likely to be due to luck rather than skill.
As a result of lower expenses, broad
index funds tend to outperform actively managed funds with equivalent risk.
Therefore, the best way for most investors to improve performance is to have a
broad index fund with minimal costs (Malkiel, 2003).[20]
As stated in a 2011 paper, using data
on active and passive US domestic equity funds (the sample included a total of
13817 funds while the CRSP Mutual Fund Database) from 1963 to 2008, the authors
observed: “Similar to others, we first
show that fees are an important determinant of fund underperformance – that is,
investors earn low returns on high fee funds, which indicates that investors
are not rewarded through superior performance when purchasing ‘expensive’ funds.
We explore a number of hypotheses to explain the dispersion in fees and find
that none adequately explain the data. Most importantly, there is very little
evidence that funds change their fees over time. In fact the most important
determinant of a fund’s fee is the initial fee that it charges when it enters
the market. There is little evidence that funds reduce their fees following
entry by similar funds or that they raise their fees following large outflows
as predicted by the strategic fee setting hypothesis. We also do not find evidence that higher fees are associated with
proxies for higher service levels provided to investors. Overall, our
findings provide little evidence that competitive pricing exists in the market
for mutual funds.”[21] (Emphasis added.)
The finding that active mutual fund
managers underperform their benchmark, net of fees, on average, is generally robust for other developed and
emerging market equity managers (e.g.,
Otten and Bams 2002[22],
Standard & Poor’s 2009[23]).
High mutual fund fees are predictive of lower returns. “[We confirm the negative relation between funds´ before fee performance
and the fees they charge to investors. Second, we find that mutual fund fees
are a significant return predictor for funds, fees are negatively associated
with return predictability. These results are robust to several empirical
models and alternative variables.” Marta Vidal, Javier Vidal-García, Hooi Hooi
Lean, and Gazi Salah Uddin, The Relation between Fees and Return Predictability
in the Mutual Fund Industry (Feb. 2015).
High-turnover funds possess inferior performance. “[F]unds with higher portfolio turnovers exhibit inferior
performance compared with funds having lower turnovers. Moreover, funds with
poor performance exhibit higher portfolio turnover. The findings support the
assumptions that active trading erodes performance….][24]
The average fund manager in the UK is unable to deliver outperformance using either security selection or market timing. “[U]sing a
new dataset on equity mutual funds [returns from January 1998–September 2008]
in the UK … [we] find that: the average equity mutual fund manager is unable to
deliver outperformance from stock selection or market timing, once allowance is
made for fund manager fees and for a set of common risk factors that are known
to influence returns; 95% of fund managers on the basis of the first bootstrap
and almost all fund managers on the basis of the second bootstrap fail to
outperform the zero-skill distribution net of fees; and both bootstraps show
that there are a small group of ‘star’ fund managers who are able to generate
superior performance (in excess of operating and trading costs), but they
extract the whole of this superior performance for themselves via their fees,
leaving nothing for investors.”[25]
Using the “CRSP Survivor-Bias-Free US Mutual
Fund Database … maintained by the Center for Research in Security Prices
(CRSP®), an integral part of the University of Chicago Booth School of Business
… In all portfolio tests, there was some benefit to using low-cost actively
managed funds, but not as much as we expected, given the reported impact that
fees have on individual fund performance. The probability of outperformance by
the all index fund portfolios remained above 70% in all scenarios … We
speculate that filtering actively managed funds may shift the probability curve
closer to an all index fund portfolio as in the low-expense example, but we are
not convinced that any filtering methodology will significantly alter the
balance in favor of all actively managed funds. This may be an area for future
research … A diversified portfolio holding only index funds in all asset
classes is difficult to beat in the short-term and becomes more difficult to
beat over time. An investor increases their probability of meeting their
investment goals with a diversified all index fund portfolio held for the long
term.”[26]
SPIVA Scorecard (For Period Ending
12/31/2014). The
S&P Dow Jones SPIVA® U.S. Scorecard is an extensive report that’s published
semiannually at mid-year and year-end. SPIVA divides mutual fund return data
into category tables covering different asset classes, styles, and time
periods. There’s also a measure of survivorship bias and style drift for every
category over each period. This accounts for funds that are no longer in
existence or have had a change in investment style. The SPIVA® U.S. Scorecard
Year-End 2014 has data going back 10 years. Excerpts from this report follow:
· “It is commonly believed that active
management works best in inefficient environments, such as small-cap or
emerging markets. This argument is disputed by the findings of this SPIVA
Scorecard. The majority of small-cap active managers have been consistently
underperforming the benchmark over the full 10-year period as well as each
rolling 5-year period, with data starting in 2002.”
· “Funds disappear at a meaningful
rate. Over the past five years, nearly 24% of domestic equity funds, 24% of
global and international equity funds, and 17% of fixed income funds have been
merged or liquidated. This finding highlights the importance of addressing survivorship
bias in mutual fund analysis.”[27]
For an easier read on the need to avoid higher fees and costs in search of alpha, and the decline over recent decades of the opportunities to secure alpha, I refer the reader to Larry Swedroe's article, Why Alpha's Getting More Elusive, and (better yet) to his book, The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches (BAM Alliance Press, 2015).
From all my research in this area, I would conclude that, to the extent investment
advisers believe that they can recommend higher-cost products that pay their
firm more, with no harm to the client, these investment advisers are not (in most cases) acting
as expert advisers in adherence to the fiduciary duties of due care and loyalty required of a fiduciary.
However, I cannot conclude, on the basis of the academic research present, that all "active management" strategies fail to withstand scrutiny. Why? First, you can never entirely "disprove" all "active management," academically. This is because each day a new active management strategy or product appears. Second, I would posit that closer academic scrutiny is needed of very-low-cost active management strategies, in relation to very-low-cost passive investment management strategies; the research in this area needs greater attention. Third, some observers take the view that application of various "factors" (such as the value and small cap risk premiums, the investment and profitability and momentum factors) in the design of an investment portfolio, or the use of tax-efficient funds (which are "managed" in essence for various tax efficiencies) are forms of active management.
Some commentators have envisioned a regulatory solution in which only index funds are permitted in tax-deferred accounts. See, e.g., Alicia H. Munnell, Anthony Webb, and Francis M. Vitagliano, "Will Regulations to Reduce IRA Fees Work," Center for Retirement Research at Boston College, Working Paper No. 13-2 (Feb. 2013) ("[V]irtually all researchers agree that most actively-managed equity funds can be expected to underperform index funds once fees are considered. It makes no sense to expose the average participant to these options. If people want to buy actively managed funds with their non-tax-advantaged saving, that is fine. But in plans that cost the taxpayer money, investing should be cost effective.") While I am a believe in "passive" investment strategies, as stated above I believe additional research is required. Not all index funds are low-cost. And not all actively managed funds are high costs. I believe further research is required before one can conclude that only index funds should be utilized. However, the use of low-cost index funds in the implementation of an otherwise-sound investment strategy is, at a minimum, circumstantial evidence that appropriate due diligence has taken place in the selection of specific investment funds.
Some commentators have envisioned a regulatory solution in which only index funds are permitted in tax-deferred accounts. See, e.g., Alicia H. Munnell, Anthony Webb, and Francis M. Vitagliano, "Will Regulations to Reduce IRA Fees Work," Center for Retirement Research at Boston College, Working Paper No. 13-2 (Feb. 2013) ("[V]irtually all researchers agree that most actively-managed equity funds can be expected to underperform index funds once fees are considered. It makes no sense to expose the average participant to these options. If people want to buy actively managed funds with their non-tax-advantaged saving, that is fine. But in plans that cost the taxpayer money, investing should be cost effective.") While I am a believe in "passive" investment strategies, as stated above I believe additional research is required. Not all index funds are low-cost. And not all actively managed funds are high costs. I believe further research is required before one can conclude that only index funds should be utilized. However, the use of low-cost index funds in the implementation of an otherwise-sound investment strategy is, at a minimum, circumstantial evidence that appropriate due diligence has taken place in the selection of specific investment funds.
Regardless of the debate between "active" and "passive" investment management, the academic evidence is compelling
that higher-cost products possess a heavy burden which, on average, and especially over longer time periods, negatively
affects the net returns secured by the individual investor. As stewards of their client's resources, financial and investment advisers possess a duty to only incur fees and costs, paid from their client's assets, which are fair and reasonable. Incurring fees and costs that lead to lower returns for the investor, over the long term, would likely constitute a breach of the fiduciary's due diligence obligation under the fiduciary duty of care. And, if the recommendation of higher-cost funds results in additional compensation to the fiduciary, either directly or indirectly, then a breach of the fiduciary's duty of loyalty has also occurred.
This fiduciary duty to both control and to account for fees and costs is widely known. In the ERISA context much has been written. See, e.g., Philip Chao, CFP®, AIFA®, "Whack-A-Molei": Catch Me If You Can. Fiduciary Considerations in Controlling and Accounting for Plan Administration Fees" (January 25, 2014) (generally discussing fee arrangements by service providers to ERISA plans, and observing: "It is the responsibility of appropriate plan fiduciaries to determine whether a particular expense is a reasonable administrative expense under §§ 403(c)(1) and 404(a)(1)(A) of ERISA" and further observing: "In being a fiduciary and a steward for “other people’s money”, understanding fees and expenses is an important factor when selecting investment asset managers (e.g. mutual funds) and administrative service providers (e.g. record keepers)." See also Legality of Aetna ERISA Plan Fees, PWBA Office of Regs. & Interpretations, Advisory Opinion No. 97-16A (May 22, 1997). ("[I]t should be noted that ERISA's general standards of fiduciary conduct also would apply to the proposed arrangement. Under section 404(a)(1) of ERISA, the responsible Plan fiduciaries must act prudently and solely in the interest of the Plan participants and beneficiaries both in deciding whether to enter into, or continue, the above-described arrangement with ALIAC, and in determining which investment options to utilize or make available to Plan participants and beneficiaries. In this regard, the responsible Plan fiduciaries must assure that the compensation paid directly or indirectly by the Plan to ALIAC is reasonable, taking into account the services provided to the Plan as well as any other fees or compensation received by ALIAC in connection with the investment of Plan assets."
Outside of ERISA state common law also imposes upon fiduciaries the duty to control and account for costs. See, e.g., the Uniform Prudent Investor Act (2008), in comment to Sect. 105 ("Under the prudent investor rule, a trustee is to incur costs that are appropriate and reasonable in relation to the assets and the purposes of the trust. ") Given the impact that higher fees and costs possess on investment portfolios, and the extremely strong evidence that higher fees and costs translate to lower returns (at least for investments in similar investment asset classes), the duty to expend client funds wisely, by controlling fees and costs, is imperative for proper adherence to the fiduciary standard of conduct.
Some legal commentators have omitted from their list of fiduciary requirements of investment fiduciaries, under state common law, of the need to avoid excessive fees. They often list disclosure to, and informed consent of, the client as solution to the incurrence of higher fees and the receipt of additional compensation. Yet, as will be discussed in a later blog in this series, where a conflict of interest occurs disclosure and consent are not, in and of themselves, sufficient. One procedural safeguard applied under the fiduciary duty of loyalty is one of informed consent, and it is a fundamental truth that no client will consent to be harmed. The additional substantive safeguard applied under the fiduciary duty of loyalty is that the transaction remain fair to the client. The recommendation of a higher-cost product, in order for the fiduciary adviser to secure additional (variable) compensation, knowing that lower-cost products exist, and with knowledge that substantial academic evidence compels the conclusion that higher-cost products (in the same asset class, generally) lead to lower returns for the investors, does not meet this "fairness" test.
I am not stating that the lowest-cost product must be recommended in all cases. There may exist academically sound reasons for a higher-cost product to be recommended. As a simple example, the low annual expense ratio of an S&P 500(r) index fund cannot be found in an index fund which invests in emerging markets stocks.
Nor am I stating that the annual expense ratio of a fund is all-determinative. There are many sources of both "disclosed" and "hidden" costs (including various forms of opportunity costs) present within pooled investment vehicles, and all of these fees and costs should be discerned (or at least estimated) while undertaking due diligence in connection with product selection (at least where other screens have narrowed the list of possible funds to several, upon which more intensive due diligence can then be applied).
One might be tempted to argue that the duty to control fees and costs is imposed upon a mutual fund's management, pursuant to the Investment Company Act of 1940, and hence an investment adviser to an individual client need not duplicate the effort to control fees and costs. However, as has long been noted, most mutual fund managers do not negotiate at arms-length with the investment advisers to the fund. [See, e.g., ("Fees, which compensate advisers for portfolio management, are negotiated annually between the adviser and its captive fund’s board. But, because the adviser dominates the board, the fee negotiation cannot truly be arm’s-length. Consequently, despite functioning in a tightly regulated environment, advisers (and their affiliated companies) are able to extract outsized rewards, even when producing sub-par results, while facing virtually no risk of getting fired for poor performance. In short, the set-up is perfectly crafted to allow mutual fund advisers and their affiliates to overpay themselves at fund shareholders’ expense.") John P. Freeman, Steward L. Brown, and Steve Pomerantz, "Mutual Fund Advisory Fees: New Evidence and a Fair Fiduciary Duty Test," 61 Ok.L.Rev. 81, 83 (2008) (citations omitted.)] See also Gallus v. Ameriprise Fin., Inc., 561 F.3d 816; 2009 U.S. App. LEXIS 7382 (2009) ["Some studies have concluded that inherent conflicts of interest and a lack of meaningful competition between mutual funds have led to systematic overpricing of investment advice. See, e.g., Birdthistle, supra; John P. Freeman, Stewart L. Brown & Steve Pomerantz, Mutual Fund Advisory Fees: New Evidence and a Fair Fiduciary Duty Test, 61 Okla. L. Rev. 83 (2008); John P. Freeman & Stewart L. Brown, Mutual Fund Advisory Fees: The Cost of Conflicts of Interest, 26 Iowa J. Corp. L. 609 (2001); Donald C. Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty, 83 Wash. U. L.Q. 1017 (2005); Lyman Johnson, A Fresh Look at Director "Independence": Mutual Fund Fee Litigation and Gartenberg at Twenty-Five, 61 Vand. L. Rev. 497 (2008); see also Lucian Bebchuk & Jesse Fried, Pay Without Performance: The Unfulfilled Promise of Executive Compensation ix (2004) ("The absence of effective arm's-length dealing under today's system of corporate governance . . . has been the primary source of problematic compensation arrangements.").]
Accordingly, no investment adviser to a retail investor can rightfully assume that all mutual fund management (or other) fees are fair and reasonable, nor negotiated at arms-length. Since higher fees result in lower returns, close scrutiny is required of all fees and costs incurred.
We have already seen, in recent years, an explosion of litigation regarding fiduciary recommendations of mutual funds in the ERISA context. As noted by Stephen D. Rosenberg in his article, "Retreat from the High Water Mark: Breach of Fiduciary Duty Claims Involving Excessive Fees After Tibble v. Edison International" (2015): "The level of expenses in investment options offered to participants in company-sponsored 401(k) plans has become an issue of significant concern, as well as litigation. A series of interrelated issues involving the expense levels in 401(k) plan investment options coalesce to simultaneously impact both the performance of participants’ plan investments and the performance of fiduciaries’ duties. The starting point for these problems is the accepted premise that greater fees severely reduce the growth in assets over time in individual participants’ account [Miller, Ross M., 'Paying the High Price of Active Management: A New Look at Mutual Fund Fees,' World Economics, Vol. 11, No. 3, July-Sept. 2010]." It does not take much foresight to predict that excessive fee litigation applying fiduciary duties outside of ERISA will likely take the main stage in the years to come.
To financial and investment advisers, I suggest this ... Fulfill your fiduciary duty by controlling, and accounting for, all of the fees and costs associated with the delivery of financial and investment advice, and the various investments chosen to implement an investment strategy. Clients such as Mary Doe deserve nothing less.
Outside of ERISA state common law also imposes upon fiduciaries the duty to control and account for costs. See, e.g., the Uniform Prudent Investor Act (2008), in comment to Sect. 105 ("Under the prudent investor rule, a trustee is to incur costs that are appropriate and reasonable in relation to the assets and the purposes of the trust. ") Given the impact that higher fees and costs possess on investment portfolios, and the extremely strong evidence that higher fees and costs translate to lower returns (at least for investments in similar investment asset classes), the duty to expend client funds wisely, by controlling fees and costs, is imperative for proper adherence to the fiduciary standard of conduct.
Some legal commentators have omitted from their list of fiduciary requirements of investment fiduciaries, under state common law, of the need to avoid excessive fees. They often list disclosure to, and informed consent of, the client as solution to the incurrence of higher fees and the receipt of additional compensation. Yet, as will be discussed in a later blog in this series, where a conflict of interest occurs disclosure and consent are not, in and of themselves, sufficient. One procedural safeguard applied under the fiduciary duty of loyalty is one of informed consent, and it is a fundamental truth that no client will consent to be harmed. The additional substantive safeguard applied under the fiduciary duty of loyalty is that the transaction remain fair to the client. The recommendation of a higher-cost product, in order for the fiduciary adviser to secure additional (variable) compensation, knowing that lower-cost products exist, and with knowledge that substantial academic evidence compels the conclusion that higher-cost products (in the same asset class, generally) lead to lower returns for the investors, does not meet this "fairness" test.
I am not stating that the lowest-cost product must be recommended in all cases. There may exist academically sound reasons for a higher-cost product to be recommended. As a simple example, the low annual expense ratio of an S&P 500(r) index fund cannot be found in an index fund which invests in emerging markets stocks.
Nor am I stating that the annual expense ratio of a fund is all-determinative. There are many sources of both "disclosed" and "hidden" costs (including various forms of opportunity costs) present within pooled investment vehicles, and all of these fees and costs should be discerned (or at least estimated) while undertaking due diligence in connection with product selection (at least where other screens have narrowed the list of possible funds to several, upon which more intensive due diligence can then be applied).
One might be tempted to argue that the duty to control fees and costs is imposed upon a mutual fund's management, pursuant to the Investment Company Act of 1940, and hence an investment adviser to an individual client need not duplicate the effort to control fees and costs. However, as has long been noted, most mutual fund managers do not negotiate at arms-length with the investment advisers to the fund. [See, e.g., ("Fees, which compensate advisers for portfolio management, are negotiated annually between the adviser and its captive fund’s board. But, because the adviser dominates the board, the fee negotiation cannot truly be arm’s-length. Consequently, despite functioning in a tightly regulated environment, advisers (and their affiliated companies) are able to extract outsized rewards, even when producing sub-par results, while facing virtually no risk of getting fired for poor performance. In short, the set-up is perfectly crafted to allow mutual fund advisers and their affiliates to overpay themselves at fund shareholders’ expense.") John P. Freeman, Steward L. Brown, and Steve Pomerantz, "Mutual Fund Advisory Fees: New Evidence and a Fair Fiduciary Duty Test," 61 Ok.L.Rev. 81, 83 (2008) (citations omitted.)] See also Gallus v. Ameriprise Fin., Inc., 561 F.3d 816; 2009 U.S. App. LEXIS 7382 (2009) ["Some studies have concluded that inherent conflicts of interest and a lack of meaningful competition between mutual funds have led to systematic overpricing of investment advice. See, e.g., Birdthistle, supra; John P. Freeman, Stewart L. Brown & Steve Pomerantz, Mutual Fund Advisory Fees: New Evidence and a Fair Fiduciary Duty Test, 61 Okla. L. Rev. 83 (2008); John P. Freeman & Stewart L. Brown, Mutual Fund Advisory Fees: The Cost of Conflicts of Interest, 26 Iowa J. Corp. L. 609 (2001); Donald C. Langevoort, Private Litigation to Enforce Fiduciary Duties in Mutual Funds: Derivative Suits, Disinterested Directors and the Ideology of Investor Sovereignty, 83 Wash. U. L.Q. 1017 (2005); Lyman Johnson, A Fresh Look at Director "Independence": Mutual Fund Fee Litigation and Gartenberg at Twenty-Five, 61 Vand. L. Rev. 497 (2008); see also Lucian Bebchuk & Jesse Fried, Pay Without Performance: The Unfulfilled Promise of Executive Compensation ix (2004) ("The absence of effective arm's-length dealing under today's system of corporate governance . . . has been the primary source of problematic compensation arrangements.").]
Accordingly, no investment adviser to a retail investor can rightfully assume that all mutual fund management (or other) fees are fair and reasonable, nor negotiated at arms-length. Since higher fees result in lower returns, close scrutiny is required of all fees and costs incurred.
We have already seen, in recent years, an explosion of litigation regarding fiduciary recommendations of mutual funds in the ERISA context. As noted by Stephen D. Rosenberg in his article, "Retreat from the High Water Mark: Breach of Fiduciary Duty Claims Involving Excessive Fees After Tibble v. Edison International" (2015): "The level of expenses in investment options offered to participants in company-sponsored 401(k) plans has become an issue of significant concern, as well as litigation. A series of interrelated issues involving the expense levels in 401(k) plan investment options coalesce to simultaneously impact both the performance of participants’ plan investments and the performance of fiduciaries’ duties. The starting point for these problems is the accepted premise that greater fees severely reduce the growth in assets over time in individual participants’ account [Miller, Ross M., 'Paying the High Price of Active Management: A New Look at Mutual Fund Fees,' World Economics, Vol. 11, No. 3, July-Sept. 2010]." It does not take much foresight to predict that excessive fee litigation applying fiduciary duties outside of ERISA will likely take the main stage in the years to come.
To financial and investment advisers, I suggest this ... Fulfill your fiduciary duty by controlling, and accounting for, all of the fees and costs associated with the delivery of financial and investment advice, and the various investments chosen to implement an investment strategy. Clients such as Mary Doe deserve nothing less.
NEXT POST: "Who Moved My Cheese": The Future of Financial Advice (Part 4).
Ron A. Rhoades, JD, CFP® is the Program Director for the Financial Planning Program and an Asst. Professor of Finance at Western Kentucky University, at its beautiful main campus in Bowling Green, KY. He is a CFP certificant, a regional board member of NAPFA, a consultant to the Garrett Planning Network, and a member of the Steering Group for The Committee for the Fiduciary Standard.
This blog represents Ron's personal views and is not necessarily indicative of the views of any institution, organization or firm with whom he may be associated.
Ron is scheduled to provide two presentations in early 2016 on the DOL's rules and the general impact of the fiduciary standard on the financial services industry:
- Feb. 24-25, 2016: FPA of Oregon and S.W. Washington Midwinter Conference 2016, where Ron will discuss: "The DOL's Transformational Conflict of Interest Rule"
- Feb. 26, 2016: FPA of Puget Sound's 2016 Annual Symposium, where Ron will discuss: "Reducing Your Risks in the New Fiduciary Era"
Connect with Ron on LinkedIn.
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Public comments to this blog are welcome, provided that no advertising occurs and that decorum is maintained. To reach Prof. Rhoades directly, please e-mail him at: Ron.Rhoades@WKU.edu. Thank you.
FOOTNOTES:
Public comments to this blog are welcome, provided that no advertising occurs and that decorum is maintained. To reach Prof. Rhoades directly, please e-mail him at: Ron.Rhoades@WKU.edu. Thank you.
FOOTNOTES:
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