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.
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.
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.
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.”
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.
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.
- 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"
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.