The Investor Revolution: A “Best Interests” Checklist for Investors and Fiduciaries

The DOL recently announced that it will not seek to delay the effective date of the department’s new fiduciary law. Beginning June 9, 2017, anyone providing advice to pension plans and plan participants will be deemed to be a fiduciary, which means that the adviser must always act in the plan’s/participant’s best interests.

Registered investment advisers are already held to the fiduciary standard’s “best interests” standard. Stockbrokers and other financial advisers will often argue that they are not held to the fiduciary standard’s “best interests” requirement, but rather the less stringent “suitability” standard. However the releases of FINRA, the primary body regulating stockbrokers and broker-dealers, suggest otherwise, stating that

In interpreting FINRA’s suitability rule, numerous cases explicitly state that ‘a broker’s recommendations must be consistent with his customers’ best interests. The suitability requirement that a  broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests.(1)

Regulatory enforcement decisions have further established a broker’s obligation to always act in a customer’s best interests, stating that a broker violates the suitability rule “when he puts his own self-interest ahead of the interests of his customers.”(2)

All of these “best interests” rules and regulations are nice, but how does an investor know that their financial adviser is actually complying with such rules and regulations. As a securities and ERISA attorney, I can tell you that in too many cases financial advisers are not meeting  their “best interests” obligations to their customers, both individual investors and pension plan sponsors.

Recently, I was asked by a 401(k) to forensic analysis of the investments in their defined contribution plan. An example using two of the mutual funds in their plan will hopefully point out the challenges investors and plan sponsors face in assessing the prudence of an .actively managed mutual fund.

The two actively managed mutual funds in this example are two funds commonly found in investment portfolios and pension plans, such as 401(k) plans: Fidelity Contrafund (retail (A) shares – FCNTX; Retirement (K) shares – FCNKX), and American Funds Growth Fund of America (Retail (A) shares – AGTHX, Investor (R-6) shares – RGAGX). Both of these fund are classified as large cap growth funds by Morningstar, so I will use the Vanguard Growth Index fund as my benchmark in this analysis – Retail shares VIGRX, retirement/institutional shares – VIGIX).

Retail Share Analysis

Nominal Load Adj. Risk Adj
Return Return Return
5 & 10 5 & 10 5 & 10
AGTHX 13.70 & 7.62 12.37 & 6.99 11.02 & 4.33
FCNTX 12.48 & 8.77 12.48 & 8.77 11.32 & 6.46
VIGRX 12.76 & 8.85 12.76 & 8.85 11.28 & 6.09

In short, what I did was take the funds’ nominal (reported) returns. I then adjusted for any front-end loads imposed on an investor’s investment since the load immediately reduces the amount of money, and return dollars, in an investor’s account. Finally, I adjusted for risk in the fund, using the fund’s standard deviation. The risk adjusted returns are based on a fund’s load adjusted returns. I used a fund’s five/ten-year annualized returns and five/ten-year standard deviation numbers in these calculations to reduce the possibility of any skew in the statistics.

The data clearly indicates the impact of front-end loads, as American Fund’s Growth Fund of America has the worst returns of the three funds. The Restatement (Third) Trusts clearly states that being cost efficient is one of a fiduciary’s duties. Therefore, the next step in my analysis is to use the funds’ risk adjusted returns to calculate the cost efficiency of the funds using my proprietary metric, the Active Management Value Ratio™ 2.0 (AMVR).

Incremental Incremental
Costs Return AMVR
5 & 10 5 & 10 5 & 10
AGTHX .85 NA (IR<0) NA
FCNTX  .99 .04 & .37 NA (IC>IR)
VIGRX NA (Bmrk) NA (Bmrk) NA (Bmrk)

Since AGTHX failed to outperform the benchmark, it does not qualify for an AMVR rating since it would have resulted in a financial loss for an investor relative to the less expensive benchmark. While FCNTX did produce positive incremental returns, it does not not qualify for an AMVR rating since the fund’s incremental costs exceeded such incremental returns, resulting in a net loss for an investor.

The AMVR also allows investors and fiduciaries to evaluate the cost efficiency of an actively managed mutual fund from other perspectives. For instance, using AGTHX and FCNTX, the AMVR allows us to see that 100% of AGTHX’s annual fees and costs are being wasted, as the fund did not produce any benefit for an investor, i.e., any positive incremental return, for either the five or ten-year returns.

FCNTX did produce a positive incremental return for both the five and ten-year period. However, given the fund’s total costs using the AMVR (117 basis points, or 1.17%), and fund’s incremental costs (99 basis points), 84% of the fund’s total annual costs were producing less than 1 percent of the fund’s five-year annualized returns and only 5 percent of the fund’s ten-year annualized returns. Hardly cost efficient.

These figures are hardly surprising. In fact, a study by Robert Arnott, Andrew Berkin, and Jia Ye concluded that only 4 percent of actively managed mutual funds beat the Vanguard S&P 500 Index Fund (VFINX) on an after-tax basis. Of that 4 percent, the average annual margin of outperformance was only o.6 percent, while those funds that failed to outperform VFINX did so by a “wealth destroying” 4.8 percent annually.(3)

The final step in my forensic analysis is to address the potential “closet  index” issue for both AGTHX and FCNTX. “Closet index,” also known as “index hugger,” funds are actively managed mutual funds that closely track a market index or an index fund that track an index, yet charge investors significantly higher fees than comparable index funds.

To evaluate a fund’s “closet index” factor, I re-calculate the funds’ AMVR scores using Ross Miller’s Active Expense Ratio (AER) metric. The AER uses a fund’s R-squared number to calculate the effective expense ratio for an actively managed fund. AGTHX’s 5/10 AER scores were 1.83 and 2.83, respectively, FCNTX’s 5/10 AER scores were 1.51 and 2.70, respectively. Since the AER scores greatly exceed the incremental returns produced by both funds, they would be cost inefficient and do not qualify for an AMVR score.

Retirement Share Analysis

Nominal Risk Adj.
Return Return
5 & 10 5 & 10
RGAGX 14.08 & 7.91 12.81 & 5.24
FCNKX 12.60 & 8.88 11.44 & 6.57
VIGIX 12.93 & 9.03 11.56 & 6.26

Notice that there is not column for load adjusted returns for the retirement shares Due to the provisions of the Employees’ Retirement Income Security Act (ERISA), retirement shares classes should not impose a front-end load on investors. Investors share classes are allowed to imposes so-called 12b-1 fees on investors. Such fees are required to be disclosed in a fund’s prospectus. Investors should note if a fund imposes 12b-1 fees and generally reject such funds since any fee reduces an investors end-returns.

Again, the next step is to calculate the funds’ AMVR score based on their risk adjusted return.

Incremental Incremental
Costs Return AMVR
5 & 10 5 & 10 5 & 10
RGAGX .52 1.25 & NA .32 & NA
FCNKX .97 NA & .31 NA/(IC>IR)

Using RGAGX and FCNKX, the AMVR shows that 100% of RGAGX”s annual fees and costs are being wasted with regard to the fund’s ten-year annual return, as the fund did not produce any benefit for an investor, i.e., any positive incremental return, during that period. The five-year annualized return resulted in a very respectable AMVR score of .42 due to the combination of the fund’s high incremental return and low incremental costs. However, from another cost efficiency perspective, 34 percent of the fund’s annual fees and costs were only producing approximately 9.75 percent of the fund’s five-year annualized return.

FCNKX did not produce a positive incremental return for the fund’s five-year return, so the fees and costs for that period were totally wasted. FCNKX did produce a positive incremental ten-year return However, the fund did not qualify for an AMVR score since its incremental costs were approximately three times the fund’s incremental return. given the fund’s total costs and fund’s incremental costs, 84% of the fund’s total annual costs were producing approximately 4.7 percent of the fund’s ten-year annualized return. Hardly cost efficient.

Again, for the final step I re-calculate the funds’ AMVR scores using Ross Miller’s Active Expense Ratio (AER) metric. RGAGX’s 5/10 AER scores were 1.93 and 2.41, respectively, FCNKX’s 5/10 AER scores were 2.96 and 3.46, respectively. Since the AER scores greatly exceed the incremental returns produced by both funds, they would be cost inefficient and do not qualify for an AMVR score.

Investors and investment fiduciaries, such as 401(k) and other pension plan sponsors are often misled by mutual fund ads, which usually reports their funds’ returns based on the funds’ nominal returns. Such data may not provide a meaningful picture since nominal returns fail to factor in the impact of such issues as front-end loads, cost efficiency and potential “closet index” issues. As shown herein, such issues can reveal the true character of an actively managed fund, exposing the fund as an imprudent investment choice for an investor or pension plan.

Stockbrokers and investment advisers are legally required to perform a due diligence analysis on an investment prior to recommending the investment to anyone in order to ensure that the investment is appropriate and in best interest of their clients. Sadly, my experience as a litigator has shown that if a due diligence analysis is done at all, it is usually cursory at best, if done at all. When I produce my analysis, the usual response is the proverbial “deer in the headlights” look.

I’m not saying my approach is the only acceptable method of analysis. However, my analysis does address legally accepted and legitimate issues with regard to the quality of investment advice. Therefore, I routinely suggest to investors, pension plan sponsors and other investment fiduciaries that they ask their financial advisers if they have considered such issues in making their recommendations and if so, would they provide then with a copy of their findings. If the financial adviser indicates that they have not considered such factors, are not legally required to do so, and unwilling to do so for you, I would keep looking for a financial adviser more dedicated to better protecting your financial security and protecting you against unwanted personal liability,

1. FINRA Regulatory Notice 12-25.
2. Scott Epstein, Exchange Act Release 59328, 2009 LEXIS 217, at *42.
3. Robert Arnott, Andrew Berkin, and Jia Ye, 2000, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Journal of Portfolio Management, vol. 26, no. 4 (Summer):84–93.

© 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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