401k Plan Sponsor Fiduciary Alert: Conflicts-of-Interest More Important than Mutual Fund Expense Ratios
How many times have your heard this: “High fee mutual funds perform worse than low fee mutual funds”? It’s almost impossible to avoid this advice. You’ll hear it from both academics and financial professionals. You’ll see it in both the mass media and the trade press. It’s repeated so often, it must be true. Right?
Well, not quite.
The confusion sets in when people replace the term “high fee” with “high expense ratio.” It turns out that’s a pretty important distinction. Research studies show it’s not, for the most part, the expense ratio that’s important, but the shareholder fees that cause the much bally-hooed underperformance problem. Unfortunately, because they are consistently reported and easy to measure, mutual fund expense ratios garner all the headlines.
Why does the misleading short-hand of “high expense ratios are bad” continue to persevere? Jonathan Reuter, Associate Professor of Finance at Boston College says, “I’m not sure that I have a great answer to this question. My best guess is that because academics are comfortable making their own investment decisions, they don’t realize how many people buy mutual funds through intermediaries like brokers or that these brokers can be reimbursed out of both 12b-1 fees and management fees. Once you begin to recognize that mutual fund investors differ in terms of their financial literacy, you begin to recognize that high expense ratios can reflect large investments in active management, which should be associated with higher before-fee returns, or larger payments to brokers, which should not. It is important to distinguish between these two cases.”
It’s popular to highlight this “high expense ratios are bad” mantra by employing index funds as a proxy for “low fee” funds and actively managed funds as a stand-in for “high fee” funds. For many, the difference between those low fees and high fees appears to explain the widely acclaimed underperformance of actively managed funds. Indeed, Reuter and Diane Del Guercio’s paper “Mutual Fund Performance and the Incentive to Generate Alpha,” (The Journal of Finance, Volume LXIX, No. 4, August 2014), begins with the sentence, “The typical actively managed U.S. equity fund earns a negative after-fee alpha (Gruber (1996), French (2008), Fama and French (2010) and others).”
Reuter and Del Guerico wanted to know why this asymmetry in performance exists. What they discovered may cause 401k plan sponsors to go on “Fiduciary Alert.”
It’s Fees, Not Operating Costs, That Matter Most to the 401k Fiduciary
“The paper that Diane and I published in the Journal of Finance last August takes a big step beyond the claim that ‘high expense ratios are bad’,” says Reuter. “We break the set of retail mutual funds down into those sold directly to investors and those sold through brokers. We then compare the performance of active and passive funds. We find that the average direct-sold active fund earns the same after-fee return as the average direct-sold index fund. Within this segment, funds earn back their management fees through successful investments in active management. In the broker-sold segment, it is a completely different story. We find that active funds underperform index funds by more than the difference in expense ratios. Why? Because broker-sold active funds face much weaker incentives to generate risk-adjusted returns, they invest more in broker commissions than in trying to find the next skilled manager. In my opinion, 401k plan sponsors should be actively avoiding broker-sold fund families.”
The fees generally considered to indicate a “broker-sold” fund include commissions, 12b-1 fees, and revenue sharing. The first two of these are readily available to plan sponsors as they conduct their due diligence, but revenue sharing can be more difficult to identify, even in this era of 401k fee disclosure. While Reuter and Del Guerico clearly demonstrate the damage caused by these shareholder fees, for the most part, they ignore the role of operating costs (as expressed through the infamous “mutual fund expense ratio”). Some economic models, however, suggest all fees should be ignored. But are these models relevant to plan sponsors?
Bruce Johnsen, Professor of Law, George Mason University School of Law, and author of the paper “Myths about Mutual Fund Advisory Fees: Economic Insights on Jones v. Harris,” 35 J. CORP. LAW 561 (2010), makes a compelling argument from utility theory that the attention to mutual fund fees, in general, is misplaced. He says, “The basis for my belief that fees don’t matter for the return mutual fund shareholders earn is based on the fact that funds issue and redeem shares daily at Net Asset Value. Money can flow in and money can flow out. Investors either know expenses or can project them in an unbiased fashion. The same goes for their ability to assess the manager’s stock picking skill. Based on this knowledge they contribute or withdraw money until their expected return is normalized. On its face, the same should apply to 12b-1 fees, commissions, revenue sharing, etc. See a 2004 article by Berk & Green in the JPE for the theory.” (Editor’s Note: “Jonathan Berk and Richard Green, 2004, “Mutual Fund Flows and Performance in Rational Markets,” Journal of Political Economy 112, 1269-1295)
In fact, Reuter’s paper concludes “The direct-sold segment resembles the world of Berk & Green (2004). Investor dollars flow to direct-sold funds with higher after-fee alphas, direct-sold funds respond to these flow-based incentives by making a wide variety of operation decisions shown to increase alpha, and there is little evidence that actively managed funds underperform index funds. These findings underscore the need for researchers to take mutual fund incentives into account when studying mutual fund performance.”
Conflict-of-Interest Costs can Increase Fiduciary Liability
The case can be made it is the fiduciary duty of 401k plan sponsors to also consider these incentives when selecting funds. Quite simply, 401k plan sponsors do not have the same luxury as retail investors, who may have their own perverse incentives for purchasing funds that underperform. Johnsen says, “We can observe the net NAV returns fund shareholders earn on paper, but we cannot observe shareholder returns net of the costs they incur to buy, hold, and sell a mutual fund share. Suppose 12b-1 fees reduce shareholders’ own costs by more than the amount of the fees? Investors would then be willing to accept lower paper returns for funds with 12b-1fees.”
Unfortunately for plan sponsors, (as cases like Tibble v. Edison remind us), it might be considered a prohibited self-dealing transaction if plan sponsors attempt to justify ignoring such conflict-of-interest fees like 12b-1 fees, commissions, and even revenue sharing. The working paper “It Pays to Set the Menu: 401k Investment Options in Mutual Funds,” (Clemens Sialm, Veronika Pool and Irina Stefanescu, December 2013) was the subject of an earlier FiduciaryNews.com article (see “Study: SEC Fiduciary Delay Costing Retirement Investors $1 Billion per Month,” February 12, 2013). Its updated version (August 27, 2014) states “affiliated funds that rank poorly based on past performance but are not deleted from the menu do not perform well in the subsequent year. We estimate that, on average, they underperform by approximately 3.96% annually on a risk- and style-adjusted basis.”
Plan sponsors, as they conduct due diligence on candidates for their plan’s menu of investment options, might want to pay attention to co-author Sialm, a Professor of Finance at the McCombs School of Business at the University of Texas at Austin, who told FiduciaryNews.com: “Investors should not just look at fund fees. They should consider some additional criteria when they select mutual funds… Obtaining additional information on potential agency conflicts in plan design is also helpful, although this information might not be easily available.”
Conflicts-of-Interest can be a terrible thing. Worse, they are often hidden or, at the very least, obscured. It’s often difficult for even trained professionals to quickly discern their existence. The DOL, however, has given 401k plan sponsors a powerful tool to uncover these investment performance nemeses: Rule 408(b)(2). When in doubt, ask your service provide to identify all mutual fund commissions, 12b-1 fees, and revenue sharing. If these service providers aren’t forthcoming, perhaps it’s time to put the plan on fiduciary alert.
Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.