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Rethinking Performance Standards (Part I – The Fatal Flaw)

Rethinking Performance Standards (Part I – The Fatal Flaw)
November 13
01:45 2018

Do Mandated Reporting Formats Unintentionally
Raise Fiduciary Liability and Mislead Investors?

With all the public debate surrounding the DOL’s now-vacated Fiduciary Rule and the SEC’s Regulation Best Interest, one would assume the universal adaptation of generally accepted standards might benefit both fiduciaries and the beneficiaries they serve. All too often, however, good intentions create hidden liabilities. Nowhere is this perhaps more apparent than in the manner in which the industry reviews investment performance.

More than a decade ago, the SEC began requiring every mutual fund to prominently disclose investment returns using (then) AIMR (now CFA Institute)-endorsed formats. Fiduciaries – and the investing public – regularly use this information by obtaining it directly from a fund’s prospectus or indirectly through various mutual fund rating organizations. However, a simple exercise, using easy-to-understand mathematics, reveals a potentially fatal flaw in these reporting standards. How do you, as a fiduciary, know when you’ve fallen victim to this defect? Better still, what represents a better way you can perform investment due diligence to avoid this terrible trap? The following example allows us to quickly discover the source of this flaw – and hints at a possible solution.

Before we begin, a word of warning. Many fiduciaries may casually underestimate the dangers this imperfection presents to them. Despite the blessing of the government, large industry associations, and independent rating agencies, a generally accepted flaw remains a flaw. Worse, those held accountable for the potential damage of the flaw are not these detached organizations, but the professionals implicitly promoting the festering error – regular people ranging from bank trustees hired to guard the interests of beneficiaries to retirement plan sponsors and trustees responsible for protecting their employees. Wouldn’t these professionals be better off if we rethink performance standards in a manner that can reduce their corporate and personal fiduciary liability?

Given the constraints of this article, the limits of space require us to only focus on one aspect of this flaw. We’ll pick the most universally applicable case – those interested in long-term investments. This type of investment appeals to nearly all investors, since it is generally preferred for ERISA and Taft-Hartley retirement plans, endowments, and many different kinds of trust portfolios. In the next few paragraphs, you will immediately see how this flaw impacts you. Then, we will introduce you to a new and exciting method that can overcome some of the dangers of this flaw.

The Fatal Flaw

It’s so common we take it for granted. Long ago established by what is now the CFA Institute – the professional association for securities analysts – it has become part of the Board of Certified Financial Planning CFP curriculum as well as the American Bankers Association CTFA curriculum. It can be found in every Morningstar report and, since 2002, the SEC has required every mutual fund to include it in its prospectus.

What is it? It is the performance reporting standard. We’ve all seen it. It is the 1-year, 5-year and 10-year performance numbers portfolio managers report to the investing public. Now, before we indict those responsible for this flaw, we must remind ourselves why this system was initially developed. Fiduciaries need to be able to objectively compare different portfolios on an apples-to-apples basis. In addition, they should avoid making a decision based only on a single (especially short-term) period of time. The industry therefore concluded it should look at a wide range of universal performance reporting periods. This generally accepted principal led to the 1, 5 and 10-year performance reporting standard we have today.

Of course, as is the whim of the law of unintended consequences, it has become apparent this broadly accepted standard contains a significant flaw. Unfortunately, the flaw’s venom can lead to potentially damaging results for the naïve investor – and to the fiduciary whose due diligence process incorporates the flaw.

The flaw deals with the accident of the calendar. For years, professional portfolio managers have been aware of this hidden trick as they eagerly anticipated a bad performance year rolling out of a performance period over the course of time. The casual observer might brush this off as a matter already addressed by looking at the three different reporting periods. We must warn this reckless observer, however, that the damage caused by the flaw is most acute for long-term investors who contribute regularly to their portfolio. This includes nearly everyone who defers a portion of their wages into a retirement plan, and, most especially, to the plan trustees ultimately responsible for protecting plan beneficiaries.

Let’s take a look at an example that easily shows our point. Chart 1 shows a standard performance reporting comparison between two hypothetical substantially similar funds with a long-term investment objective. This represents a graphical depiction of the 10-year, 5-year and 1-year performance reporting periods required by the SEC. A typical fiduciary would take advantage of this information to compare the two funds. Based on this chart, which fund do you think most investors would prefer to invest into? Chances are, most trustees would invest in Fund B. The reason should be obvious. Fund B has performed better than Fund A in the most recent periods and equal to Fund A in the longest period.

A few of the more cynical readers might think there must be some kind of trick here. (Spoiler alert: there is). You might be saying to yourself, “I’d look at more than the standard reporting periods, I’d also look at the annual periods.” As a reward for your diligence, we present Chart 2 showing the annual performance reporting. Does this help? Unless you have a beautiful mind, it’s probably difficult to discern which portfolio offers the best potential. While Fund B has plenty of 0% return years, when it hits, it hits big. Fund A, on the other hand, though resplendent with many positive years, does have a couple of bad years, including one significant negative year. The fact you’re constantly investing only complicates matters.

The Tale of Two Funds

Face it, most people would look at the annual returns and come away with no clear decision. If anything, in looking at both performance charts, there may be a tendency to select Fund B. After all, it appears to both preserve wealth (it has no down years in Chart 2) yet offers a comparable long-term return (Chart 1 shows it has the same ten-year return). Unfortunately, most retirement plans, most notably 401k plans, feature regular contributions. Given this, what real-life impact would each Funds’ respective return have on a typical plan beneficiary. This practical question mimics the kind of decisions plan trustees across the nation must make every day. To give our example some meat, let’s say you’re a plan trustee of a typical 401k plan. The plan offers beneficiaries the option to place their investments among two substantially different investment objectives. You must choose between Fund A and Fund B for one of these investment options. (Sorry, you can’t get away with choosing both. In real life some plan sponsors might, but, as a sophisticated fiduciary, you know giving plan beneficiaries enough rope to hang themselves only increases your fiduciary liability.) Given this, which Fund will you bet your career on?

Chart 3 shows the impact periodic contributions have on the actual ending dollar value when investing the exact same amount in each fund ($8,000) at the beginning of each of the ten years of our study. Surprisingly, we discover our typical 401k beneficiary would have $10,000 more to spend by investing in Fund A, despite each fund having an identical 10-year performance record. This difference could be quite substantial for the average employee investing in a 401k retirement plan. Furthermore, to emphasize the critical issue of the timing of reporting periods, an employee that retired in Year 9 (i.e., a year before the end of our reporting period) would have 26% more assets by investing in Fund A versus Fund B! Is this difference a mere random event? No, this information is embedded in the actual performance data of each fund. The problem: the SEC does not require funds – or mutual fund rating organizations – to present performance reporting data in a manner that is both relevant to and easily applicable to retirement plan trustees and their beneficiaries. Given our litigious society, it would not be surprising to see a day when an enterprising trial attorney uses this kind of analysis in a class action against a retirement plan fiduciary. This old way of looking at investment performance, though generally accepted by the government and industry, may inadvertently imperil fiduciaries and the investing public.

Next Week: Rethinking Performance Standards (Part II: The Solution)

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary Solutions,  Hey! What’s My Number? How to Improve the Odds You Will Retire in ComfortFrom Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on TwitterFacebook, and LinkedIn.

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.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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