Barry’s Pickings Online: Passive Aggression

Art by Joseph CiardielloIn 401(k) fee litigation and, more broadly, in attacks on the 401(k) “industry,” it is common to compare the fees charged by actively managed funds to those charged by passive/index funds and point to the strong performance of the indexes as “proof” that active managers are overcharging.

The passive vs. active debate is ancient and (notwithstanding the views of the partisans) unresolved. I think it is fair to say that the Employee Retirement Income Security Act (ERISA) did not take sides in this debate—the idea that ERISA mandates only the use of passive management is absurd.

To be clear about my view on this topic: I believe active management can add value in many markets and can be both efficient and efficiently priced. In my view, it is possible, in markets that are not already at “peak efficiency,” for a group of smart people with special expertise to spend time and energy developing a knowledge advantage versus “the market.” I’m pretty sure that that is the mainstream view. Comparing the active management cost of, e.g., a small cap fund to the cost of an S&P 500 Index fund is, simply and obviously, a category mistake.

The problem—especially for plaintiff’s lawyers—is that active management is an inherently non-transparent process. Indeed, with respect to, e.g., hedge funds, its non-transparency is regarded as a feature not a bug. And—for defendant’s lawyers—the transparency of, e.g., index funds is a bug not a feature.

There is a (semi-)famous study, “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds,” evaluating “why individuals invest in high-fee index funds.” The underlying premise of this study—which seems to me pretty obvious—is that “funds tracking a given index offer virtually identical portfolio returns before fees.” The study notes that:

“The mutual fund industry has countered that ‘S&P 500 index funds themselves are not commodities. These funds differ from one another through the services that are packaged with their securities portfolios and through other characteristics’ …. These non-portfolio services include financial advice, customer service, and discounted access to complementary investment instruments. Thus, investors in expensive funds may receive higher quality non-portfolio services that fairly compensate them for their lower financial returns.”

Perhaps. But as the study’s authors observe, “even if it were established that investors were receiving some extra services in exchange for lower portfolio returns, it would remain unclear whether a rational investor would pay such a high price for these services.” In my humble opinion (IMHO), these “additional services” look a lot like a talking point and a post-hoc attempt to de-commoditize what is obviously a commodity. What are these additional services actually worth, and why should their value be a function of assets under management (the fund’s expense ratio)?

Sponsors who think that by going “all-passive” they will avoid getting sued have—again IMHO, catastrophically—missed the point of the last 15 years of 401(k) fee litigation. The cases that the plaintiff’s lawyers are winning are not about “high fees.” They’re about “higher fees.” Plaintiff’s lawyers are winning where they can prove that a sponsor-fiduciary could have gotten the same services for less.

That’s hard (impossible?) to prove where the services are “unique”—e.g., the services of an active manager with unique personnel and a unique style. That’s easy to prove where the services are a “commodity.” And the most obvious targets for the plaintiff’s lawyer’s commodity argument are recordkeeping (consider Tussey v. ABB) and index funds (consider the Anthem and Chevron lawsuits).

Yes, it may be possible for a fiduciary to defend paying higher fees for an index fund (than some other fund tracking the same index) because of the additional services that are provided. Likewise, it may be possible to defend paying higher fees for recordkeeping (than some similarly situated comparable plan) on the same basis. But I seriously doubt that courts are going to allow such a defense based on vague hand-waving. Fiduciaries are going to have to prove that all these additional services actually do add demonstrable value. And—and please prove me wrong—I seriously doubt whether many sponsor-fiduciaries have any documentation supporting any of that.

Moreover, while it is sponsor-fiduciaries who are getting sued in these cases, it is, ultimately, providers who are going to suffer. Because, if I were a fiduciary and lost a multi-million dollar case because I paid my fund manager too much, I’d never use that fund manager again.

So if there is a way to de-commoditize recordkeeping and passive investment services—to prove that the additional services provided are worth the additional assets under management fees plans are paying—fiduciaries and providers should get on it.

In reviewing recent litigation in this area I was struck by this line, from a motion to dismiss in the MassMutual litigation: “Nothing in ERISA bars every financial firm except one low cost provider based in Pennsylvania from offering investments to retirement plans.” With respect to actively managed funds, I say “Amen.” But it may be the case that even if you do use that “low cost provider based in Pennsylvania,” if you don’t get its cheapest product, you may be violating ERISA.

Michael Barry is president of the Plan Advisory Services Group, a consulting group that helps financial services­ corporations with the regulatory issues facing their plan sponsor clients. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly http://moneyvstime.com/ about retirement plan and policy issues.