The Fiduciary's Default Investment Choice
Armstrong, Frank, III, The CPA Journal
Index Funds Provide Some Safe Harbor for Fiduciaries
Several high-profile class-action lawsuits concerning fiduciary duty are now winding their way through the federal courts. These suits allege that various pension and 401(k) plans are responsible for high costs, sustained underperformance, and failure to disclose and account for revenue sharing and other "under the table" payments. Because these issues should have never come up, the fiduciaries involved have only themselves to blame.
All relevant fiduciary standards-including the 1974 Employee Retirement Income Security Act (ERISA), the 1994 Uniform Prudent Investor Act (UPIA), the 1997 Uniform Management of Public Employee Retirement Systems Act (UMPERSA), the 2006 Uniform Prudent Management of Institutional Funds Act (UPMIFA), and the 2002 Restatement of the Law Third, Trusts: ftudent Investor Rule - have embedded language suggesting that passive investment strategies, such as index funds, asset class funds, and exchange traded funds (ETF), are the appropriate implementation of a fund's investment policy. Fiduciaries ignore such language at their own peril.
The direction to consider passive strategies as the default implementation is so explicit that it provides considerable "safe harbor" for fiduciaries. Recommending index funds, asset allocation funds, and ETFs should keep fiduciaries safe from litigation.
Although active strategies are not specifically prohibited, their justification requires a high burden of proof, which is seemingly impossible to meet in practical terms. As the Reporter for the Restatement says in the fourth generalization concerning prudent investment, 'To the extent an investment strategy involves extra management, tax, and transaction costs or a departure flora an efficiently diversified portfolio, that strategy should be justifiable in terms of special circumstances or opportunities or in terms of a realistically evaluated prospect of enhanced return [from the strategy]." The Reporter adds, "The greater the trustee's departure from one of the valid passive strategies, the greater is likely to be the burden of justification [for selecting the proposed active strategy] and also of continuous monitoring [of it]. Failure to diversify on a reasonable basis in order to reduce uncompensated risk is ordinarily a violation of both the duty of caution and the duties of care and skill."
With this guidance, the commentary to Section 227 of the Restatement of the Law Third, Trusts: Prudent Investor Rule cautions, "Because market pricing cannot be expected to recognize and reward a particular investor's failure to diversify, a trustee's acceptance of [uncompensated] risk cannot, without more, be justified on grounds of enhancing expected return." This implies that fiduciaries must prefer passive strategies from a risk management perspective.
Prevailing academic research, as well as the author's own experience, indicates that active management strategies are a highly effective method of increasing risk while reducing returns. Active investors can reliably expect to reduce their returns by 1% to 2% per year while bearing a significant load of uncompensated risk. Over the lifetime of a pension participant or a trust account, this becomes significant sustained uriderrjerformanee, placing fiduciaries squarely in the crosshairs of the plaintiffs bar.
Index funds offer "pure market exposure" with minimum uncompensated risk, which should be the objective of every fiduciary.
The overwhelming evidence shows that actively managed accounts cannot reliably add value when compared to an unmanaged index. Although 20% to 30% may beat the index in any particular timeframe, winners in one period are no more likely to outperform during subsequent periods than chance might indicate. Actively managed funds tend to underpetform by the amount of their additional expense. …