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Industry Voices

Commentary: Inclusion of high-fee funds not necessarily a breach of fiduciary duty

The past few years have seen a proliferation of ERISA litigation in which plaintiffs allege that 401(k) plan fiduciaries selected inferior funds for inclusion in plan offerings. Since 2015, more than 20 financial institutions have been sued under the Employee Retirement Income Security Act statutes. The crux of the plaintiffs' allegations in these matters is that the plan fiduciaries breached their fiduciary duties by including proprietary or affiliated mutual funds as investment options in the plans and failed to consider lower-fee options, typically passively managed index funds.

The key economic premise at the heart of the plaintiffs' allegations is that actively managed high-fee mutual funds are necessarily inferior to the lower-cost passively managed index funds. (Despite the common theme among recent ERISA cases, each matter is unique, with a distinct set of allegations requiring fact-specific inquiries and expert analyses beyond the scope of this article.)

In a recent paper, "Actively Managed vs. Passive Mutual Funds: A Race of Two Portfolios," we compared the performance of actively managed and passively managed funds. While we find that actively managed funds do have higher fees than their index fund counterparts — not surprising given the costs of research required to actively manage a fund rather than passively mimic an index — the net-of-fee performance of the active fund portfolio is superior to the corresponding portfolio of passive funds. This finding implies that inclusion of a higher-fee active fund in a 401(k) plan does not necessarily imply an inferior choice. A higher-fee fund's gross (i.e., before-fees) performance can be superior enough to more than compensate for its higher fees, thereby delivering a higher net-of-fee performance.

Plaintiffs in these ERISA cases nonetheless have focused on the higher fees of active funds as a central part of their claims. One complaint, for example, supports this argument quoting a 2009 study by the Government Accountability Office that found, "even a seemingly small fee can have a large negative effect on savings in the long run ... an additional 1 percent annual charge for fees would significantly reduce an account balance at retirement." Plaintiffs use this argument to imply a higher fee fund will not outperform a lower fee alternative. Our paper specifically examines this claim.

For this paper, we collected data from Morningstar Inc.'s open-end U.S. mutual fund database. Our data set comprises 77,687 fund-year observations across 7,469 unique funds, both active and passive. The data set is free from survivorship bias because it encompasses all funds, dead or alive, from 1996 to 2015.

Using this data, we constructed two portfolios. Both portfolios contain the five largest funds in the prior year across each of the three major asset categories: U.S. equity, non-U.S. equity and fixed income. Both portfolios are reconstituted annually using data from the prior year to eliminate hindsight bias. While the analysis in the paper is limited to retail funds available to the average investor, by selecting the largest funds, we analyze funds similar to those used in ERISA plans.

This table shows some of the key performance statistics for the two portfolios:

Table 1 Performance of the two portfolios, 1996-2015
Average annual returns5.9%5.5%
Standard deviation14.8%15.7%
Sharpe Ratio0.240.20
Sortino Ratio0.130.12

The results show that, despite higher fees, the actively managed fund portfolio outperforms the passively managed one. The active portfolio's average return is better than that of the passive portfolio by 40 basis points per year, while exhibiting less volatility of returns (measured by the standard deviation). Consequently, the Sharpe ratio is higher for the active funds compared with the passive funds. Examining the performances of the two portfolios across the individual years, 1996-2015, we find this outperformance is explained by the comparatively better returns of active funds during market downturns. This suggests active funds likely provide higher downside risk protection than their passive counterparts.

Many prior academic studies have compared the performance of active funds to market indexes and have typically found that, on average, active funds generally underperform indexes. By contrast, in our study, we have compared the performance of the largest funds available in their respective asset category. We find that the largest funds' performance is indeed superior to that of relatively smaller funds, which explains, in large part, why our results are different from the findings in the other academic studies.

Our findings call into question the plaintiffs' claims that the selection of higher-fee funds is necessarily against plan participants' interests. However, as noted earlier, each case is fact-specific and an individualized inquiry would be required to reach any specific view in a particular matter.

Also, while our paper does not specifically analyze the institutional share classes commonly used by ERISA plans, the funds used (the largest in their respective category) generally offer institutional share classes. As institutional share classes typically have lower fees than retail share classes, the incorporation of these share classes is likely to only increase the outperformance of the actively managed portfolio.

Atanu Saha is chairman and Alex Rinaudo is chief executive of Data Science Partners, New York. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.