fi360 Blog

Why does my index fund fail my due diligence screening?

Every once in a while the fi360 Tools team is asked the question, “Why does my index fund fail my due diligence screening?” The answer changes from fund to fund and is dependent upon the data and circumstances at the time. However, the common conception that index funds as passive investments are “set it and forget it” strategies is incorrect. They must be monitored along with all investments. Furthermore, don’t be surprised if the index fund you’ve selected earns a poor Fiduciary Score or lags its peers in performance.

To illustrate this point, we examined index funds in the fi360 Toolkits for the period ended September 30, 2009.  We identified index funds that fell below the median for both the Fiduciary Score QTR and AVG (see the fi360 Fiduciary Score Methodology Document for more information on our process), and index funds that fell below the median manager in their peer group for several return periods.   The results in the table below show that index funds can rank poorly against a comprehensive process like the Fiduciary Score or, for that matter, many performance periods.

	# of Peers	Index Funds below Median	% Below Median
Fi360 Fiduciary Score (QTR)	968	398	41.12%
Fi360 Fiduciary Score (AVG)	968	351	36.26%
1 Year Return	968	647	66.84%
3 Year Return	968	534	55.17%
5 Year Return	735	419	57.01%
10 Year Return	273	196	71.79%

The next important step in the monitoring process, especially for index funds, is to dig into the shortfalls.  For example, you may want to begin by comparing the index fund’s performance to its specific tracking index in addition to its assigned peer group.  Funds may be correctly tracking the stated index, but still fall below the median manager in their peer group.  This could occur because:

• The fund manager is tracking an index not followed by others in the peer group.
• The peer group chosen for a fund may not be appropriate.

Certainly, there are other qualitative analysis points that may need to be pursued when monitoring an index fund. The point being, the combination of both a core due diligence process and an evaluation of the fund’s tracking index will help identify any deficiencies of the index fund, and lead to improved decision-making related to watch vs. replace decisions.

These are our thoughts. How do you examine index funds in the course of your due diligence process? Let us know in the comments section below.

Fiduciary Links: Thanksgiving week

We hope most of you had the chance to recharge and enjoy time with family over the Thanksgiving break. It was a relatively slow week for any fiduciary-related news or blog posts, so instead of the typical intro to our fiduciary links, we'll say that we are thankful that over the past year we are finally seeing a more widespread commitment to fiduciary standards of care. It is unfortunate that it took a financial crisis and scandal to get on the agenda of the policy makers and it remains to be seen just how far regulatory reform goes in creating real protections for investors. But, with more skeptical and demanding investors and a growing base of dedicated professionals, the options for trusted advisory relationships continue to grow. We'd also like to say thank you to our own membership base of AIF and AIFA designees and Toolkit subscribers who continue to support us. Many of them have been dedicated to improving their own fiduciary processes and promoting a culture of fiduciary responsibility in the industry for as long as we've been around or longer.

Thanks again and on to the best of last week's fiduciary links...  

In the news/commentary:

• Opinion: by the time DC advice rules are out, participants will have missed them when they needed them most
• Opinion: it's about time mutual fund fees were scutinized
• Fiduciary Q&A on regulatory reform
• CalPERS launches investigation into their own oversight of hedge fund investments
• Madoff and other Ponzi-scheme victims' lawsuits could mean trouble for fiduciary liability insurers

From the organizations/associations/government/academia:

• Fiduciary Benchmarks and Bdellium launch index to measure how well investors are preparing for retirement
• Planners in Australia also face harmonization to fiduciary standards
• Advice provision may be pulled from Fair Disclosure Act
• The House Financial Services Committee directly addresses a critic of regulatory reform

From the blogs:

• The difference between fee-only and fee-based
• A new blogger put himself on our radar when he commented on our blog last week. Thanks David Spaulding, a.k.a. "The Investment Performance Guy".

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.

Target date funds: What about risk?

In my most recent Fiduciary Corner column, I looked at how fiduciaries can make the difference in reforming target date funds. A question arose however as to where risk is accounted for. An email I received made the case that the products were being made on the cheap, saying "What is missing is the most important factor of all: RISK. These life-cycle funds are fatally flawed as they assume the same risk tolerance for all investors retiring in a certain year. Risk drives behavior. Individuals usually fail because of behavior." The emailer suggested that by not providing subsets based on risk tolerance for each target date year, managers are feeding the same bad investor behavior that causes investor performance to consistently lag behind fund performance.

Risk is obviously an important factor in the construction of a portfolio--second only to time horizon. If an investor has a very short time horizon, i.e. they have an immediate liquidity need, their opportunity to diversify is limited. That is why the question of whether the target date fund is targeting "to" or "through" retirement is so critical.  If the intent of the investor is to invest "to" retirement, a target date fund may be entirely appropriate (ignoring for the moment other correctable flaws in many of the funds I mentioned in my article).

By definition, diversification is intended to manage risk, which is why I assumed it.  Pre-diversified portfolios have risk management as their reason for being. If investors were capable of building and maintaining a customized portfolio themselves or had access to professional advice to help them, target date funds might not be necessary. But keep in mind that these funds are primarily designed for investors who are either unable or unwilling to structure an appropriately designed portfolio for themselves.

To say that a pre-diversified option is "fatally flawed" seems to me to be an overstatement in the same sense that it would be an overstatement to say that no one can ever benefit from buying preassembled furniture. Custom built furniture will generally be superior, but pre-built isn't inherently worthless. Of course, if someone needs a desk and goes shopping for something pre-built but comes home with a dresser, their needs aren't going to be met. There is a certain level of understanding that the buyer needs to have of what they need and what they are buying.

As I indicated in my article, there are currently some inherent problems with target date funds. For example, the "to" versus "through" issue is the equivalent of getting a pre-built piece of furniture without knowing what’s in the box. In addition, the exemption that treats underlying funds in the target date product as not being plan assets allows the provider to have conflicts of interest. But these and other flaws are correctable, not fatal.

To be clear, I am not a big fan of target date funds. However, in the limited circumstance of trying to address the needs of people who are otherwise likely to chase the returns of whatever happens to be the hottest performing fund of the moment, or those who will only park their money in a money market or stable value fund that won't get them to their retirement income goals, new and improved target date funds can play a role (e.g. as a QDIA).

Fiduciary Links: performance reporting season

With end of year performance reporting looming, advisors should be preparing what they'll be communicating to clients, including the past year's performance and the outlook going forward. In his book Asset Allocation: Balancing Financial Risk, Roger Gibson writes about the troublesome issue of performance reporting both for the advisor and the client when short term results can overshadow long term planning. His recommendation is to focus on evaluating performance in terms of progress made towards financial goals. Our own Prudent Practices recommend year end reviews not only report returns, but also review fees, expenses and fiduciary operations.

Other than that, free resources or information on the web about year end presentations were difficult to find. If you have any that you know of, please post them to the comments for others to see or email them to blog@fi360.com. In addition, we'll be hosting a free webinar in which we give our recommendations of what to include in your year-end presentations and what clients should be looking for when they sit down with their advisor for the year-end report.

On to the rest of the links...  

In the news/commentary:

• Why investors are pulling their money out of brokerages
• Investors forgetting last year already? Chasing higher yields
• The 60 second explanation of fiduciary
• Update on the status of the fiduciary debate in Australia
• Minneapolis Star-Tribune explains fiduciary v. suitability
• Fiduciaries need liability insurance

From the organizations/associations/government/academia:

• FINRA increasing lobbying budget
• DoL finally killed the Bush advice rule, new rule to be written
• Financial planners say some advice shouldn't be covered in new regulations

From the blogs:

• How to find a financial planner you can trust
• Is your target date fund appropriate?
• Planners need to ask their clients the tough questions

Tweet of the week:

@SherylGarrett: Express support for #fiduciary standards for all advisors at http://www.thefiduciarystandard.org Get involved!

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.

Laying the groundwork for a big 2010 for fiduciary law

With the final month of 2009 fast approaching, 2010 is looking to be a big year in the fiduciary arena as regulators and legislators prepare to pass key regulations and legislation, and the high court delivers a key ruling and also considers whether to take up more fiduciary issues. 

This week, the Department of Labor announced another delay in the effective date of the investment advice regulations that were originally published in January.  The delay is in line with a previous announcement made by Phyllis Borzi, the Assistant Secretary of the Employee Benefits Security Administration, that the agency would pull the rules finalized in January and issue new rules.  With a new effective date of May 17, 2010 set, DOL will likely seek to release new proposed investment advice rules for public comment in early 2010 and finalize the rules by May.  DOL is also expected to finalize its long awaited 408(b)(2) plan fee and expense disclosure rules in early 2010. 

Meanwhile, on Capitol Hill, House Financial Services Committee Chair Barney Frank announced that the House vote on financial regulatory reform will likely not occur until the second or third week of December.  The House Financial Services Committee is still working this week to finalize pieces of the comprehensive legislation the House will consider.  Once the legislation is ready, the House is expected to take at least three days to consider the package of financial reforms, including the extension of the fiduciary standard to all investment professionals who provide advice, as detailed in the Investor Protection Act (HR 3817). 

In the other chamber of the Capitol, the Senate Committee on Banking will hold its first hearing this morning to consider opening statements on the Restoring American Financial Stability Act of 2009, which is the Senate version of a comprehensive financial regulatory reform package.  As I explained in my post last week, the proposed bill also seeks to extend the fiduciary standard, but would take a different statutory approach.  Following today's hearing, the Senate Banking Committee is expected to continue its consideration of financial regulatory reform right after Thanksgiving.  With the House and Senate separately considering similar financial reforms and time in 2009 quickly running out, it is becoming increasingly likely that a final consolidated bill enacting financial regulatory reforms will not be ready for President Obama's signature until early 2010. 

Finally, this past month, the high court was presented with another opportunity to consider fiduciary issues related to fund fees with the filing of a petition for review by employees of Deere & Co.  The employees are seeking review of a decision by the U.S. Court of Appeals for the 7th Circuit, which ruled against the employees and found that Deere did not violate its fiduciary duty under ERISA by imprudently selecting investment options with excessive fees.  The 7th Circuit denied a petition for rehearing earlier this year, clearing the path for the Deere employees to seek review by the Supreme Court.  It remains unclear whether the Supreme Court will take up Hecker v. Deere, and its decision could hinge on its final ruling in Jones v. Harris Associates, which the court heard arguments on earlier this month.  Although the Jones case involves fiduciary duties under a different law, the Investment Company Act of 1940, it is tied to the Heckercase because both cases rest on a premise that fund fees are the result of market competition and both cases were decided by the 7th Circuit.  A ruling in Jones is not expected until summer of 2010, which could mean the court will not decide whether to take up the Hecker case until then as well.  

Practice SA-1.1: Know and follow the rules

The first of the Prudent Practices is all about knowing and following the rules. This goes for all rules impacting the portfolio, including legal requirements and those set in documents related to the establishment and management of investments. The starting point for the fiduciary process is similar to the starting point in any management task or starting a new business: know your goals and objectives, know the rules, and know what limitations you face. Let's take a look at the Practice and criteria themselves:

Applicable law and oversight depends on the type of portfolio being managed. One of the first things you will want to do as a fiduciary is to verify with legal counsel the appropriate body of law governing the plan or portfolio. In general, corporate qualified plans like 401(k)s and pensions fall under ERISA with Department of Labor oversight; Taft-Hartley multiple-employer plans, which have a special sub-set of rules under ERISA, do as well. Most other fiduciary portfolios fall under state oversight. In these cases, there are uniform codes drafted by a national commission that states may choose to adopt (MPERS for public retirement plans, UPMIFA for foundations and endowments, and UPIA for private trusts) or they may have adopted their own legislation or tweaked the uniform acts for their state. You will need to confirm the exact statutes governing these types of plans for your state.

The next place to look for special rules are in trust or plan documents set at the establishment of the portfolio. Here you may find restrictions on certain asset classes, socially-responsible investment mandates, relief of certain fiduciary duties, participant and beneficiary requirements, etc. This criterion serves two purposes: to familiarize yourself with the special rules and to ensure special plan rules are not in conflict with legal requirements.

The remaining essential document to review at the outset is the investment policy statement. The IPS is perhaps the most important document in the management of an investment portfolio. It is the equivalent of the business plan and needs to contain detail such that a competent third party can step in and administer the portfolio if necessary. We won't get into the development of an IPS until Practice 2.6, but if your review of plan documents for an existing portfolio reveals that no IPS exists or it is poorly written, you will want to take steps to address the deficiency immediately.

Finally, you'll want to compile the various documents pertaining to fiduciary processes into a "Fiduciary File."  This ensures that there is a single place to refer to when questions about plan or portfolio management arise and for the successful continuation of that management in the case of steward or advisor turnover. At a minimum, the fiduciary file should include trust documents, the IPS, meeting minutes from investment committee meetings, custodial and brokerage agreements, service agreements with investment service providers, ADVs for each mutual fund manager, and performance reports from service providers. If you look back to our post on the fiduciary role of investment stewards, the fiduciary file would contain any documents you would want with you when you visited "the chair" to defend your investment management decision-making process.

Different types of fiduciaries will have different levels of expertise, and each will have to dedicate varying amounts of time and energy on the first Practice.  Each portfolio is different, which is why it is so important for every individual or firm stepping into a fiduciary role to familiarize themselves with the unique needs and requirements of the investors they are serving.

For more information on fiduciary rules, check out the following resources:

• Full text of Practice 1.1 from Prudent Practices for Investment Stewards
• Legal substantiation by Reish and Reicher
• fi360's IPS Generator
• The National Conference of Commissioners on Uniform State Laws website for more information on MPERS, UPIA and UPMIFA
• All about UPMIFA
• Cross reference of ERISA in U.S. Code with links to complete text 
• Department of Labor ERISA compliance assistance
• Morningstar Investing Classroom's Creating your IPS

Special note to Practice 1.1: For this post, we are referring to the first practice on the Practice Periodic Table, all of which apply to both investment stewards and advisors. However, in the Prudent Practices for Investment Advisors handbook there is a unique practice that precedes SA-1.1 . This additional Practice was added to cover those rare circumstances when the advisor may not be deemed to be a fiduciary. In such situations the advisor must still demonstrate an awareness of fiduciary roles and responsibilities in order to assist the client who does have fiduciary status.

* * * * *

The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com.  If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.

Fiduciary Links: Senate's answer to regulatory reform released

Since its release in mid October, much of the financial services regulatory reform discussion has focused on the House Financial Services Committee's Investor Protection Act. That is until Tuesday, when the Senate Banking Committee released their Restoring American Financial Stability Act. In her post last Wednesday, Kristina explained that the major difference in how the bills address the fiduciary issue is that the House bill would add provisions to the Securities Exchange Act that would require brokers who provide advice to meet the same standards as advisers while the Senate bill would remove the broker-dealer exemption from the Investment Advisers Act and require all brokers to register as advisers. Each has presented a different way to solve the same problem, and each one offers different challenges to overcome, as evidenced by the reactions coming from advocacy groups for advisers, brokers, the insurance industry, consumers, etc. For his part, Barney Frank of the House Committee said he liked the Senate's bill and was encouraged that both were moving in the same direction.

Here are more links related to the Senate bill:

• Dodd's regulatory reform bill would eliminate broker-dealer exemption
• Dodd's plan would also let SEC decide if mandatory arbitration is permissible
• Advisers support Dodd's bill
• Dodd's bill may require insurance agents to register as advisers
• Is the Senate over-regulating?
• Is Dodd picking fights?
• Dodd bill would make brokers fiduciaries, SIFMA prefers House option

On to the rest of the links...  

In the news/commentary:

• "Congress must establish baseline competency, practice and ethical standards for planners"
• Fiduciaries can fix what's wrong with target date funds
• Caterpillar 401(k) fee lawsuit settlement good news for future fee litigation
• Ethics can hedge risk and make your firm more profitable

From the organizations/associations/government/academia:

• Fiduciary Benchmarks can now benchmark 98% of all 401(k)s
• Life insurance industry weighs in on Investor Protection Act, seek more protections for commissioned sales people
• Advisers, consumer groups, state regulators all applaud Frank's plan to contest IPA provision for FINRA oversight of broker-affiliated advisers
• On top of all the other good reasons for fiduciary protections, a paper from University of Windsor says they are efficient

From the blogs:

• Brokers need to prepare for a fiduciary world
• Fiduciary News interviews Bright Scope's Ryan Alfred
• Investors make mistakes, not investments

Tweet of the week:

• @pitiso: @ Accredited Investment Fiduciary Analyst training in FL. Ida on its way but we're sticking to class. Well worth it.

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.

The fiduciary role of investment stewards

Last month, we looked at how investment fiduciaries could generally be broken down into three different categories. Now we'll begin looking at each type in more depth, starting with the investment steward.

As noted in that first post on the types of investment fiduciaries, investment stewards are the trustees, investment committee members, plan sponsors and others in similar positions who are responsible for managing the money of others. The Department of Labor defines their basic responsibilities thusly:

[T]o run the plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. Fiduciaries must act prudently and must diversify the plan's investments in order to minimize the risk of large losses. In addition, they must follow the terms of plan documents to the extent that the plan terms are consistent with ERISA. They also must avoid conflicts of interest. In other words, they may not engage in transactions on behalf of the plan that benefit parties related to the plan, such as other fiduciaries, services providers or the plan sponsor. 

Investment Stewards make for an interesting case because they carry the most risk and are in charge of managing the entire investment process and yet are usually the least trained and experienced in investment decision making.  Beyond the basic tenets of fiduciary responsibility described above, statutes, regulations and case law have defined more specifically what the prudent management of investment decisions entails. Liability arises in the gaps where certain duties are potentially not being performed, exposing investors to unnecessary risk or to less than diligent decision making. The best way to reduce liability for stewards is to follow processes, document decisions, delegate to professionals the roles they are not equipped to perform themselves and, above all, remember what is at stake for those who have placed them in a position of trust and act accordingly.

While investment stewards can limit their liability, they can never fully abdicate their responsibility to be the true managers of the investment process. All decisions need to be made with proper due diligence and conscientious monitoring, including the decision to delegate responsibilities to professionals and the ongoing monitoring of their effectiveness. The steward starts with and retains all fiduciary responsibilities and will be held accountable for their being performed appropriately. In our classroom programs we illustrate the point by asking students to imagine themselves in "the chair" in a courtroom defending their decisions. Could you confidently say all duties were being performed? Could you articulate your decision making processes? Do you have documentation that proves you acted prudently? Would you be able to look others in the eye and say that you made decisions because they were right for those whose money you were managing?

Despite individually sitting at the top of the fiduciary pecking order and collectively managing a majority of all assets invested in capital markets, it is not uncommon for investment stewards to be virtually unaware of the scope of their duties, if they even realize their liability exists at all. One of the most important fundamental shifts needed to improve the management of retirement assets and other investment management is for a greater awareness among stewards of both the extent of their responsibility and the specifics as to what is required for prudent management.

For more information on basic fiduciary responsibilities for investment stewards, check out the following resources:

• fi360's Self-Assessment of Fiduciary Excellence for Investment Stewards: http://safe.actifi.com
• fi360's Prudent Practices for Investment Stewards handbook: http://www.fi360.com/main/practices_sa.jsp
• DOL site on fiduciary responsibilities: http://www.dol.gov/dol/topic/retirement/fiduciaryresp.htm
• DOL site for fiduciary education: http://www.dol.gov/ebsa/fiduciaryeducation.html
• The law firm Reish & Reicher's publications for plan sponsors: http://www.reish.com/publications/content.cfm
• TIAA-CREF's guidelines for fiduciary compliance http://www.tiaa-cref.org/administrators/compliance/guidelines/categories/fiduciary.html

Senate Banking Committee ready to address fiduciary and oversight issues

Yesterday, the Senate Committee on Banking released more than 1,100 pages of draft financial regulatory reform legislation, over 200 pages of which addresses investor protection and securities regulation.  While the Senate's Restoring American Financial Stability Act of 2009 seeks to address the same issues as the House's Investor Protection Act, the Senate has taken a very different approach to responding to the Obama Administration's mandate to raise the standard of conduct for broker-dealers providing investment advice to the fiduciary standard.

Specifically, the Senate Banking Committee proposes to remove the exemption from the Investment Advisers Act of 1940 for brokers who provide advice that is "solely incidental" to their brokerage activities.  With the removal of this exemption, any broker who fits the definition of an "investment adviser" under the federal securities laws would be required to register as such with the SEC and be subject to investment adviser requirements, including the fiduciary standard. 

The Senate committee's approach is markedly different from the House Financial Services Committee's proposal, which would keep the broker exemption in place and add a requirement to the Securities Exchange Act of 1934 that brokers providing advice to retail customers follow the same standard of conduct as investment advisers.  However, the approach has proven to be messy because it keeps two separate sets of rules in place for brokers and investment advisers making the ultimate goal of "harmonizing" investor protection rules for financial professionals harder to achieve.  It also has presented opportunities for legislators to add amendments to the House's proposed bill that could chip away at the fiduciary standard on the broker side rather than bringing the standard for brokers up to the same stringent level as the standard currently applicable to advisers.

Overall, the Senate committee's proposal provides a much cleaner way to provide consistent protections to investors who receive advice by keeping the established fiduciary standard in place and extending it more broadly to brokers.  Moreover, the committee's draft bill has recognized the need to accomodate certain aspects of the broker business model by proposing amendments to the Advisers Act that would allow professionals to receive asset management fees and commissions and would give the SEC the authority to exempt persons and transactions from the current prohibition against principal trading if in the public interest.  Again, such concessions still keep the fiduciary standard in place while making it possible to bring more consistent regulation to all professionals providing advice.  In addition, the Senate has proposed additional investor protections that would require professionals to properly manage conflicts of interests and disclose to clients limitations on the range of investment products that they offer and recommend.  

Of course, increasing investment adviser registrations at the SEC begs the question of how will an already strained adviser examination program take on additional responsibilities.  The Senate committee has tried to address that issue through a proposed provision that would raise the assets under management threshold for federal registration to $100 million shifting some responsibility to the states.  In addition, other proposed provisions would allow the SEC to transition to a self-funded model allowing it to set its budget each year without Congressional approval and retain fees it collects from registered entities to fund the budget.  Such a model would give the SEC more access to funding and resources needed to effectively run its programs. 

The Senate Banking Committee is expected to hold hearings and start marking up the proposed legislation in the coming weeks with the goal of completing the bill by December and sending it to the Senate floor.  The full House is also expected to vote on comprehensive financial reform legislation in early December. 

Fiduciary links: Target date funds under the microscope

In another busy week of work towards regulatory reform, it was an investment product that made the most headlines this week. The Senate Special Committee on Aging held target date fund hearings last week, where the funds were criticized for disclosure problems, excessive fees, inconsistent design and conflicts of interest. The hearings prompted a slew of interest and commentary, as legislators want to fix some of the problems in the increasingly popular retirement funds. Here are just some of the target date fund related links from the past week:

• News coverage: WSJ, Bloomberg, USN&WR
• Just having the same target date doesn't mean funds resemble each other
• 401(k) rating company Bright Scope launched their target date fund rating service
• Bright Scope's Ryan Alfred discussed TDFs on CNBC
• Blaine's latest Fiduciary Corner column says fiduciaries are on the hook to improve the product
• Just google "target date fund" and check the "news" and "blogs" tabs for many more results

On to the rest of the links...

In the news/commentary:

• Supreme Court suggests they will leave mutual fund fee debates to the SEC
• ICI prez says courts should leave mutual fund fees alone
• States may take over more RIA oversight
• One commentary looks at what the future may hold for FINRA
• Does your business need fiduciary insurance?
• The Investor Protection Act made it out of committee
• SEC's authority, budget to increase?
• More investment advice from 401k plans

From the organizations/associations/government/academia:

• Industry groups were lining up against FINRA oversight of broker-affiliated advisers
• And more the next day
• And then Frank says he'll push to kill the amendment

From the blogs:

• When the decisions don't work out, they question becomes, "what was the process?"
• What's your motivation for running your company's 401(k)?
• Post-game analysis of the mutual fund fee case

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.