The scrutiny of fees within retirement plans has reached a fever pitch and shows no signs of abating. The endless stream of lawsuits accusing plan fiduciaries and service providers of charging excessive fees, of all types, has fostered a heighted sense of anxiety amongst plan sponsors and advisors. Understanding plan expenses in relation to services provided and paying only reasonable costs is of the utmost importance; however, examining fees in isolation is problematic. This is particularly true when applied to investments.
Selecting the lowest cost option or a passive fund due to fear of litigation does not fulfill fiduciary obligations nor does it excuse liability and, potentially, may not be in the best interest of plan participants. According to a recent Cerulli report and survey titled “Facing Fiduciary Fears: Choosing passive does not equal fiduciary hall pass,”¹ the primary motivating factor for plan sponsors to select a passive fund over an active fund was to alleviate concerns related to lawsuits as opposed to having a developed argument against the investment merit of active management. This approach toward investment selection could be interpreted as putting the plan sponsor’s interest ahead of those of the plan participants and their beneficiaries, violating a fiduciary’s responsibility under ERISA.
According to an often overlooked study titled “Out of Sight, Out of Mind: The Effect of Expenses on Mutual Fund Flows” by Brad M. Barber, Terrance Odean, and Lu Zheng which was published in the Journal of Business in 2005, “there is no discernible relationship between performance and expenses for the majority of funds.”² The authors obtained data on U.S. equity mutual funds between 1970 and 1999 from the CRSP database. They then sorted the funds by expense ratios into deciles and calculated the mean monthly return, capital asset pricing model (CAPM) alpha, and Fama-French alpha. After examining the results, their research concluded that only funds in the two most expensive decile groups “underperform by an economically large margin (26 to 37 basis points per month).”
In the Journal of Financial Planning, March 2016, Vol. 29, No. 3 edition, David Nanigian, Ph.D., provided an update to Barber, Odean and Zheng’s original report. In addition to analyzing U.S. actively managed funds between 2000 – 2015, Nanigian also analyzed passively managed U.S. equity mutual funds, which were not included in the original report. Nanigian’s study on the relationship between expenses and performance provides strikingly similar results to Barber, Odean, and Zheng in that, funds in the 9th and 10th decile portfolios, those with the highest expense ratios, delivered negative CAPM alphas. Portfolios in deciles 1 through 8 generated positive alphas during the analysis period. Nanigian further notes that “although the index funds portfolio generated more alpha than the decile 9 and decile 10 portfolios, it generated less alpha than each of the eight portfolios that consisted of funds that ranked in the bottom 80 percent of expense ratio.”
Fiduciaries of all size plans, from the mega market to the small market, should be cognizant that selecting investments based on expenses alone may not be considered a prudent process and may expose themselves to additional liability. Additionally, we feel it is imperative that plan sponsors and advisors keep in mind, just as the Department of Labor states in their publication titled “A Look at 401(k) Plan Fees”, “cheaper in not necessarily better.”³
- The Cerulli Edge – U.S. Edition October 2015
This article was written by Calamos Investments. To read “Fees, Funds and Fiduciaries – Cheaper is Not Always Better” in its entirety please click here or copy and paste the link below into your web browser.