Over the last few years we have seen an increase in the number of lawsuits bringing brought against employers for conflicts revolving in and around the retirement plans they provide for their employees. One of the most recent headlines involves New York based money manager, Neuberger Berman, who is potentially on the hook for breaching their fiduciary duty to their employees through self-dealing.
According to an article published on InstitutionalInvestor.com, “attorneys for the plaintiff claim that Neuberger breached its duty as a fiduciary by offering employees a fund that was managed in-house when an externally managed index fund tracking the Standard & Poor’s 500 index would have generated better returns than VEF [Value Equity Fund], with lower fees.” The Value Equity Fund is managed by Neubeger Berman, which collects fees from participants for attempting to deliver outperformance against its comparable benchmark, which in this case would be a US Large Cap Value Index.
Attorneys for Neubeger Berman responded by stating, “Bekker [plaintiff] has not established that VEF’s fees were excessive, or its performance poor, because he improperly compares VEF to a passive fund with a completely different objective and investment style.” They go on to state, “VEF actually outperformed the S&P 500 Index.”
Now, although the attorneys for Neuberger Berman are technically correct in that VEF has a different investment objective and style than that of an S&P 500 index fund, it still doesn’t address the question of, “how did your fund do compared to that of an index fund of a similar investment style?” While the plaintiff is making a very common error in comparing an actively managed fund against the S&P 500, it shouldn’t excuse Neuberger Berman answering this particular question.
There is where we at IFA are happy to assist and potentially put a nail in the coffin of Neuberger Berman’s lawsuit.
Our Take on the Lawsuit
The essence of this lawsuit is like the many that came before it, which is whether or not there is a breach of fiduciary duty for an employer who offers an actively managed fund for a particular asset class and not a passive alternative for the same asset class? While we believe the answer is a resounding, “YES,” we are willing to dig into the number a little bit to justify our conclusion.
Data for VEF, which is an internally managed fund by Neuberger Berman, is not available to the public, so instead we asked, “how does Neuberger Berman do as an active manager, in general?”
Fees & Expenses
Our analysis begins with an examination of the costs associated with the strategies. It should go without saying that if investors are paying a premium for investment “expertise,” then they should be receiving above average results consistently over time. The alternative would be to simply accept a market's return, less a significantly lower fee, via an index fund. Our sample is based off of 28 active strategies that have at least 3 full years of performance history.
The costs we examine include expense ratios, front end (A), level (B) and deferred (C) loads, and 12b-1 fees. These are considered the “hard” costs that investors incur. Prospectuses, however, do not reflect the trading costs associated with mutual funds. Commissions and market impact costs are real costs associated with implementing a particular investment strategy and can vary depending on the frequency and size of the trades taken by portfolio managers. We can estimate the amount of cost associated with an investment strategy by looking at its annual turnover ratio. For example, a turnover ratio of 100% means that the portfolio manager turns over the entire portfolio in 1 year. This is considered an active approach and investors holding these funds in taxable accounts will likely incur a higher exposure to tax liabilities to short term and long term capital gains distributions relative to incurred by passively managed funds.
The table below details the hard costs as well as the turnover ratio for all 28 active funds offered by Neuberger Berman. You can search this page for a symbol or name by using Control F in Windows or Command F on a Mac. Then click the link to see the Alpha Chart. Also remember that this is what is considered an in-sample test, the next level of analysis is to do an out-of-sample test (for more information see here).
On average, an investor who utilized an equity strategy from Neuberger Berman experienced a 1.17% expense ratio, a 0.21% 12b-1 fee, and a 5.75% max front-end load for equity funds with a load. Similarly, an investor who utilized a bond strategy from Neuberger Berman experienced a 0.81% expense ratio, a 0.25% 12b-1 fee, and a 4.25% max front-end load for bond funds with a load. This can have a substantial impact on an investor’s overall accumulated wealth if it is not backed by superior performance. The average turnover ratios for equity and bond strategies for Neuberger Berman were 95.52% and 119.57%, respectively. This implies an average holding period of about 10 months to 12 months, on average. It is safe to say that Neuberger Berman makes investment decisions based on short-term outlooks, which means they trade quite often. Again, this is a cost that is not itemized to the investor, but is definitely embedded in the overall performance. In contrast, most index funds have very long holding periods--decades, in fact, thus deafening themselves to the random noise that accompanies short-term market movements, and focusing instead on the long term.
Excess Return Against Commercial Benchmark
The next question we address is whether investors can expect superior performance in exchange for the higher costs associated with Neuberger Berman’s “expertise.” We compare each of the 28 strategies against their current Morningstar assigned benchmark to see just how well each has delivered on their perceived value proposition. We have included alpha charts for each strategy at the bottom of this article. Here is what we found:
- 57% (16 funds) have underperformed their respective benchmarks since inception, having delivered a NEGATIVE alpha
- 43% (12 funds) have outperformed their respective benchmarks since inception, having delivered a POSTIVE alpha
- 0% (0 funds) have outperformed their respective benchmarks consistently enough since inception to provide 95% confidence that such outperformance will persist as opposed to being based on random outcomes
It is important to mention that these performance figures do NOT include the front-end load. If an investor paid the front-end load, their return is worse than the results we show here. Not all investors pay the front-end load depending on who sold the fund to the investor, if the fund is in a qualified retirement plan, etc.
In general, we conclude that Neuberger Berman has no expectation of producing above-average returns for their investors. The vast majority (57%) of their funds didn’t beat the average since their inception. The inclusion of statistical significance is key to this exercise as it indicates which outcome is the most likely vs. random-chance outcomes.
Fama/French 3 Factor Regression Adjusted Performance
Now some readers may believe that we are not properly analyzing performance since we do not take into account risk (Beta). We understand your concern. Because Morningstar is limited in terms of trying to fit the best commercial benchmark with each fund in existence, there is of course going to be some error in terms of matching up proper characteristics such as average market capitalization or average price-to-earnings ratio. A better way of controlling for these possible discrepancies is to run multiple regressions where we account for the known dimensions (Betas) of expected return in the US (market, size, relative price, etc.). For example, if we were to look at all of the US based strategies from Neuberger Berman who have been around for at least the last 10 years, we could run multiple regressions to see what their alpha looks like once we control for Beta. The chart below displays the average alpha and standard deviation of that alpha for the last 10 years ending 12/31/2015.
As you can see, not a single fund produced an alpha that was statistically significant at the 95% confidence level (green shaded area). This is what we would expect in a well functioning capital market.
While Neuberger Berman’s lawyers may be technically correct, they are really missing the essence of the lawsuit. Would the plan participants of their employer sponsored 401(k) would have been better off investing in a passively managed alternative to their active strategies? The answer is a resounding yes! Not only are Neuberger Berman’s fees expensive, they have been unable to prove that their higher fees are justified by superior performance.
At its very core, being a fiduciary is doing solely what is in their employees’ best interest at all times. It’s very hard to make the case that this is what is going on at Neuberger Berman.
Here is a calculator to determine the t-stat. Don't trust an alpha or average return without one.
The Figure below shows the formula to calculate the number of years needed for a t-stat of 2. We first determine the excess return over a benchmark (the alpha) then determine the regularity of the excess returns by calculating the standard deviation of those returns. Based on these two numbers, we can then calculate how many years we need (sample size) to support the manager's claim of skill.
About the Authors
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.