NEWLY FILED SUITS NOW TAKE AIM AT TARGET DATE FUNDS AND LOWEST COST CHOICES IN 401(K) PLANS – WHAT ARE PLAN TRUSTEES TO DO NOW?

If you’re a sponsor or trustee of a 401(k), 403(b), 457, or other defined contribution plan, you might believe that the use of “target date retirement funds” (TDFs) shields you from potential class-action lawsuits alleging a breach of fiduciary duty. You may also think that opting for the lowest cost providers would further safeguard you against such accusations. Unfortunately, these assumptions could lead you down a precarious path.
 

Recently, ThinkAdvisor reported a surge of lawsuits against companies like Citigroup and Genworth Financial, among others, due to the underperformance of their BlackRock TDFs. This highlights an often overlooked tension between cost and performance: “Citigroup, Genworth Face Lawsuits Over BlackRock TDFs in Their 401(k)s”, Melanie Waddell reports that:

“Citigroup and Genworth Financial are among at least six firms that are facing class-action lawsuits filed since Friday over “underperforming” target date funds from BlackRock. . . .”

Earlier class-action lawsuits against plan sponsors and trustees primarily centered around excessive cost-related claims, which were relatively straightforward to prove. However, these excess cost-related claims tend to be marginal compared to the potential damage from chronic underperformance claims, which can accumulate significantly over time.

As legal firms become more aware of this discrepancy, they are shifting their focus towards alleged chronic underperformance as a violation of fiduciary duties. Consequently, plan sponsors, trustees, and their advisors who have been emphasizing lower-cost choices as a protective measure may find themselves in hot water.
The class-action suits argue that the BlackRock TDFs underperformed compared to many alternative mutual funds. The lawsuits stress that any objective evaluation of the BlackRock TDFs would have led to the selection of better-performing options. Instead, defendants are accused of chasing low fees without considering return on investment.

This brings us to an essential point: cost and performance should not be considered in isolation; they must be evaluated in tandem. The process of “weighing” these factors is critical, although the specifics of this process and the definition of “performance” remain undefined.

At Decision Technologies Corporation (DTC), we’ve spent decades addressing these issues. Our newly released Professional RapidReview ToolTM / our “ProRRTTM” allows for a comprehensive evaluation of up to 48 different performance parameters, including costs. This tool enables plan trustees to objectively score and rank thousands of choices, identifying those best at producing the desired composite performance over time.
By using this selection and ongoing performance monitoring process, plan trustees can demonstrate that they have fulfilled their fiduciary duty and acted in the best interests of their plan’s participants.

If you’re a trustee of a defined contribution plan, we encourage you to visit our Trustee Empowerment & Protection, Inc. website, which refers plan sponsors and trustees to investment advisors trained to perform protective reviews of your plan’s investment options. Understanding and mitigating your risks, including personal liability, is crucial.

And if you’re an investment advisor, we invite you to learn how DTC’s patented decision-assistance technology can enhance the investment recommendations you offer to your clients. Visit our Trustee Empowerment & Protection, Inc. website to learn how you can qualify to provide these protective reviews, expanding your advisory business while serving a vital role.

Written by Eric Smith, J.D., President and an Investment Advisor Representative of Trustee Empowerment & Protection, Inc.,
A Registered Investment Adviser.  He is also Chairman & CEO of Decision Technologies Corporation.

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Plan Fiduciaries Prevail In First Published Appellate Opinion Applying Supreme Court’s ERISA Ruling In Hughes v. Northwestern

Troy, MI – June 29, 2022 – On June 22nd, the 6th Circuit Court of Appeals handed down Smith v. CommonSpirit Health, et al., dismissing a class-action complaint alleging (in part) fiduciary imprudence by the 401(k) Plan’s trustees for having poorer performing actively managed investment choices rather than lower cost (and apparently better performing) passive choices. 

 

We don’t disagree with the result.  Just the fact that a Plan has actively managed choices which are under-performing passively managed choices alone is probably not enough.  But, the Court did not take the position that chronic under-performance was somehow OK?  Here are a couple of key quotes from the Opinion:

  • “We accept that pointing to an alternative course of action, say another fund the plan might have invested in, will often be necessary to show a fund acted imprudently (and to prove damages). But that factual allegation is not by itself sufficient. . . . these claims require evidence that an investment was imprudent from the moment the administrator selected it, that the investment became imprudent over time (emphasis added), or that the investment was otherwise clearly unsuitable for the goals of the fund based on ongoing performance.” No. 21-5964 Smith v. CommonSpirit Health, et al. Pages 7-8
  • “That a fund’s underperformance, as compared to a “meaningful benchmark,” may offer a building block for a claim of imprudence is one thing. Meiners, 898 F.3d at 822. But it is quite another to say that it suffices alone, especially if the different performance rates between the funds may be explained by a “different investment strategy.” Id. at 822–23. A side-by-side comparison of how two funds performed (emphasis added) in a narrow window of time, with no consideration of their distinct objectives, will not tell a fiduciary which is the more prudent long-term investment option. A retirement plan acts wisely, not imprudently, when it offers distinct funds to deal with different objectives for different investors.”  Id., Page 9.

It appears clear, that deteriorating performance overtime – holding chronically under-performing choices – can lead to a valid claim of fiduciary imprudence, when the comparison is “apples to apples” – i.e., when actively managed funds, with the same investment goals, are compared.  This is precisely what TEPI’s iCPR(TM) is designed to do.

However, our Goal is to help prevent plan trustees and trustees from getting sued in the first place . . . because even if a plan sponsor and trustees “win,” as they did this case, they “lose.” Why?

How much did defending the case up to the 6th Circuit Court of Appeals cost?  What as the plan sponsor’s deductible (“retention”) in their fiduciary liability insurance policy (assuming they likely have one).  And, what reputational damage (for which there is no insurance coverage) has been done to both the plan sponsor and individual trustees?  That damage extends to family members as well, who have to face comments and inquiries about publicly made allegations that a spouse and/or parent has breached their fiduciary duty . . . has been a “bad” trustee.  Unfortunately, these 2nd and 3rd order, collateral effects are seldom thought through by plan sponsors, trustees, and those advising them.

Reputation matters . . . and, in many cases / to many persons and companies, it matters more than the money.

TEPI is working not just to help plan sponsors and trustees “win” such cases, but to prevent the filing of such cases and to simultaneously improve the investment results and retirement security of the plan’s participants.

Written by Eric Smith, J.D., President and an Investment Advisor Representative of Trustee Empowerment & Protection, Inc.,
A Registered Investment Adviser.  He is also Chairman & CEO of Decision Technologies Corporation.

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NASAA Receives DTC’s Response to SEC RFI Describing Its Patented RegTech/WealthTech Decision Assistance Technology That Could Support Tougher Rules​

NASAA Receives DTC’s Response to SEC RFI Describing Its Patented RegTech/WealthTech Decision Assistance Technology That Could Support Tougher Rules

FOR IMMEDIATE RELEASE: Troy, MI – December 2, 2021 – As States consider adopting their own, potentially more rigorous “fiduciary” and “best interest”-type rules and  regulations, Decision Technologies Corporation (DTC) has announced that it has provided the North American Securities Administrators Association (“NASAA”) with a complete copy of its recent informational filing with the SEC describing its newly launched ProRapidReview Tool (“ProRRT”) – the first-of-its-kind RegTech/WealthTech application of its patented decision-assistance technology.

DTC’s ProRRT enables investment advisors and securities brokers to select multiple performance parameters and hierarchically arrange and weight them, profiling the ideal “investment effect” desired within any covered asset class. Using this composite blend of weighted performance factors, users can objectively score and rank hundreds of choices, identifying which mutual funds and ETFs have been the best at producing the composite investment results they and their investor clients are seeking over time, and they can do this in mere moments.

“After more than a decade of in-house testing and use with advisors and individual investors,” says Eric Smith, the Chairman & CEO of DTC, “we believe that in making it more broadly available, this technology will ultimately change the way investment selection is performed and that this submission could ultimately affect what the SEC and various state regulators view as regulatorily possible and reasonable.” 

Smith believes: “The combined RegTech and WealthTech effects of this technology, could prove to be a ‘game changer,’ especially in helping securities brokers and investment advisors stay ahead of evolving new regulations through improving transparency, filtering out conflicts of interest, and enhancing chances of improving investment results.  It should also provide a meaningful competitive edge to early adopters, who can use it show the historic investment results prospective clients have been getting versus what they could be getting with the help of this newly available technology.” 

DTC is the creator of the cutting-edge, patented decision-assistance technology which enables users of data, in a broad range of applications, to score and rank thousands of choices in a manner specific to individual needs, goals, and preferences by applying user-specified weighted blends of performance and other characteristics. Its decision engines are designed to address a growing challenge faced by people in in both their businesses and personal lives – the often-paralyzing complexity of decision making in a world of too many choices and too much information about them. DTC’s technology empowers users to optimize their choices in an objective way, cutting through market “noise”, filtering out conflicts of interest, and increasing probabilities of future success through facilitating better choices.

For more information contact:

Jack Findley, COO

 jack@decisionengines.tech

+1 947-282-2901

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DTC Responds to SEC RFI With Notice of New RegTech/WealthTech Offering ​

Its game changing technology may effect what the SEC views as possible and reasonable in its evolving review of RegBI requirements.

FOR IMMEDIATE RELEASE: Troy, MI – November 11, 2021 – Decision Technologies Corporation (DTC) has announced that it has responded to the SEC’s recently issued RFI regarding use of technology to develop and provide investment-advice, SEC RFI – FILE NO. S7-10-21, with a description of its newly launched ProRapidReview Tool (“ProRRT”), the first-of-its-kind RegTech/WealthTech application of its patented decision-assistance technology.

DTC’s ProRRT enables investment advisors and securities brokers to select multiple performance parameters and hierarchically arrange and weight them, profiling the ideal “investment effect” desired within any covered asset class. Using this composite blend of weighted performance factors, advisors and brokers can rapidly and objectively score and rank hundreds of choices, identifying which mutual funds and ETFs have been the best at producing the composite investment results they and their investor clients are seeking over time.

“After more than a decade of in-house testing and use with advisors and individual investors,” says Eric Smith, the Chairman & CEO of DTC, “we believe that in making it more broadly available, this technology will ultimately change the way investment selection is performed. This submission could ultimately affect what the SEC and other regulators view as regulatorily possible and reasonable.” 

Smith believes that “the combined RegTech and WealthTech effects of this technology could prove to be a ‘game changer,’ especially in helping users stay ahead of evolving new regulations and in conferring a meaningful competitive edge to early adopters through improving transparency, filtering out conflicts of interest, and enhancing chances of improving investment results.”

Read DTC’s response to the SEC’s RFI here.

DTC is the creator of the cutting-edge, patented decision-assistance technology which enables users of data, in a broad range of applications, to score and rank thousands of choices in a manner specific to individual needs, goals, and preferences by applying user-specified weighted blends of performance and other characteristics. Its decision engines are designed to address a growing challenge faced by people in in both their businesses and personal lives – the often-paralyzing complexity of decision making in a world of too many choices and too much information about them. DTC’s technology empowers users to optimize their choices in an objective way, cutting through market “noise”, filtering out conflicts of interest, and increasing probabilities of future success through facilitating better choices.

For more information contact:

Jack Findley, COO

 jack@decisionengines.tech

+1 947-282-2901

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DTC’S RESPONSE TO SEC RFI – FILE NO. S7-10-21 INFORMATION ON INVESTMENT ADVISER USE OF TECHNOLOGY TO DEVELOP AND PROVIDE INVESTMENT ADVICE

DTC'S RESPONSE TO SEC RFI – FILE NO. S7-10-21 INFORMATION ON INVESTMENT ADVISER USE OF TECHNOLOGY TO DEVELOP AND PROVIDE INVESTMENT ADVICE

From: Eric S. Smith, J.D., Chairman & CEO, Decision Technologies Corporation (“DTC”)

To: The Securities & Exchange Commission (“SEC”) via rule-comments@sec.gov File No. S7- 10-21 // cc: Division of Trading and Markets, Office of Chief Counsel, via tradingandmarkets@sec.gov and Division of Investment Management, Investment Adviser Regulation Office via IArules@sec.gov.

Date: October 1, 2021

Re: Information regarding a newly available decision-assistance technology, introduced and described at ProRRT.com, that enables investment advisors to score and rank investment choices in a manner specific to the needs, goals, and propreferences of individual investors, optimizing investment selection recommendations in such a way as to ensure that such recommendations are provably in the best interests of individual investor clients and that conflicts of interest, both known and unknowable, are effectively filtered out.

EXECUTIVE SUMMARY:

Ongoing federal and state regulatory efforts toward ensuring that what is being recommended and sold by securities brokers and investment advisors is in their customers’ and clients’ “best interests” continue to face industry push-back. The principal arguments against such efforts have been that:

  • there is no way to determine what is “best” for any client; there are too many choices and too much information about them; and securities brokers / FINRA additionally argue that
  • requiring FINRA-registered securities brokers to effectively become “fiduciary” advisors will prevent small investors from being served – that unless “suitable” products (as defined by FINRA) can simply be sold to them, it will not be economically feasible for securities brokerage firms to serve small investors at all.

A newly available decision-assistance technology appears to effectively address these objections and provides a way for brokers and advisors to comparatively evaluate thousands of investment choices in a manner specific to individual clients’ needs, goals, and preferences. Moreover, it does so objectively, transparently, and in a way that effectively filters out all conflicts of interest, both known and unknowable.

The technology enables investment professionals to pick any number of performance parameters (from 48 possible choices – more are being added), which can then be hierarchically arranged and weighted to profile the ideal “investment effect” desired. Utilizing that composite blend of weighted factors, the available investment choices, within any relevant asset class, can be scored and ranked. The resulting ranked list shows how the client’s investment selections objectively compare with those mutual funds and ETFs that have proven best over time at producing the desired composite performance, within the relevant asset class.

This newly available technology is now being offered to professional investment advisors and securities brokers at ProRRT.com, where detailed information about it can be reviewed.

The technology was developed with one key goal in mind – to help answer this important question: “Of all the available choices, which ones are best for my clients?”

There’s now an objective and transparent way to answer that question and provably demonstrate that what is being recommended and sold to customers / clients is in their best interests. The ability to answer that question may now help to determine what is regulatorily possible and reasonable.

DISCUSSION:

THE INVESTOR PROTECTION “PROBLEM” AND SOME UNDERLYING CAUSES.

In the continuing struggle to ensure that investors are protected from the adverse effects of:

  • Pervasive conflicts of interest;
  • Deceptive, manipulative, and/or predatory practices; and the
  • Growing number of investment choices and overwhelming amounts of information about them,

these listed issues all appear to coalesce in one simple question: “Of all the available choices, which ones are best for the client?” Strangely, there appears to be little serious interest in finding a way to for brokers and advisors (much less their clients(1)) to objectively answer that question. Why?

The debate surrounding the promulgation of the Department of Labor’s ill-fated “fiduciary rule” and the SEC’s creation of its Reg. BI, is enlightening. Both regulatory efforts faced strong pushback from the financial services industry, especially from securities brokers and FINRA.(2) Pointing to the bewildering and growing number of investment choices, they effectively argued that it is not possible to determine what is “best” for any client, and regulations should not require the impossible.

To date, that argument appears to have been both successful and virtually impossible to refute. Yet, in this “information age,” is it reasonable to believe that it has not been possible for a $90+ trillion financial services industry to develop a way to manage all of that data? Is it truly impossible to find a way to ensure that what advisors and brokers are recommending and selling to their clients is provably in their best interests? Or is there little to no interest in doing so? Would doing so simply be too disruptive of the way the financial services business has always been conducted? Unfortunately, the answers to the last two questions might well be “yes,” and one reason immediately seems obvious.

The financial services marketplace is and has been vendor-dominated since its inception. The sale of financial products is the motivating force driving it. Moreover, competition among its vendors typically involves pricing and compensation “incentives” designed to ensure the preferential recommendation and sale of one vendor’s products over those of other vendors. Until the SEC’s recent action compelling disclosure of these arrangements, these conflicts of interest were seldom voluntarily disclosed, for obvious reasons – nothing about those arrangements is good for investors.

IS REQUIRING THE DISCLOSURE OF CONFLICTS OF INTEREST THE “SOLUTION?”

We submit that the answer, unfortunately, is “NO” – that is, if the goal is to try to ensure that what is being recommended and sold to customers / clients is in their best interests. The reason is that requiring even the full disclosure of conflicts of interest will not alone be sufficient to structurally change the way the financial services marketplace works. That marketplace will still be vendor- dominated and still likely incentive-driven. One can simply perform the following though experiment to understand the concern:

  • Imagine that brokerage and investment advisory firms all scrupulously comply and begin to disclose that each, in some form or fashion, receives incentive compensation or are in other ways benefited from vendor relationships in ways that can potentially affect their investment recommendations and the universes of investment choices from which they recommend and sell. If all or virtually all disclose such conflicts, with no ready way for customers / clients to identify and move to others with no such conflicts (assuming they exist), has anything truly protective of investors really been accomplished? Or will such disclosures become “just one more ‘form’” that the broker or advisor must present and get signed by their customer / client? Will the customer / client simply believe (or perhaps be led or encouraged to believe) that such disclosures are going to be pretty much the same wherever they go and so conclude that it’s likely to be futile to inquire further . . . better to just go ahead and sign it and move on?

We submit that it is unlikely that requiring even complete conflict of interest disclosures will alone be sufficient to produce meaningful structural changes in the way the financial services industry works, nor is it likely to be sufficient to ensure a significantly more effective level of investor protection. We believe the key to achieving a desired greater level of investor protection will require a way to effectively address the large and growing number of financial products and the bewildering array of information about them. In other words, we believe the key will lie in overcoming the arguments relied upon by the financial services industry in its resistance to rules designed to ensure that what is being recommended and sold to clients is in their clients’ best interests.

Effectively addressing the overwhelmingly large and growing number of financial products and information about them is the key. It is estimated that there are now over 30,000 mutual funds and share classes and as many as 5,000 – 6,000 separate account managers in the U.S. alone. With so many choices and so much information available about them, there has been no practical way for even “experts” to be knowledgeable about, much less be able to comparatively evaluate, all of them.

Consequently, many brokerage and advisory firms simply select relatively small “approved” subsets of investment choices from which they recommend and sell. They often justify this by arguing that there is no practical way to do due diligence on so many choices. But exactly how these relatively small, proprietary universes are created is seldom disclosed. What it takes be included / to “get in” is not generally available and not verifiable by customers or clients, or even their advisors, and this too often proves to be where those wanting “in” must “pay to play.” Ultimately, a major part of the problem arises from competition among thousands of vendors, in which those with dominant market positions and much greater resources can secure competitive advantages through incentivized distribution arrangements against which smaller vendors with less resources cannot effectively compete.

Having too much information, with no practical way to use and benefit from it, is the functional equivalent of having no information at all. This has long worked to the advantage of the financial services industry.(3) Having too many choices and too much information about them, with no practical way to comparatively evaluate them, has effectively required investors at all levels (both individual and institutional) to be almost entirely dependent upon the investment recommendations of securities brokers and investment advisors.(4) As discussed above, this has also served as a justification of the financial services industry’s push-back against regulations focused on ensuring that what is recommended and sold to investors must be in the investors’ “best interests.”

The patented decision-assistance technology now being introduced fundamentally changes this. Because it is often difficult to envision what one has never experienced, seeing the technology demonstrated is indispensable in understanding its potential benefits and likely effects. We look forward to providing such demonstrations for those of the SEC’s staff reviewing this submission.

THE SEARCH FOR AN ANSWER / A WAY TO BETTER PROTECT INVESTORS.

For us, the key question – “Of all the available choices, which one is best?” – lingered, unanswered for years and ultimately resulted in an important realization – that to answer that question, three things would be needed:

  1. Universal market access to all available choices, something most believed impossible to secure;
  2. No compromising relationships with vendors of financial products and services, the accomplishment of which appeared to be simply a matter of corporate “Will”; and,
  3. A “Process” that could accomplish 3 things, also generally thought impossible to achieve:
    1. The ability to cut through all of the “noise” in the markets from the plethora of advertising and marketing materials;
    2. The ability to filter out all conflicts of interest, both known and unknowable; and, the
    3. Ability to use the vast amounts of obtainable information to comparatively evaluate all available investment choices in a manner specific to the needs, goals, and preferences of advisors and investors.

The last of the three led to the creation the patented decision-assistance technology that enables users, whether investment advisors, brokers, and (ultimately) individual investors, to comparatively evaluate literally thousands of mutual funds, ETFs, money managers and (prospectively) annuities and other financial products in a manner specific to their individual needs, goals, and preferences. The technology optimizes and objectifies investment selection in a way previously unavailable(5) to securities brokers and investment advisors and, in doing so, provides a way to definitively answer the key question posed above.

As illustrated below, the technology works by enabling users to select any number of performance parameters, which can then be hierarchically arranged and weighted, to profile the “composite investment effect” ideally desired from any asset class comprising an investor’s portfolio. The technology then enables the user to score and rank thousands of choices and to identify which of the mutual funds, ETFs, or money managers have been the best at producing the desired composite investment effect over time.

When users are not only able to see but also control the selection of, and degree of emphasis placed on, the factors important to them, transparency is assured. And, if an investor client can not only see but can also directly participate in how his or her investment advisor is comparatively evaluating choices within the universes from which the

client must choose (e.g., helping to select and weight the performance factors being used), there is no way to “game” the process, meaning actual and potential conflicts of interest are filtered out. We believe that, in this way, the goal of true investor protection could possibly be realized.

But there is another important dimension to the application of this decision-assistance technology. Much like the key question posed above regarding investment selection, we submit that there is another key question – one regarding ongoing performance monitoring and investment retention and replacement decisions. That additional question is not: “How did our mutual funds, ETFs, and/or investment managers do?” Investors get that question answered. They’re shown how much their investment choices went up or down and that is then typically compared to a “benchmark index.”

That’s typically all that’s provided. Instead, we submit that the question virtually all investors would ideally wish to have answered is this: “How did our choices do relative to all of the others we could have selected?” Much like the earlier discussed “key question,” this question appears to have also seldom (if ever) been seriously addressed, and current performance reports (at both the individual and institutional levels) typically do not enable investors to answer either of the above two questions.(6)

There is a significant difference between “absolute performance” (which is currently reported) and “relative performance” (which almost never is) and what has been missing is relative performance information – information that will enable advisors and their investor clients to answer the above two important and common sensical questions. In this “information age,” it is surprising and difficult to understand why, despite chronically poor investment results, there has been no meaningful evolution in investment performance reporting and in the information provided to investors.(7)

THIRD PARTY REVIEWS AND EVALUATIONS.

Included with this submission is an independent evaluation of the application of the decision-assistance technology within the financial services marketplace. It was performed by one of the top “Quants” on Wall Street, C. Michael Carty, former President of the NYC Chapter of QWAFAFEW (www.qwafafew.org). His conclusions are worth special attention.

It is believed that this technology represents an evolutionary step beyond the most sophisticated metrics currently used in investment consulting. Beyond the continuing use of bar charts and scatter charts in institutional investment reports, 30-40 year old “technology” that provides no actionable data, some of the most sophisticated metrics currently in use (e.g., Sharpe Ratios, Sortino Ratios, Information Ratios, etc.) are also quite old and were developed before later advances in computing power. Component parts of these metrics cannot be varied – i.e., factors cannot be added or deleted, and the degree of influence of any factor cannot be increased or decreased.

In contrast, with this newly available technology, any number of performance parameters can be selected, hierarchically arranged and weighted. With that resulting blend of weighted factors, full universes of available choices can be scored and ranked in a manner specific to the unique needs, goals, and preferences of the brokers, advisors and their clients, and this can be done in real time and in mere moments. Importantly, this process produces actionable data. Brokers, advisors, and their clients can see the investment choices that have proven best over time at producing the composite investment effects they are seeking. Attention can then be more efficiently shifted to qualitative due diligence focused on only the top performers.(8)

Additionally, the nationally prominent Wagner Law Group (https://www.wagnerlawgroup.com/) has also rendered a legal Opinion strongly supportive of the use of the decision-assistance technology, especially in helping to meet the requirements of Reg. BI, as well as the requirements of ERISA regarding the investment-related decision making of retirement plan sponsors and trustees. Included with this submission is a copy of that legal Opinion.

Although both evaluations focus principally on the protective, compliance related “RegTech” aspects of the technology, the “WealthTech” benefits should not be overlooked or minimized. As discussed above, use of this technology will likely result in improved performance for the investor. Specifically, performance gaps revealed using the technology, between choices currently in place and qualified alternatives, are often quite dramatic and (while past performance is no guarantee of future results) moving to choices demonstrating better composite performance over time can have a dramatic effect on the financial wellbeing and retirement security of investors. Simply filtering out conflicts of interest, which can too often corrupt investment recommendations and degrade investment results, should almost assuredly help to improve investment results. Any process that can effectively help to improve investment results could have powerfully beneficial and far-reaching effects.(9)

SUMMARY – IS THIS NEWLY AVAILABLE TECHNOLOGY “THE SOLUTION?”

We believe that it may be, if accepted and used.(10) From over a decade-long experience with the application of this newly available technology,(11) we are confident that it provides a unique answer to the industry’s pushback against “best interests” and “fiduciary” rules and regulations, at both the federal and state levels. How much better can one ensure (and provably demonstrate) that what is being offered to an investment customer / client is in that investor’s “best interests” than to score and rank all available choices, using hierarchically arranged and weighted blends of performance factors specifically selected to match that investment customer’s / client’s needs, goals, and preferences, especially when the process, factors, and weightings are transparently visible to the customer / client who can also directly provide their input? Importantly, since the application of this technology can effectively filter out all conflicts of interest (both known and unknowable), it appears to provide a solution that not only achieves conflict of interest-related regulatory goals but appears to go beyond what has likely been believed to be possible. Consequently, we believe this is a technology of which the SEC should be aware and one deserving of consideration.(12)

 

Endnotes:

(1) For individual investors, the question is nearly identical: “Of all the available choices, which ones are best for me?”

(2) The brokerage community / FINRA also argue that requiring brokers to effectively become “fiduciary” advisors will prevent small investors from being served. Because “advising” clients is more time consuming and necessitates higher total fees than smaller investors can easily afford, they argue that, unless “suitable” products can simply be sold to them, it will not be economically feasible for small investors to be served at all. That appears to assume that small investors are somehow benefited from the ability of the brokerage industry to sell them what securities brokers and FINRA unilaterally determine to be “suitable,” as in “trust me, this is ‘suitable’ for you.” However, increasing regulatory focus on this issue appears to suggest that, in actual practice, this “standard” has not been sufficient to protect the investing public, especially not small investors.

(3) One real, though less obvious, benefit is that it effectively operates to help prevent investment products from becoming “commoditized” – a result feared by financial product vendors. If brokers and advisors could quickly and easily comparatively evaluate financial products, it could effectively “commoditize” them. Large and better-known mutual fund companies especially consider this to be a very serious threat, and something to be prevented.

(4) As perceived “experts,” with greater access to information and superior product knowledge, their recommendations are almost universally accepted and relied upon. Both institutional and individual investors have virtually no meaningful ways to independently “vet” the investment information and recommendations they are given.

For trustees of 401(k), 403(b) and other defined contribution plans, this could soon become a crisis, as the result of a dramatic increase in class-action lawsuits against both the sponsors and trustees of such plans. The defense often offered by plan trustees, that “we relied on the advice of our investment consultant,” cannot be relied upon. A federal court has ruled that relying on the advice of an investment consultant was not a complete defense to a charge of fiduciary imprudence

. . . that, at the very least, the trustees must have some way to ensure that their reliance on the advice of their investment consultant is reasonably justified. See the line of cases, culminating in the unanimous U.S. Supreme Court decision in Tibble v. Edison, 135 S.Ct. 1823, 1825 (2015) – decision in favor of the plaintiffs (the participants in Edison’s 401k plan).

(5 )The granting of a U.S. Patent covering this technology, and advisory process that is supported by it, is prima facie evidence that there was nothing similar available within the U.S. financial services marketplace. When patent applications are filed, a “prior art” search is conducted and, if something similar is found, a patent is not issued because the invention has failed the “uniqueness” test.

(6) Even though the investment reports of institutional investment consultants typically contain a vast of amount of statistical and other data concerning the fund’s investments and investment results, the information they provide is too often not actionable and is seldom sufficient to help prevent pervasive chronic underperformance. Their investors clients can certainly conclude that they are not happy with their performance, but that is all. They typically cannot tell, from their investment reports, which investment choices have been performing better than theirs, much less which have been best at producing the composite investment results that would most closely match their needs, goals, and preferences over time.

(7) Regarding this, one prominent (now retired) CFO of a major city, when shown this newly available decision-assistance technology, stated: “I was around when bar charts and scatter charts were introduced into institutional performance reporting, some 30+ years ago. Since then, I’ve never seen any evolution the way performance reporting has been done, until now. I had almost given up hope of ever seeing any improvement.”

(8 )This is important, because this provides a meaningful counterargument to the industry’s objection (to stronger “best interest” rules) that “there’s no way any company, no matter how large, can do qualitative due diligence on so many choices.” With is process, qualitative due diligence (which will always be necessary) can be focused on only the top 3-5 choices. Why would one perform qualitative due diligence on number 176, for instance, if there is no interest (from a composite performance point of view) in picking that choice? This technology will help produce much greater efficiencies in investment choice selection and ongoing performance monitoring.

(9) For example, chronic underfunding of public pension plans is becoming an existential threat to far too many cities, counties, and states. Rather than a remedy to underfunding, chronically subpar investment performance too often proves to be an aggravating factor, making chronic underfunding worse. Clearly, for such chronically underfunded and underperforming plans, whatever process is being used for active investment manager selection and ongoing performance monitoring has not been working well and hasn’t been for some time.

(10) Whether or not it will be adopted and used, and at what rate, by FINRA-registered brokers and SEC-regulated investment advisors is presently unknown. Securities brokers and investment advisors effectively enjoy a “monopoly:” on information relating to investment choices. As such, we’ve found that some feel that they don’t need this technological capability. Because their clients simply accept their recommendations, some appear to feel that they don’t need to try to determine what’s objectively “best” for their clients. On the other hand, in a financial services marketplace in which everyone appears to be doing the same things in largely the same ways, we believe this technology could offer significant competitive advantages, especially to early adopters. We believe it could both increase their revenue and help them recruit clients away from competitors. This important “WealthTech” effect makes it possible for prospective clients to be shown, in minutes, an answer to this key question: “How did my choices do in comparison with all of the others I could have selected?” When the answer reveals that the top scoring funds produced average returns hundreds of basis points higher per year over the last 5 years than theirs, for instance, often with less volatility (i.e., no equivalent risk premium for that large return premium), the “recruitment” of that client away from a competitor may be easy to envision. If that begins to occur, the adoption of this decision technology may accelerate and, with that growth, we believe a beneficial transformation of the financial services marketplace could result, with or without additional regulatory action.

(11) The decision-assistance technology was developed, tested, and practically applied within an SEC registered investment advisory firm for nearly a decade before it was transferred, to Decision Technologies Corporation to facilitate its further development and distribution – to make available within the brokerage and investment advisory communities.

(12) The fact that similar (though non-identical), overlapping rules by the SEC, DOL, and various states (e.g., NY, NJ, MD, NV, and likely others) are now being considered and adopted simply heightens the perceived need for a single process that can help to ensure compliance with them all.

Eric Smith, J.D. is President and an Investment Advisor Representative of Trustee Empowerment & Protection, Inc.,
A Registered Investment Adviser.  He is also Chairman & CEO of Decision Technologies Corporation.

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C. Michael Carty – Independent Evaluation of DTC’s New Decision-Assistance Technology to Serve Clients’ Best Interests

New Decision-Assistance Technology to Serve Clients’ Best Interests – An Independent Evaluation

By C. Michael Carty

A recent advance in investment decision-assistance technology promises to reduce the conflicts of interest targeted by new regulations and judicial rulings, mitigate increasing compliance cost pressures, and better match consumers’ investment preferences. The process and its applications are described with a critical view towards evaluating its efficacy in this new regulatory, competitive, and economic environment.

I.   Background

There is a growing need to empower investors of all types, individuals and institutions alike, with the ability to comparatively evaluate the thousands of investment choices in order to select those that best satisfy their specific individual needs, goals, and preferences. Too many advisors limit their clients’ investment choices based on their compensation and not those best for the client. Recently, a process has been designed to enable these investors to obtain a definitive answer to the question, “Of all the available choices, which one is best for my client?”

Currently there are over 25,000 mutual funds1 and share classes, 5,000 to 6,000 separate account managers, and thousands of other financial products. Having too many choices and too much information about them, with no way to identify the “best” selection is the functional equivalent of having no information at all. In the absence of such a capability, investors have been entirely dependent on vendors of funds and advisory services, “professionals”, with no way to independently “vet” the recommendations they are given.

A patented process2 newly offered by Decision Technologies Corporation promises to enable investors of all types to select various relevant performance parameters, hierarchically arrange and weight them to score and rank all qualified choices. This produces the following desired effects:

  1. It cuts through all of the “noise” in the market produced by advertising and marketing materials of the competing vendors;

  2. It filters out all of the behind the scenes relationships, deals, and compensatory arrangements; e., all conflicts of interest; and

  3. It enables investors to use relevant performance and other data on all available choices to identify those that most closely satisfy their needs; i.e., those that have proven best at producing the desired composite blend of investment results over

Advisors and fiduciaries are often called upon to choose from a limited number of alternatives without knowing all that are available. In such situations, the fiduciary is typically powerless to independently “vet” the few recommendations provided to them which are seldom the “best” and quite often a “subpar” choice.

The vendor-dominated financial services industry takes advantage of this inability of investors to comparatively evaluate all available choices for themselves in the sale of their products, often to the disadvantage of an uninformed public. This new decision technology-based process helps responsible advisors and clients make more informed and objective decisions for the exclusive benefit of the client, thereby ensuring that applicable standards of “fiduciary duty” can be and have been met.

II.  The evolving market for investment services

Adoption of New Standards of Fiduciary Duty

New standards of fiduciary duty are evolving as the market for investment services grows in complexity and size. The role of the fiduciary must adapt to new laws, regulations, and judicial rulings defining the role of a fiduciary. This requires embracing a new fiduciary model based on new methods, new processes and new technologies.

Trustees’ duties under trust law dating to the 19th century were relatively simple; requiring a continuing duty to monitor investments and remove imprudent ones, separate and apart from exercising prudence in selecting investments. Later, the Investment Advisors Act of 1940 (“’40 Act”)3 extended those duties by requiring conflicts of interest to be disclosed and avoided. More recently, the Employee Retirement Income Security Act of 1974 (“ERISA”)4 added the requirement that most conflicts of interest be eliminated. If they are not, conflicted advice is only allowed through a prohibited transaction exemption.

In April 2016, the U.S. Department of Labor (“DOL”) introduced the Conflict of Interest Rule,5 popularly referred to as the “fiduciary rule.” It is intended to protect investors by requiring all who provide investment advice to retirement plans to abide by a “fiduciary” standard that puts their customers’ best interests before their own profits. Compliance with the rule was delayed until June 9, 2017. Certain exemptions from the rule, the Best Interest Contract Exemption (“BICE”),6 will be phased in effective January 1, 2018.

DOL’s fiduciary rule broadens the definition of a fiduciary to anyone who receives direct or indirect compensation for providing advice intended to result in action. It also requires that such compensation be “reasonable,” but without defining the standard for what constitutes “reasonable.” Without a meaningful definition, any method of compensation can be questioned. For example, is a onetime upfront 3.5% commission preferable to a level 0.75% annual fee? If the investment is held for 5 years or more the former is less costly.

The dilemma lies in determining a reasonable level compensation for fiduciaries which is also in the best interests of the client. The rule’s impending enforcement has had its critics call for it to be vacated or at least delayed in implementation.7 Its future, however, depends largely upon the new Trump administration. President Trump has yet given no indication of his position or its priority.8

Regardless of the new administration’s position, recent judicial decisions have ruled against delaying the fiduciary rule’s implementation. On August 25, 2016, in U.S. District Court (D.C.) Judge Randolph Moss ruled against enjoining the rule because it would delay protecting retirement investors from conflicted advice and potential losses to their retirement savings.9 On November 28, 2016, in U.S. District Court (Kansas) Judge Daniel Crabtree upheld the earlier court’s ruling that the plaintiff, an insurance company, was not entitled to injunctive relief because they did not prove that the DOL failed to follow appropriate procedures by putting fixed annuities under BICE. The Court also ruled that it “need not question whether the rule is improper because it imposes significant challenges to the plaintiff’s business model.”10

In a precedent setting case, Tibble v. Edison,11 beneficiaries of the Edison 401(k) Savings Plan (“Plan”) sued Edison International (“Edison”) and the Plan’s fiduciaries, to recover damages for losses suffered from breaches of their fiduciary duties. The plaintiffs argued that Edison acted imprudently by offering higher priced retail-class mutual funds as Plan investments when materially identical lower priced institutional- class mutual funds were available. U.S. District Court (Central California) Judge Stephen Wilson noted that the defendant had “not offered any credible explanation” for including the higher priced mutual funds costing the Plan to incur wholly unnecessary fees.12 He concluded that with respect to those mutual funds the defendants failed to exercise their fiduciary responsibility.

The defendants further claimed that their investment selection process was reasonable and thorough because they relied on the advice of the Plan’s single investment consultant, Hewitt Financial Services, regarding which mutual fund share classes should be selected for the Plan. Their expert witness stated that the Plan’s fiduciaries did not have access to information about different share classes and that their reliance on the consultant’s advice was therefore reasonable. The Court however reasoned that reliance on a single consultant’s advice was “an incomplete defense to a charge of imprudence.” Judge Wilson went on to say: “At the very least, Plan fiduciaries must ‘make certain that reliance on the expert’s advice is reasonably justified,’” The Court could not conclude that reliance on the expert’s advice, whatever it might have been, was reasonable.  It therefore awarded damages to the plaintiffs.13

The District Court’s ruling was unanimously upheld by the U.S. Supreme Court14 in 2014. It ruled “that respondents violated their fiduciary duties with respect to three mutual funds added to the Plan in 1999 and three mutual funds added to the Plan in 2002.” Further they “acted imprudently by offering six higher priced retail-class mutual funds when materially lower priced institutional-class mutual funds were available.” With respect to those mutual funds, the respondents had failed to exercise “the care, skill, prudence and diligence under the circumstances that ERISA demands of fiduciaries.”

In sum, DOL’s fiduciary rule, the D.C. and Kansas District Courts’ rulings, and the Tibble v. Edison decision being upheld by the U.S. Supreme Court have redefined fiduciary duties. Fiduciaries, including plan sponsors, now have an affirmative ongoing duty to prudently select investments, monitor their performance, and dispose of imprudent ones. They must also disclose and eliminate any conflicts of interest while putting their customers’ best interests before their own profits. Moreover, the responsibility to discharge these duties is not mitigated by reliance on the advice of a single investment consultant or advisor, with no reasonable way to independently “vet” the advice or recommendations they are providing. Importantly, this newly defined role applies to anyone who receives direct or indirect compensation for providing advice intended to result in action, i.e., trustees, directors, brokers, insurance agents, investment advisors, financial planners, etc. Former methods for discharging these duties are inadequate and new methods must be adopted.

Competitive Cost Pressures

Simultaneously with changes in the regulatory environment, changes in investor preferences and competition are putting pressure on fees. Investors are increasingly unwilling to pay for underperforming investments. Research conducted by Vanguard using Morningstar data ending June 30, 2015 found, “Over the past 20 years, only 27% of actively managed U.S. equity mutual funds outpaced their prospectus benchmarks.”15 Active managers, on average, cannot outperform passive benchmarks such as the S&P 500 or Russell 2000 due, in part, to their greater turnover rates and higher transaction costs.

Investors know that one of the best ways to build assets for retirement, or for any other purpose over the long run, is to minimize investment costs. The easiest way to accomplish this is to invest in low-cost passive index funds. Statistics compiled by the Investment Company Institute (“ICI”) strikingly illustrate the pronounced trend towards investing in passive exchange-traded funds and away from actively managed mutual funds. In the five years from 2010 and 2015, the total net assets in domestic mutual funds grew to $6,046 billion from $4,053 billion, at an annual rate of 8.3%.16 In comparison, domestic index mutual funds grew to $14.9 billion from $7.0 billion, at an annual rate of 16.2%.17

While the better relative investment performance of indexed ETFs explains part of their impressive growth, their lower expense ratios are a significant contributing factor. In 2015, the average expense ratio for an indexed equity fund was 11 basis points vs. 84 basis points for the active equity fund, a difference of 74 basis points.18 This represents a considerable difference if one considers what an annual saving of 74 basis points can mean to investment performance over the long run.

The ICI’s statistics also indicate that by 2015 expense ratios for indexed funds dropped to 11 basis points from 27 basis points in 2000, a total reduction of 59.3%. This compares favorably against active funds’ expense ratios which dropped to 84 basis points in 2015 from 106 basis points in 2000, a drop of only 20.8%. The active funds’ higher expense ratios and smaller decline in response to competition from index funds is likely due to the higher costs of operating those funds but without tangible investment benefits.

On December 1, 2016, Labor Assistant Secretary Phyllis Borzi, the principal architect of DOL’s fiduciary regulation, addressed the Consumer Federation of America Conference stating it has already led to “low-cost, transparent investments for retail accounts” and will continue to do so.19 Ms. Brozi also cited announcements by several wirehouses and independent broker-dealers that they will no longer offer commission-based products in retirement accounts. If internal support for commission-based products is thought to be too costly or the potential liability too high, they will eventually no longer be provided. If so, low-cost transparent products must be created to replace them.

Changing Demographics

New and future products must be designed to reflect investors’ changing demographics and technological preferences. In mid-2015, 91% of U.S. households owning mutual funds had internet access, up from 68% in 2000.20 Internet access traditionally has been greatest among younger people, in both mutual fund–owning households and the general population, and the gap is only slowly narrowing among older households.

Digital advice is especially appealing to younger Generation X and Millennial investors who tend to be more technically sophisticated and more financial services wary than the older Baby Boomer generation. The new wave of internet applications permits banking and brokerage transactions, financial planning, risk preference questionnaires and asset allocation advice, and up-the-minute investment news. The automated nature of these services makes them both inexpensive and timely. Those navigating them are empowered to perform much of their own research and analysis, increasing their confidence in making their own decisions. This trend is expected to continue, with the greatest wealth transfer in human history over the next 30 years of an estimated $30 trillion from Baby Boomers to their Gen X and Millennial survivors.21

The Future of Advice a study by A.T. Kearney (2016),22 found two-thirds of mass affluent investors don’t know how much they pay for investment advice. On average, 72% of those who do know are willing to switch for lower fees. Of those under 35 years old, 90% are willing to switch for lower fees. Those who switch to providers for lower fees will most likely embrace digital solutions.

III.  Business practices targeted by the new regulations

New regulations and judicial rulings promise to reduce conflicts of interest, result in better matching of consumers’ investment preferences, increase compliance cost pressures, and ensure fees are reasonable. They have also expanded the definition of a fiduciary to include anyone who offers advice and receives direct or indirect compensation. This is having a direct and significant impact on the way business will be conducted.

Retirement plan sponsors must now be more proactive in overseeing their retirement programs; advisors now have the burden of proving their advice is prudent and suitable; and broker-dealer supervisors need to identify and eliminate any conflicts of interest when their brokers offer expensive products or strategies. Clients’ best interests must be served above those of fiduciaries’.

Most of these new requirements are rooted in past practices. Acting according to the doctrines of prudence, loyalty and suitability is standard practice. Disclosing and eliminating conflicts of interest is also not new. But, now a fiduciary must act in the client’s best interest or obtain exemptive relief under BICE.

These new regulations further imply that lower costs for investment products and services are in clients’ best interests. Reducing advisory fees to investors saving for retirement is clearly the intent of DOL’s regulation. The Kansas and DC District Court rulings support that intent. Moreover, Tibble v. Edison demonstrates the militancy with which investors will seek to recover losses from excessive fees. These events have caused a legal realignment in favor of customers purchasing investment products or services and away from those who might improperly profit from them.

Fiduciaries must now provide informed, justifiable advice at a reasonable cost. This requires using decision-oriented processes which are objective, all inclusive, analytically sound, relevant, and cost-effective.

IV.  Investment Technology will play a major role

For responsible fiduciaries, the task of overseeing or offering investment advice has grown in both magnitude and complexity. How can one convincingly argue that what is being offered is in the best interest of a client if they haven’t investigated all other options, risks and costs?

Businesses creating financial products must now offer a sufficiently large variety of choices to satisfy numerous client demands at “reasonable” prices. This has contributed to the growth of the fintech industry, one form of which are robo-advisors. Robo- advisors offer automated, low-cost, investment advisory services through web-based and/or mobile platforms. They offer fully digital investment management services which provide automated, diversified, and mostly ETF portfolios to mainly mass affluent customers at low-cost. A robo-advisory services study23 conducted by A. T. Kearney in 2015 estimated their assets under management will reach over $2 trillion by 2020, growing at 68% annually. Since the low fees charged by robo-advisors are typically a fraction of those charged by a full-service advisor, they are presumably in their customers’ best interests.

A second but no less important form of the fintech industry is becoming known as the decision-assistance advisor. DTC’s patented process provides plan sponsors and other fiduciaries with a uniquely flexible framework for scoring and ranking investment universes or subgroups using customized, weighted blends of performance criteria specific to each given application to ensure offered choices are in the client’s best interest.

Other firms offering information to facilitate investment decisions, e.g., Morningstar, Standard and Poor’s, and Value Line, partition investments into groups according to fixed criteria, a “one-size-fits-all approach” without regards to the individual needs, goals, and preferences of the individual user, While placing investments into groups is intended to distinguish between the investment performance of high and low ranked groups, it doesn’t identify the best performing investments within a group. Furthermore, a group ranking doesn’t indicate whether an investment is moving up or down within the group from one period to the next.

V.  Applying decision-assistance technology to mutual fund selection

DTCs’ process quantifies the relative attractiveness of investments in a variety of asset classes; i.e., separately managed accounts, mutual funds, fixed annuities, etc.

Analyzing an asset class, such as large cap mutual funds, requires the following steps.24

  1. Choosing a representative universe to include all investible large cap mutual

  2. Filtering out investments that do not belong, such as funds that do not describe themselves as large cap, or are not open to new investment, or do not comply to standards set by the Association of for Investment Management and Research (“AIMIR”).

  3. Selecting relevant performance parameters characteristic of previously successful investments; g., 1-, 3-, and 5-year annual returns or standard deviations.

  4. Weighting the parameters to emulate successful composite performance in the asset class; e.g., return might be given a 60% weight and risk the remaining 40%. These weights could be determined heuristically or statistically depending on the

  5. Scoring all investments and a relevant benchmark index contained in the filtered

  6. Ranking the investments from the highest to the lowest

  7. Reviewing the results by comparing the composite scores of the current holdings with those of the leading funds or a relevant

  8. Deciding on one or more appropriate actions; replacing a current holding with an apparently superior fund, putting a current holding on the “watch list,” or conducting further research.

  9. And most importantly, implementing appropriate

As with most quantitative studies, historical values of the parameters are used. Although past performance of a single investment is no guarantee of its future performance, superior future performers can usually be found among a large diversified group of previously successful investments.

To illustrate the process, a universe of large cap mutual funds is chosen. Other asset classes could also have been chosen to vet the process, e.g., separately managed accounts, mid or small cap funds, fixed income or variable annuity subaccounts.

Assume a case in which a plan fiduciary wishes to review large cap mutual funds to add more promising funds and dispose of less promising holdings. Exhibit 1 illustrates one possible set of Risk and Return components, their selected parameters and weights for analyzing large cap mutual funds in November 2016

Exhibit 1. Parameters and Weights Relevant to the Large Cap Funds’ Composite Scores

 
  

Source: Decision Technologies Corporation

As shown in Exhibit 1, Risk is given 40% of the overall weight in analyzing the funds and Return the remaining 60%. The 3 parameters used to construct the Risk component are: the average standard deviations over 1-year (10%), 3-years (25%) and 5-years (65%). The 3 parameters used to construct the Return component are: the average returns for 1-year (10%), 3-years (25%) and 5-years (65%). Using these weights, the score for each fund is computed and ranked in descending order.

To restrict the analysis to purely large cap funds, additional filters are imposed. Excluded are funds that do not describe themselves as large cap blend, growth or value, or are not AIMR compliant and not open to new investors. The resulting sample consists of 1,425 large cap mutual funds.

The top 10 scoring funds determined by DTC’s process are shown in Exhibit 2 along with the S&P 500 Index and the lowest scoring Morningstar 5 Star fund. The Sharpe ratios, though not used in the analysis, are shown for comparison against the composite scores. As one might expect, there appears to be a positive correlation between the composite scores and Sharpe ratios.

Exhibit 2. The Top 10 Large Cap Funds, Composite Scores, the S&P 500, Morningstar Ratings and Sharpe Ratios

    

5 year

Rank

Large Cap Mutual Funds

Score

Stars

Sharpe

    

Ratio

1

Parnassus Endeavor Inv.

8.57

5

1.61

2

JNL/S&P Div. Inc. & Gro.

7.95

5

1.66

3

First Trust Value Line Div.

7.91

5

1.62

4

PowerShares S&P 500 Qty

7.84

5

1.65

5

SEI Dynamic Allocation

7.84

5

1.65

6

Amer. Beacon Bridgeway

7.83

5

1.55

7

SEI US Managed. Volatility

7.82

5

1.72

8

Metro West AlphaTrak 500

7.78

5

1.51

9

Clearbridge Lrg Cap Gro

7.76

5

1.48

10

Invesco Diversified Div

7.67

5

1.69

99

S&P 500 Composite

7.26

N/A

1.38

648

Fidelity OTC

6.47

5

0.99

Source: Decision Technologies Corp. and Morningstar

Exhibit 3. Performance Elements of the Top 10 Large Cap Funds and S&P 500 for the Period Ending November 2016

 

1 Yr

3 Yrs

5 Yrs

1 Yr

3 Yrs

5 Yrs

Rank

Large Cap Mutual Funds

Avg.

Avg.

Avg.

Std.

Std.

Std.

 

Retn.

Retn.

Retn.

Dev.

Dev.

Dev.

1

Parnassus Endeavor Inv.

17.55

14.61

18.48

14.79

11.94

11.42

2

JNL/S&P Div. Inc. & Gro.

15.50

10.67

15.06

9.28

8.93

9.02

3

First Trust Value Line Div.

15.41

11.74

14.51

8.47

9.07

8.87

4

PowerShares S&P 500 Qty

10.71

10.46

15.11

8.57

9.59

9.10

5

SEI Dynamic Allocation

7.68

11.59

15.15

10.00

10.22

9.11

6

Amer. Beacon Bridgeway

12.28

9.92

16.39

11.40

11.00

10.51

7

SEI US Managed. Volatility

10.07

10.22

14.47

8.31

8.44

8.36

8

Metro West AlphaTrak 500

11.54

9.98

16.32

11.06

10.88

10.76

9

Clearbridge Lrg Cap Gro

5.02

10.92

16.60

10.92

11.23

11.18

10

Invesco Diversified Div

9.21

8.94

14.25

7.94

8.29

8.35

99

S&P 500 Composite

8.06

9.07

14.45

10.52

10.77

10.36

648

Fidelity OTC

2,89

10.90

15.83

19.85

16.26

15.8

Source: Decision Technologies Corporation

Five significant conclusions can be reached by examining the performance elements in Exhibit 3.

  1. DTC’s scoring system provides a primary rule for adding, retaining or liquidating a Superior scored funds should, of course, be retained or added to a portfolio while lower scored funds be avoided or liquidated. Clearly superior funds are found above the S&P 500’s score, mediocre and poor performing funds below it.

  2. 98 funds score better than the S&P 500 benchmark based on average returns and standard deviations over 1-, 3- and 5-year periods. Clearly, a significant number of funds can be found among that number to outperform the S&P

  3. Two of the top 10 funds fail to beat the S&P 500 over the 1-year period. SEI’s Dynamic Allocation Fund has a lower 1-year return, 7.68%, than the S&P 500’s 8,06%, but it also has an offsetting lower standard deviation which contributes to its higher composite score. The Clearbridge Large Cap Growth Fund’s 1-year return also falls short of the S&P 500’s, but with greater standard deviations over 1-, 3-, and 5-years suggesting the possibility of lower scores in the future unless performance

  4. All top scoring funds outperform Fidelity’s OTC Fund over 1-year in both returns and standard deviations. The Fund’s 5-year return is superior to 5 of the top 10 funds, but its greater 1-, 3-, and 5-year standard deviations reduce it to the 648th

  5. DTC’s process can identify Morningstar 5 Star rated funds with significantly poorer performance than the S&P 500. This raises two important questions. Would a plan sponsor be acting prudently by holding a 648th ranked fund even if it has a 5 Star rating but is scored well below the S&P 500? How credible would his defense be if he claimed the decision was “reasonable” based on the Fund’s 5 Star rating?

The scoring process also provides a secondary rule for monitoring funds likely to increase or decrease in rank. Simply by recording a fund’s change in rank from one period to the next, or over several periods, important trends can be observed. If a fund is moving up in rank, it merits further research into the causes. A new manager, better economic prospects, or changes in investors’ preferences might portend a continuation of those favorable trends. Alternatively, a fund with a persistent decline in rank should be cause for concern and merit further scrutiny.

The distribution curve in Exhibit 4 illustrates the relative scores of all managers and the S&P 500 Index (represented by the green triangle located at 99 on the horizontal axis). The highest scoring managers are in the upper right of the chart. The #1 scoring fund, Parnassus Endeavor is represented by the orange circle between the 8th and 9th scores on the vertical axis. Lower scoring managers are represented by the declining scores to the left. If the difference in score between two managers is substantial, it will produce a noticeable difference in their relative position on the curve. A relatively large difference in relative score may be more significant than the numerical difference in score in terms of evaluating two managers’ performances. For example, the numerical difference between the #1 and #648 ranked funds (1.61-0.99=0.62) masks the significant difference in their relative scores shown in Exhibit 4.

Exhibit 4. Distribution of Composite Scores

– Large Cap Funds

 
  

Source: Decision Technologies Corporation

The quantitative nature of the process provides plan sponsors, brokers, advisors, or individual investors with an objective and granular scoring and ranking system superior to the grouped ratings of other processes. Although all funds shown in Exhibits 2, 3 and 4 have Morningstar 5 Star ratings, not all have or deserve equal scores.

The City of Miami General and Sanitation Employees’ Retirement Trust held its monthly meeting in September 2016 during which its portfolio’s performance was reviewed. At that meeting, DTC’s process was used to assist in evaluating the relative performance of the Trust’s investment managers. The following exhibits are excerpts of publicly available information from the board meeting. Full information is contained in “Demonstration of the Process” on www.GESE.org.25

As seen in Exhibit 5, and previously in Exhibit 1, recent values of the Risk and Return parameters are more heavily weighed than those in the past. However, 3 new Risk parameters are introduced.31 The first, “Down Mkt 5yr,” is commonly called the “downside capture ratio.” It expresses a portfolio’s returns relative to its benchmark’s negative returns. A portfolio’s performance is superior to its benchmark if it has positive or less negative returns during periods when its benchmark has negative or zero returns. The second new Risk parameter is the number of negative quarters a portfolio has in the previous 5 years, an indication of its downside risk. The third Risk parameter is a portfolio’s return in the worst 4-trailing quarters of the last 5 years. In addition, a new Return parameter is introduced, the 5-year batting average which is simply the percent of quarters in which the portfolio achieved positive returns.

Exhibit 5. The Components, Parameters and Weights Relevant to the Composite Scores of Funds in the Trust

 
  

Source: Decision Technologies Corporation

Taken together, the 3 new Risk parameters combine measures which include the relative strength of a portfolio in a weak market, a possible persistence in its negative performance, and its worst returns over 4 trailing-quarters. In this sense, they provide a more comprehensive perspective than single static measures currently used in analyzing portfolio performance. For example, the Sharpe ratio26 measures the average return earned in excess of the risk-free rate per unit of standard deviation using strict assumptions imposed by Capital Asset Pricing Theory.27 The Sortino ratio,28 a variant of the Sharpe ratio, uses the standard deviation of a portfolio’s negative returns to assess its exposure to negative risk. Although each is often used as a standalone measure of return relative to risk, or negative risk, serious analysts would prefer using additional Risk parameters.

To restrict the analysis to funds purely in their asset class, additional filters are imposed. For example, the analysis of international large cap value equity requires funds be excluded that do not describe themselves as international equity, large cap, or value.

Likewise, filters used for the analysis of large cap growth funds would require that they describe themselves as large cap and growth. Funds that are not AIMR compliant or not open to new investors are also excluded.

An additional filter is imposed on the international large cap value asset class. It excludes funds having 5-year average standard deviations less than 11.09% or greater than 18.47%. This is intended to limit the scoring process to only those funds having volatility close to the average of the asset class. The resulting 49 funds therefore represent a more homogeneous group. Using the parameter weights shown in Exhibit 5, the score for each of the 49 funds is computed and ranked in descending order

Exhibit 6 contains the top 10 ranked international large cap value funds, the MSCI EAFE Index, and a 47th ranked fund, the Allianz Global Investors International Value Fund. This latter fund is included as one of the Trust’s holdings. Learning that the fund ranks 47th out of 49 funds is valuable information for the Trustees, and can only be uncovered by a scalar scoring rather than a group ranking process.

Exhibit 6. DTC’s Top 10 Top Scoring International Large Cap Value Funds, the MSCI EAFE Index and Composite Scores

Rank

Int’l Large Cap Value Funds

Comp

  

Score

1

Burgundy Asset: EAFE Equity

9.71

2

Pyrford Int’: European Equity

8.20

3

Federated Inv: Int StratVal ADR

6.89

4

Deleware Inv: ADR-London MA

6.88

5

Mondrian Invst: Focused IAQ

6.86

6

Boston Partners: BP Intl Equity

6.66

7

MFS Invt Mgmt: Japan Equity

6.44

8

Tocqueville: IMEC

6.32

9

Schaffer Cullen: Intl Hi Div ADR

6.25

10

Mondrian Inv: Foc ACWexUS

6.07

23

MSCI EAFE Index

4.75

47

AllianzGI INTL

2.51

Source: Decision Technologies Corporation

As evident in Exhibit 7, the Allianz Global Investors International Value Fund has poorer average returns over 1-, 3-, and 5-years than the top 10 ranked funds and the MSCI EAFE Index. Its declining momentum is revealed by the contrast in its 5-year average return of -0.67% versus a 3-year average return of -3.88% and an even worse 1-year return of -15.14%. The significant difference between the Fund’s 1-year return and Burgundy Asset’s EAFE Equity Fund (the #1 ranked fund) is 21.53%, (6.39%+15.14%), which suggests a need for decisive action.

Exhibit 7. DTC’s Top 10 Ranked International Large Cap Value Funds, the MSCI EAFE, and Return Parameter Values

   

3 Yrs

5 Yrs

Bat

Rank

Int’l Large Cap Value Funds

1Yr

Avg

Avg

Avg

  

Retn

Retn

Retn

5 yrs

1

Burgundy Asset: EAFE Equity

6.39

8.59

10.58

80.00

2

Pyrford Int’: European Equity

-1.38

5.19

6.74

55.00

3

Federated Inv: Int StratVal ADR

-2.78

1.78

4.55

50.00

4

Deleware Inv: ADR-London MA

-5.43

5.02

4.26

60.00

5

Mondrian Invst: Focused IAQ

-6.36

5.48

4.78

60.00

6

Boston Partners: BP Intl Equity

-4.95

5.55

6.34

70.00

7

MFS Invt Mgmt: Japan Equity

-1.70

6.78

7.43

50.00

8

Tocqueville: IMEC

-0.32

7.81

4.41

60.00

9

Schaffer Cullen: Intl Hi Div ADR

-3.02

1.95

3.09

55.00

10

Mondrian Inv: Foc ACWexUS

-6.68

2.64

3.04

45.00

 

23

MSCI EAFE Index

-7.87

2.68

2.76

0.00

 

47

AllianzGI INTL

-15.14

-3.88

-0.67

35.00

Source: Decision Technologies Corporation

Exhibit 8. DTC’s Top 10 Ranked International Large Cap Value Funds, the MSCI EAFE, and Risk Parameter Values

  

1 Yr

3 Yrs

5 Yrs

Down

Neg

 

Rank

Int’l Large Cap Value Funds

Std.

Std.

Std.

Mkt

Qtrs

Worst

  

Dev.

Dev.

Dev.

5 Yrs

5 Yrs

4 Qtrs

1

Burgundy Asset: EAFE Equity

10.24

8.58

11.38

49.03

5.00

-1.86

2

Pyrford Int’: European Equity

6.92

8.97

11.12

58.62

5.00

-4.80

3

Federated Inv: Int StratVal ADR

9.86

10.00

11.46

67.71

7.00

-12.86

4

Deleware Inv: ADR-London MA

11.58

10.87

11.58

74.41

6.00

-9.57

5

Mondrian Invst: Focused IAQ

11.89

11.02

11.89

74.42

6.00

-9.95

6

Boston Partners: BP Intl Equity

11.47

11.58

13.75

83.17

6.00

-9.36

7

MFS Invt Mgmt: Japan Equity

21.73

15.16

13.69

56.34

8.00

-4.99

8

Tocqueville: IMEC

13.36

11.94

14.18

90.49

6.00

-16.89

9

Schaffer Cullen: Intl Hi Div ADR

9.45

9.82

12.78

84.22

6.00

-9.41

10

Mondrian Inv: Foc ACWexUS

12.85

10.61

12.12

82.66

7.00

-10.26

23

MSCI EAFE Index

12.72

11.85

14.78

100.00

7.00

-13.38

47

AllianzGI INTL

17.27

12.89

15.95

116.32

8.00

-17.73

Source: Decision Technologies Corporation

Note that the huge “return premium” between the Burgundy Asset’s EAFE Equity Fund and Allianz’s International Fund is not accompanied by an equivalently large “risk premium” as shown in Exhibit 8. The #1 fund’s risk is lower in all 6 categories than the #47th fund. Had the top scoring fund been held instead of the 47th fund, the portfolio’s overall risk could have been significantly reduced. The distribution of composite scores in Exhibit 9 shows a steep drop in ranks from top to bottom. This is due to the wider range of values of the return-related parameters and their greater weight than risk-related parameters in the composite scores.

As pointed out earlier, in the discussion of Exhibit 4, if the difference in score between two funds is substantial, it will produce a noticeable difference in their relative position on the curve. A relatively large difference in relative score may be more significant than their numerical difference in evaluating two funds’ performances. Here, in Exhibit 9, the relatively large difference between the #1 ranked fund and the #47th is dramatic.

Exhibit 9. Distribution of Composite Scores

  • International Large Cap Value Funds

 
  

Source: Decision Technologies Corporation

Exhibit 10 illustrates the typical tendency of top scoring funds to bunch together. The difference between the scores of the first and tenth ranked large cap growth funds is quite small, 1.05; (8.73-7.68=1.05). Their scores are also significantly above their benchmark, the Russell 1000 Growth Index. Three of the Trust’s holdings, the Atlanta Capital Funds, highlighted in orange, scored well below the benchmark with relative ranks near the bottom of the sample, a reason to consider remedial action. Exhibit 10. The Top 10 Ranked Domestic Large Cap Growth Funds, Russell 1000 Growth Index, and Composite Scores

Rank

Large Cap Growth Funds

Comp

  

Score

1

Vontobel US Equity

8.73

2

CBI LM Retail: CB LCG ESG (MA)

8.61

3

Polen Capital: Polen Focus Grow

8.43

4

CBI LM Retail: CB LCG (MA)

8.18

5

HS Management Concentrated Gr

8.18

6

Loomis Sayles: Large Cap Grow

8.02

7

ClearBridge Inv: LCG

7.97

8

Boston Harbor: Select 40

7.70

9

BMO Asset Mgt: Disciplined LCG

7.69

10

Pioneer Invest: Concent. Growth

7.68

58

Russell 1000 Growth Index

6.15

176

Atlanta Capital: HQ Gro Plus MA

4.68

182

Atlanta Capital: HQGP

4.56

227

Atlanta Capital: HQ Foc Growth

3.45

Source: Decision Technologies Corporation

Exhibit 11. The Top 10 Ranked Domestic Large Cap Growth Funds, Russell 1000 Growth Index, and Return Parameter Values

   

3 Yrs

5 Yrs

Bat

Rank

Large Cap Growth Funds

1Yr

Avg

Avg

Avg

  

Retn

Retn

Retn

5 yrs

1

Vontobel US Equity

7.95

13.15

15.24

65.00

2

CBI LM Retail: CB LCG ESG (MA)

7.63

16.31

15.70

70.00

3

Polen Capital: Polen Focus Grow

11.78

16.63

14.91

55.00

4

CBI LM Retail: CB LCG (MA)

5.73

16.03

15.73

75.00

5

HS Management Concentrated Gr

3.19

12.72

15.81

55.00

6

Loomis Sayles: Large Cap Grow

7.11

15.43

15.02

55.00

7

ClearBridge Inv: LCG

5.81

16.02

15.42

65.00

8

Boston Harbor: Select 40

5.56

11.84

14.51

50.00

9

BMO Asset Mgt: Disciplined LCG

3.89

15.82

14.67

70.00

10

Pioneer Invest: Concent. Growth

4.94

15.02

14.42

55.00

58

Russell 1000 Growth Index

2.52

13.61

12.38

0.00

176

Atlanta Capital: HQ Gro Plus MA

2.07

11.25

9.62

40.00

182

Atlanta Capital: HQGP

1.91

11.27

9.57

40.00

227

Atlanta Capital: HQ Foc Growth

2.29

11.09

8.44

45.00

Source: Decision Technologies Corporation

As evident in Exhibit 11, the Atlanta Capital Funds’ poor scores and ranks are attributable to their poorer 1-, 3- and 5-year returns relative to the top 10 ranked funds as well as the Russell 1000 Growth Index. The Return parameters’ values for all 3 funds are well below those of the top 10 funds. Moreover, as illustrated in Exhibit 12, their Risk parameter values were also deficient in comparison to the leaders, with greater 3- and 5-year standard deviations.

Exhibit 12. The Top 10 Ranked Domestic Large Cap Growth Funds, Russell 1000 Growth Index, and Risk Parameter Values

  

1 Yr

3 Yrs

5 Yrs

Down

Neg

 

Rank

Large Cap Growth Funds

Std.

Std.

Std.

Mkt

Qtrs

Worst

  

Dev.

Dev.

Dev.

5 Yrs

5 Yrs

4 Qtrs

1

Vontobel US Equity

8.37

7.25

9.65

40.48

4.00

7.70

2

CBI LM Retail: CB LCG ESG (MA)

9.51

7.40

12.12

78.16

4.00

5.74

3

Polen Capital: Polen Focus Grow

7.24

8.56

12.25

68.94

4.00

2.82

4

CBI LM Retail: CB LCG (MA)

11.01

8.37

12.74

83.25

4.00

5.73

5

HS Management Concentrated Gr

5.45

7.04

11.60

52.63

2.00

3.19

6

Loomis Sayles: Large Cap Grow

11.43

9.25

11.66

60.72

5.00

4.43

7

ClearBridge Inv: LCG

10.73

8.34

13.02

85.38

4.00

5.44

8

Boston Harbor: Select 40

9.28

7.04

11.07

47.62

4.00

2.57

9

BMO Asset Mgt: Disciplined LCG

9.47

8.96

12.49

83.80

4.00

3.89

10

Pioneer Invest: Concent. Growth

9.64

8.72

11.82

80.82

5.00

4.94

58

Russell 1000 Growth Index

10.33

8.44

12.79

100.00

4.00

2.52

176

Atlanta Capital: HQ Gro Plus MA

8.16

8.22

14.13

116.38

3.00

-2.25

182

Atlanta Capital: HQGP

8.67

8.45

14.27

118.92

4.00

-2.47

227

Atlanta Capital: HQ Foc Growth

10.42

9.63

16.16

134.50

6.00

-5.78

Source: Decision Technologies Corporation

Exhibit 13 illustrates a noticeable difference in the relative positions of Atlanta Capital’s 3 funds and the top 10 ranked funds on the distribution curve. 2 of them, the HQ Growth Plus and HQGP Funds scored in the third quartile, and its HQ Focus Growth in the bottom quartile. Since scoring is based primarily on 1-, 3- and 5-year return and risk performances, their poor scores in Exhibit 10 and weak return and risk parameters in Exhibits 11 and 12 suggest all 3 have persistent performance problems requiring remedial action.

Exhibit 13. Distribution of Composite Scores

  • Domestic Large Cap Growth Funds

 
  

Source: Decision Technologies Corporation

Exhibit 14. Top 10 Ranked U.S. Intermediate Fixed Income Funds, Barclays U.S. Aggregate Bond Index, and Composite Scores

Rank

U.S. Intermediate Fixed Income

Comp

  

Score

1

Guggenheim Inv: Core Plus FI

7.92

2

Belle Haven: Taxable PLUS

7.74

3

Guggenheim Inv: Fixed Income

7.72

4

Dolan McEniry: DMC Core Plus

7.63

5

Templeton Finl: Inter Taxable Bd

7.63

6

Carnival Hill Inv: Core A or Better

7.36

7

Belle Haven: Tax Ladder PLUS

7.31

8

National Invest: Intermed PLUS

7.30

9

Karpus Inv Mgt: Fixed Inc. Mgt

7.29

10

Pioneer Invest: U.S. Core Fixed

7.29

217

Chicago Equity: High Qual Interm

6.13

234

Barclays U.S. Aggr. Bond Index

6.04

Source: Decision Technologies Corporation

Exhibit 14 contains the top 10 ranked domestic U.S. intermediate fixed income funds. Since the performance of fixed income securities is determined for the most part by their maturity and relationship to the yield curve for U.S. government securities, the spread among the highest ranked funds is small, 0.63. The Plan’s holding, the Chicago Equity: High Quality Intermediate Bond Fund has a score of 6.13 which is 1.79 below the top ranked fund, and ranked 217th of over 250 funds. It is therefore possible to improve the Trust’s fixed income risk-adjusted performance with a higher scoring fund.

The Return component of the fixed income investments carry a weight of 60% in the composite score. Exhibit 15 contains the scores of the top 10 funds and the Trust’s 217th ranked fixed income holding. The top 10 funds have significantly higher returns than this fund over 3- and 5-years and, hence, their higher rank than Chicago Equity’s.

Exhibit 15. The Top 10 Ranked U.S. Intermediate Fixed Income Funds, Barclays U.S. Aggregate Bond Index, and Return Parameter Values

   

3 Yrs

5 Yrs

Bat

Rank

U.S. Intermediate Fixed Income

1Yr

Avg

Avg

Avg

  

Retn

Retn

Retn

5 yrs

1

Guggenheim Inv: Core Plus FI

1.70

4.43

6.67

70.00

2

Belle Haven: Taxable PLUS

4.45

4.23

5.76

90.00

3

Guggenheim Inv: Fixed Income

2.20

4.71

7.11

95.00

4

Dolan McEniry: DMC Core Plus

2.33

3.73

5.39

65.00

5

Templeton Finl: Inter Taxable Bd

5.75

4.69

6.25

90.00

6

Carnival Hill Inv: Core A or Better

2.25

3.52

4.90

55.00

7

Belle Haven: Tax Ladder PLUS

3.58

3.33

4.92

80.00

8

National Invest: Intermed PLUS

2.03

2.63

4.46

60.00

9

Karpus Inv Mgt: Fixed Inc. Mgmt

6.50

5.34

6.55

75.00

10

Pioneer Invest: U.S. Core Fixed

1.26

3.23

4.86

60.00

217

Chicago Equity: High Qual Interm

2.35

1.50

2.85

25.00

234

Barclays U.S. Aggr. Bond Index

1.96

2.50

3.78

0.00

Source: Decision Technologies Corporation

Exhibit 16. The Top 10 Ranked U.S. Intermediate Fixed Income Funds, Barclays U.S. Aggregate Bond Index, and Risk Parameter Values

  

1 Yr

3 Yrs

5 Yrs

Down

Neg

 

Rank

U.S. Intermediate Fixed Income

Std.

Std.

Std.

Mkt

Qtrs

Worst

  

Dev.

Dev.

Dev.

5 Yrs

5 Yrs

4 Qtrs

1

Guggenheim Inv: Core Plus FI

2.02

2.79

2.87

-34.62

3.00

1.70

2

Belle Haven: Taxable PLUS

3.63

3.03

2.57

24.91

3.00

0.59

3

Guggenheim Inv: Fixed Income

3.46

3.49

3.31

33.26

3.00

0.92

4

Dolan McEniry: DMC Core Plus

3.04

2.53

2.35

-39.73

4.00

1.59

5

Templeton Finl: Inter Taxable Bd

3.76

3.48

3.31

32.42

2.00

-0.52

6

Carnival Hill Inv: Core A or Better

3.37

2.51

2.29

28.84

3.00

0.71

7

Belle Haven: Tax Ladder PLUS

2.99

2.79

2.57

38.08

3.00

-0.37

8

National Invest: Intermed PLUS

2.24

2.18

2.12

15.85

3.00

0.72

9

Karpus Inv Mgt: Fixed Inc. Mgmt

5.40

4.55

3.80

34.42

3.00

-2.52

10

Pioneer Invest: U.S. Core Fixed

2.50

2.60

2.41

10.56

2.00

0.76

217

Chicago Equity: High Qual Interm

3.17

2.42

2.55

76.57

4.00

-2.03

234

Barclays U.S. Aggr. Bond Index

4.14

3.20

3.02

100.00

5.00

2.02

Source: Decision Technologies Corporation

One might expect that a fixed income fund with significantly lower returns than others in its asset class would also have significantly lower volatility. This, however, is not the case as shown in Exhibit 16. Chicago Equity’s average standard deviations are comparable to those of the top 10 scoring funds, lower than some and higher than others, but in proximity to all. It therefore has no discernable offsetting lower volatility.

Exhibit 17. Distribution of Composite Scores – International Intermediate Fixed Income Funds

 
  

Source: Decision Technologies Corporation

Exhibit 17 supports two relevant observations. First, it demonstrates the stark contrast between Chicago Equity’s relative rank and its entire asset class. Its mid-fourth quartile rank is so poor that the Trust’s performance will most likely be improved by simply replacing it. Second, it provides graphical evidence of the narrow differences in scores between the high and low ranked funds in this asset class. Highly scored and ranked investments are bunched together at the top of the distribution curve. Beyond that the curve enters a range of mediocre performance and then drops abruptly. This pattern is characteristic of intermediate fixed income investments and sharply contrasts the pattern of large cap growth investments found in Exhibit 13.

For a diversified portfolio to be efficient, it must not only consider the risk and return of its investments but also the pair-wise covariance between them. Scalar scoring within an asset class does not necessarily result in an optimal portfolio asset allocation. Its only objective is to efficiently distinguish between superior and inferior investments within an asset class.

Investments in an asset class should be highly correlated or they shouldn’t be included in that asset class. That is not to say, however, that the pair-wise lack of correlation between asset classes does not contribute to a portfolio’s optimality, i.e., efficiency. In fact, it does. A diversified portfolio of low-, negatively-, or un-correlated asset classes could, in fact, approach optimality if it holds the highest scoring investments in each asset class.

VII.  Decision-assistance technology vs. performance measurement services

The role played by decision-assistance technology in the investment process sharply contrasts that played by conventional performance measurement services. It enables investors to identify the relative merits of qualified investments using customized performance parameters and proactively facilitates investment decisions.

By comparison, the role played by performance measurement services is limited to simply reporting the positions of current holdings relative to benchmark indexes within quartiles of their asset classes. It highlights poor performing investments, identifying situations that should be reviewed, but it does not offer choices and does little to define decisive courses of action.

Exhibit 18 is a typical performance report used by most consultants for several decades. It is taken from the “Investment Performance Analysis”34 commissioned by the City of Miami General & Sanitation Employees’ Retirement Trust. This analysis identifies the relative position of the Atlanta Capital HQ Growth Plus Fund’s total returns with respect to the Russell 1000 Growth Index and the quartiles of a large cap growth universe defined by the consultant. While the analysis correctly reports the relatively poor performance of Atlanta Capital’s total returns, it does little else. It completely ignores important parameters, e.g., volatility and drawdown, and fails to identify other more suitable investment choices.

Exhibit 18. Large Cap Growth Performance Comparisons

 
  

Source: Southeastern Advisory Services, Inc.

In contrast, the analyses contained in Exhibits 1, and 10 through 13 above provide a more comprehensive view of the investment process. Exhibit 1 identifies the relevant risk and return parameters, their weights, and relative importance in the composite scores. Exhibit 10 lists the top 10 scoring and ranked funds, the Russell 1000 Growth Index, and the 3 Atlanta Capital Funds. Exhibit 11 identifies the parameters contributing to the Return component and the values used in computing the composite scores.

Exhibit 12 identifies the Risk parameters and their values. And, finally, the distribution curve in Exhibit 13 compares the relative performance of the over 250 investments. The combined information in those exhibits support decisions to liquate, hold, or acquire more suitable investments based upon an informed knowledge of their scores, ranks, and risk/return parameters.29

VIII.  Implications for the post-DOL fiduciary rule environment

Limited information coming from the new Trump Administration and Congress is casting doubt on the speed with which DOL’s fiduciary rule will be implemented. Nevertheless, investor demand for reform, recent judicial rulings, more cost-conscious consumers, growing pressure on retail fees, changing demographics, and technological advances have irrevocably altered the market for investment services.

All manner of fiduciaries, plan sponsors, advisors, broker/dealers, CPAs, and lawyers, etc., must embrace new technologies to dispense defendable, objective advice to comply with the new standards of fiduciary responsibility mandated by regulations and judicial rulings.

Fiduciaries using new technologies will enjoy a competitive advantage by providing superior investment advice which should lead to their customers’ investment success and satisfaction.

Competitive pricing pressures will require employing more cost-effective automated processes to remain profitable. Deferring problems related to growing labor costs, research, marketing, and operations will eventually hurt profitability. The solutions lie in adopting an adaptable, low-cost technology.

The time required to make and act on informed investment decisions will continue to be reduced through electronic market-making and high frequency trading. Successful fiduciaries will not only profit by reducing the time necessary to take decisive actions, but also by reducing the opportunity costs of failing to take them in a timely manner.

Prudent automated, low-cost retirement advice is available to a greater number of underfunded Baby Boomers through fintech providers such as DTC. These same providers will also offer automated financial advice to Millennials and Gen Xers.

IX.  Summary and conclusions

The patented process offered by Decision Technologies Corporation has been analyzed with a critical view towards evaluating the efficacy of its applications in this new regulatory environment. It filters out irrelevant information, focuses on relevant information, and identifies investment choices that are most likely in an investor’s best interest and most closely satisfy their risk/return preferences.

In addition, DTC’s process promises to mitigate increasing compliance costs by providing solutions that reduce conflicts of interest between fiduciaries and their customers. New regulations and judicial rulings have increased compliance costs, the possibility punitive actions, and/or financial liabilities. By helping responsible advisors

and clients make informed and objective decisions for the exclusive benefit of the client, it ensures that applicable standards of “fiduciary duty” can be met

Changes in investor preferences are also putting pressure on fees. Investors are no longer willing to pay for underperforming investments. Most active fund managers consistently underperform passive investments causing investors to seek acceptable performance with low-cost index funds. Fiduciaries seeking to reaffirm their value must now employ a low-cost, comprehensive and theoretically sound process to identify investments likely to outperform their peers and benchmarks.

New regulations and judicial rulings have expanded the definition of a fiduciary to include anyone who offers advice and receives direct or indirect compensation. Those defined as fiduciaries must now be proactive in providing advice that is prudent and suitable without significant conflicts of interest. This requires using a decision-oriented process which is objective, inclusive, analytically sound, relevant, and cost-effective.

DTC’s decision-assistance process is evaluated to determine its efficacy in providing actionable decisions. Part of that evaluation consists of going step-by-step through the process and evaluating its claimed features: objectivity, relevance, flexibility, scalar sorts and ranks, discrimination, and decision orientation. This evaluation included reviewing large cap mutual funds and 3 additional asset classes in an existing retirement trust: international large cap value equities, domestic large cap growth equities, and domestic intermediate fixed income.

The process is determined to be objective based on the set of parameters and weights selected. It is also relevant to the extent the selected parameters are relevant. The process is flexible in permitting the use of different parameters and filters, although their selection implies some subjectivity. It provides three output forms; scalar scores, ranks and distribution graphs which differentiate high from low scored investments relative to appropriate benchmarks. The output therefore distinguishes between superior and inferior performing investments and clearly delineates the need, or lack thereof, for appropriate action.

In conclusion, this decision-assistance technology provides fiduciaries with six benefits:

  1. It offers a justifiable defense against charges of imprudence.

  2. It offers a complete view and therefore control over the investment process from the prudent selection of top ranked investments based on relevant criteria, to monitoring performance, and facilitating the liquidation of imprudent

  3. It indicates when an investment is increasing or decreasing in attractiveness from one period to the

  1. It permits creating customized templates containing proprietary performance criteria, weightings, defined investment datasets, and process

  2. It can further refine the scores and ranks of other ranking and rating systems, g., Morningstar’s 5 star ratings, Standard & Poor’s, and Value Line’s.

  3. It is a significant and productive departure from conventional performance measurement services which typically report the total returns of a portfolio’s holdings relative to a benchmark index and within quartiles of their asset

Endnotes

  1. Investment Company Institute, 2016 Investment Company Fact Book. Washington, DC: ICI, 2016, 178.

  2. Smith, Eric S., and Joseph Simko, Decision Assistance Platform Configured for Facilitating Financial Consulting Services. S. Patent Office, Patent No: US 7,711,633 B2. Washington, DC: USPO, May 4, 2010.

  3. Securities and Exchange Commission, Investment Advisers Act of 1940, Section 206,

Washington, DC: SEC, 1940, p.27.

  1. Department of Labor, Employee Benefits Security Administration, “Department of Labor Finalizes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle Class Families Billions of Dollars Every Year.” Washington, DC: DOL, April 8,

  2. Department of Labor, Employee Benefits Security Administration, Final Rule. Federal Register/Vol. 81, No. 68/April 10, 2016/Rules and Regulations. Washington, DC: DOL, 20945.

  3. Department of Labor, Employee Benefits Security Administration, Final Rule; extension of applicability date. Federal Register/Vol. 82, No. 66/April 7, 2017/Rules and Regulations. Washington, DC: DOL, p. 16902.

8 Schoeff, Mark Jr., “Trump stumps industry,” Investment News, January 16, 2017, pp. 3,19.

  1. Schoeff, Mark , “Judge’s questions show inclination to uphold DOL fiduciary rule.” InvestmentNews, August 26,2017, p.3.

  2. Schoeff, Mark , “Kansas judge again upholds DOL fiduciary rule,” InvestmentNews, Friday, February 17, 2017.

  3. Tibble et al v. Edison International et al, Case 2:07-cv-05359-SVW-AGR Document 405 Filed 07/08/10 Page 1 of 82 Page ID #:16617.

  4. Ibid, 64

  1. Ibid, 56.

  2. Supreme Court of the S., Tibble et al. v. Edison International et al, May 18, 2015,

  3. 1.

  4. Wallick, Daniel. W. et al, “Keys to improving the odds of active management ” Valley Forge, PA: The Vanguard Group, October 2015, p.3.

  5. Investment Company Institute, 2016 Investment Company Fact Book. Washington, DC: ICI, 2016, 174.

  6. Ibid, p. 218.

  7. Ibid, 97.

  • , Schoeff, Mark, , “Borzi: Labor’s rule already reducing fees.” InvestmentNews, December 6, 2016, p.2.

  1. ICI Research Perspective, “Ownership of Mutual Funds, Shareholder Sentiment, and Use of the Internet, 2015,” ICI Research Perspective, 20-21.

  2. Malito, Alessandra, “The great wealth transfer is coming, putting advisors at risk,” InvestmentNews, July 13,

  3. Hedges, Bob et al, Future of Advice Study. New York, NY: T. Kearney, June 2016, pp.15-16.

  4. Epperson, Teresa et al, Hype Reality: The Coming Waves of “Robo” Adoption.

New Yok, NY: A.T. Kearney, June 2015. p. 26.

  1. CSSC Investment Advisory Services, “Demonstration of Process,” September 30, 2016, 12-20. Can be found at http://www.gese.org/09302016/CSSC.PDF

  2. Ibid, pp. 2-11.

  3. Sharpe, William F., “The Sharpe Ratio.” The Journal of Portfolio Management, Fall

  4. CAPM assumptions include those of a freely competitive market including no commissions, no taxes, numerous investors with the equal access to securities, all having equal expectations and planning horizons, able to borrow or lend at the risk-free rate, an ability to short any security, and invest in fractional shares. Sharpe, William F., “Capital Asset Prices – A Theory of Market Equilibrium Under Conditions of Risk”. Journal of Finance. XIX (3), 1964, 425–42.

  5. Rollinger, Thomas and Scott Hoffman, “Sortino Ratio: A better measure of risk.”

Futures Magazine, February 1, 2013.

  1. A more complete analysis of large cap growth funds presented to the Plan’s Trustees can be found on GESE.org.

References

Department of Labor, Employee Retirement Income Security Act of 1974. Washington, DC, 1974.

International Association of Securities Commissions, IOSCO Research Report on Financial Technology (Fintech). London, U.K.: IOSCO. February 2017.

Investment Company Institute, 2016 Investment Company Fact Book. Washington, DC: 2016.

InvestmentNews, 2017 Adviser Technology Study. New York, NY: InvestmentNews, March 20, 2017.

Michaud, Richard O. and Robert O. Michaud, Efficient Asset Management, Second Edition. New York, NY: Oxford University Press, Inc., 2008.

Rollinger, Thomas and Scott Hoffman, “Sortino Ratio: A better measure of risk.” Futures Magazine, February 1, 2013.

Securities and Exchange Commission, Investment Advisers Act of 1040. Washington, DC, 1940.

Sharpe, William F., “Capital Asset Prices – A Theory of Market Equilibrium Under Conditions of Risk”. Journal of Finance. XIX (3), 1964, pp. 425–42.

Sironi, Paolo, FinTech Innovation. West Sussex, U.K: John Wiley & Sons Ltd. 2016

Supreme Court of the U.S., Tibble et al, v, Edison International, et al. Washington, DC: October 2014.

U.S. District Court, Central District of California, Tibble, et al v. Edison International, et al, Case 2:07-cv-05359-SVW-AGR, Document 405, Filed 07/08/10

Certification of Independence

The foregoing report is an independent evaluation of the decision-assistance process offered by Decision Technologies Corporation. It was conducted from the outset with the contractual understanding that I would be free to conduct my research and submit my findings free of external influences.

My objectives in pursuing this investigation were to 1) determine the validity of the process and its applications in identifying superior investments, and 2) evaluate its efficacy in this new regulatory, competitive, and economic environment. These objectives were accomplished by independently acquiring, examining and testing all necessary information. The result is this final report.

I herewith attest to the fact that the findings, opinions and conclusions contained in this report are my own and were arrived at independently

Sincerely,

 
  

Michael Carty

Biography

Michael Carty is principal and founder of CMC Consulting, LLC which specializes in designing active growth, growth & income, and value income strategies for separately managed accounts, pension plans, mutual funds, exchange-traded products, and long/short market neutral strategies. The firm also designs passive equity products including index and smart beta funds for licensing as ETFs. Other activities include providing expert witness testimony. He can be reached at 917-697-9464.

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WAGNER LAW GROUP OPINION OF COUNSEL REGARDING DTC’S PATENTENTED TECHNOLOGY​

WAGNER LAW GROUP OPINION OF COUNSEL REGARDING DTC'S PATENTENTED TECHNOLOGY

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THE WAGNER LAW GROUP

October 22, 2019

Re:Opinion for Decision Technologies Corporation

Dear Mr. Smith:

Decision Technologies Corporation (“DTC”) has developed a patented decision-assistance technology (“Decision Assistance Technology” or “DAT”) for use in the financial services industry. DTC’s DAT may be used by registered broker-dealers and their registered representatives (“Reps”), registered investment advisors (“RIAs”) and their individual advisor representatives (“IARs”) (collectively, “Firms” at the institutional level or “Advisors” at the individual representative level) to comparatively evaluate investment products. DAT may be used by Firms offering investment-related services through their Advisors to investor clients to comparatively evaluate and identify appropriate investment products for their clients. Investor clients may include fiduciaries to employee pension benefit plans (“Plan Fiduciaries”) that are subject to Title I of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) or participants with one or more accounts in such plans. Investor clients may also include individuals with one or more individual retirement accounts (“IRAs”), other similar tax­ advantaged accounts that are not subject to Title I of ERISA, and retail investment accounts.

Title I of ERISA requires fiduciaries of employer-sponsored retirement plans to act in accordance with a “Prudent Man Standard of Care.”

On June 5, 2019, the Securities and Exchange Commission (“SEC”) adopted Regulation Best Interest1, which requires broker-dealers and their registered Reps to act in the best interest of their retail customers when making recommendations of any securities transactions or investment strategies involving securities. Regulation Best Interest has a compliance date of June 30, 2020.2

You have asked for our opinion as to whether the use of DAT (a) by Firms, their fiduciary Advisors, and Plan Fiduciaries of ERISA plans may help them meet ERISA’s prudence standard, and (b) by broker-dealers and Reps may help them to meet the standard of conduct as set forth in Regulation Best Interest owed to “retail customers.”

  1. EXECUTIVE SUMMARY OF ANALYSIS AND CONCLUSIONS
  • ER/SA’s Prudent Man Standard of Care. Title I of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) requires fiduciaries of employer-sponsored retirement plans (e.g., 401(k), profit sharing, defined benefit, multiemployer, and Taft­ Hartley plans) to act in accordance with a “Prudent Man Standard of Care.” It provides, in part, that a fiduciary shall discharge its duties solely in the interest of participants and beneficiaries and (i) for the exclusive purposes of providing benefits to participants and beneficiaries and defraying reasonable expenses in administering the plan; (ii) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character with like aims; (iii) by diversifying investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so. Thus, a fiduciary must carry out its duties prudently with regard to all aspects of the retirement plan. With regard to an investment or an investment course of action taken by the fiduciary, a fiduciary is deemed to comply with the Prudent Man Standard of Care if the fiduciary gives “appropriate consideration” to relevant facts and circumstances and making a determination that the particular investment or investment course of action is “reasonably designed to further the purposes of the plan.”
  • Using Decision Assistance Technology to Meet Prudent Man Standard of Care. ERISA is silent with respect to the use of any particular type of investment tool to satisfy the Prudent Man Standard of Care. DAT ranks and scores universes of investment choices that have been filtered and shaped, using hierarchical blends of weighted performance factors solely based on the client’s investment goals, risk tolerance, performance preferences, and other distinguishing factors. In our view, use of DAT by fiduciary Advisors or Plan Fiduciaries, would assist them in giving (and demonstrating to regulators and in court proceedings that they have given) appropriate consideration as to whether a plan’s investments or the investment course of action taken is reasonably designed to further the objectives of the ERISA plan.
  • Tibble’s Duty to Monitor Investments. In Tibble v. Edison International, the U.S. District Court for the Central District of California ruled in favor of plaintiff 401(k) plan participants in a case involving prudence issues concerning the higher costs associated with retail class (in contrast to institutional class) mutual funds that had been in the plan’s

organization of financial planners working under registered investment advisers, filed suit challenging Regulation Best Interest as unlawful and injurious to registered investment advisors by creating a competitive disadvantage with respect to broker-dealers who are permitted to take into account their own personal interest in providing recommendations.

investment lineup for many years. The Supreme Court concluded that, under trust law, a fiduciary has a continuing duty to monitor trust investments and to remove imprudent ones. The District Court, in applying this standard, stated that the fact a plan fiduciary secured independent advice does not necessarily indicate that he acted prudently.

  • Using Decision Assistance Technology to Satisfy the Duty to Monitor Investments. Tibble does not expressly describe the manner in which the ongoing duty to monitor plan investments must be met. Engaging and uncritically accepting and following the advice of an independent investment professional for the provision of investment advice with respect to ERISA plan investments does not necessarily mean that a Plan Fiduciary has acted prudently. Use ofDTC’s DAT involves the repeated use of its four-step process every quarter to comparatively evaluate how previously selected investments have performed since their selection. Securing the advice of an Advisor alone, without more, may not meet the Plan Fiduciary’s or the Advisor’s duty to monitor investments. DAT’s comparative evaluation of investments by scoring and ranking them based on the client’s investment objectives provides a process that could help ensure independent oversight of an Advisor’s investment recommendations – a protective “second opinion,” if you will- as encouraged by Tibble. In our view, repeated use of DAT by fiduciary Advisors or Plan Fiduciaries on a quarterly basis or other appropriate periodic intervals to comparatively evaluate the performance of an ERISA plan’s investments will help them satisfy (and help them demonstrate that they have satisfied) their fiduciary duty to monitor investments and identify chronically underperforming or imprudent ones so that they can be removed and replaced with more prudent ones.
  • SEC’s Regulation Best Interest. Regulation Best Interest imposes a standard of conduct on registered broker-dealers and their Reps when making a recommendation to a retail customer of any securities transaction or investment strategy involving securities. It requires the broker-dealer or Rep to act in the retail customer’s best interest and not place its own interests ahead of the customer’s interests (“General Obligation”). To satisfy the General Obligation, a broker-dealer or Rep must satisfy four component obligations: (i) the Disclosure Obligation, (ii) the Care Obligation, (iii) the Conflict oflnterest Obligation, and

(iv) the Compliance Obligation (collectively, the “Component Obligations”). Thus, the failure to meet any one of the Component Obligations (discussed in Section III.C.1) constitutes a violation of Regulation Best Interest.

  • Using Decision Assistance Technology to Satisfy the Care Obligation Under Regulation Best Interest. Regulation Best Interest is silent with respect to the use of any particular process or type of interactive tool to satisfy the Care Obligation. When using DAT, the Rep will also apply client-specific factors (perhaps even those selected by the client) to “shape” and identify the qualified universe of investment choices that will eventually be scored and ranked. The Rep will then hierarchically arrange and weight client-specific investment performance parameters to reflect each parameter’s relative importance to the client. The factors and parameters that are chosen, applied, arranged and weighted specific to the client will indicate and demonstrate what the client considers to be in the client’s best interests, and will likely be consistent with the information gathered from the client’s investment profile. Any inconsistencies will prompt further productive discussions between the Rep and the client about the client’s investment objectives, financial circumstances, risk tolerance, investment preferences, etc. Assuming a Rep obtains an adequate investment profile of the retail customer (i.e., “know your customer”3), the use of DAT can assist the Rep in complying with (and demonstrating compliance with) two of the components of the Care Obligation. Specifically, DAT will assist the Rep in exercising reasonable diligence, care and skill to (i) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation, and does not place the financial or other interest of the broker-dealer or Rep ahead of the interest of the retail customer; and (ii) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile, and does not place the financial or other interest of the broker-dealer or Rep making the series of recommendations ahead of the interest of the retail customer.
  • Using Decision Assistance Technology to Satisfy the Conflict of Interest Obligation Under Regulation Best Interest. DAT scores and ranks investment products based on the performance parameters selected, hierarchically arranged and weighted to reflect their relative importance to the client. DAT recommends and provides a practical means to consider a broader universe of investments than just those limited by the broker-dealer’s or Rep’s inventory or “approved  lists.”  Considering this broader pool of investment products, and comparatively evaluating the products, based solely on whether and how well they meet the client’s composite weighted blends of performance criteria, may reduce the likelihood that recommendations made to retail customers place the interest of the broker­ dealer or Rep ahead of the interest of the retail customers. Indeed, the use of DAT to comparatively evaluate the full range of available investment choices, based purely upon objective client-specific performance parameters, should effectively “filter out” or eliminate conflicts of interest that might otherwise encourage or incentivize recommendations of one investment choice over another and should enable the broker­ dealer and Rep to demonstrate that such conflicts of interest have been eliminated. In our view, the use of DAT by Reps when advising retail customers will be helpful in complying with (and demonstrating compliance with) components (i), (ii) and (iii) of the Conflict of Interest Obligation. In addition, the use of DAT can be referenced in the broker-dealer’s reasonably designed policies and procedures as a means of reducing the likelihood that conflicts of interest may unduly influence Reps, including those associated with more limited product offerings.
  • Use of Decision Assistance Technology is Consistent with Best Practices. ERISA, to a great extent, is a process driven statute (although there is also a strong substantive prudence requirement). As such, it does not focus on the outcome of a decision by an Advisor or Plan Fiduciary, but instead on the process by which that decision was reached. DAT is an investment selection process that can take into account the broadest possible universe of investment products, and not only those investment products that are available to a particular Advisor (although it can also be used to comparatively evaluate even limited product universes). By applying an investor’s preferences thereafter to “shape” the available investment universe (of qualified choices), and then applying a hierarchically arranged and weighted blend of performance parameters reflecting each specific client’s needs, goals, and preferences, the results of such a process may also result in improved investment performance and thus make actual achievement of investment and retirement goals more likely. Taken together with its recommended focus on the broader universe of investment options rather than restricting its analysis to the products available to the Advisor, DAT’s method approaches a best practice. In our view, when all this is taken together with prudent policies and procedures, the use of a tool such as DAT may be an evolving best practice for use in selecting and monitoring the performance of investments for ERISA plans.
  1. FACTUAL OVERVIEW OF THE TECHNOLOGY

From your perspective, the investment selection process used by Advisors – how and why certain products are selected – has long lacked transparency. The critical question DAT is trying to answer for the investor client is: Of all the available choices of investment products, which one is best for me? Note that DAT is not limited to evaluating those products available to a particular Advisor, which it can certainly be applied to perform, but can be and ideally is utilized to evaluate the broadest possible universe of “qualified” investment products, as discussed below.

In your opinion, DAT identifies the best investment product for the client because it accomplishes three things: (i) it cuts through all of the “noise” from advertising and marketing materials, (ii) it filters out all conflicts of interest, both known and unknowable, and (iii) it comparatively evaluates all existing investment choices in a manner specific to a client’s needs, investment goals, preferences, and risk tolerance.

DAT enables any user, whether an IAR, Rep, Plan Fiduciary, IRA account holder, or retail investment account holder to comparatively evaluate thousands of mutual funds, money managers, annuities and other financial products based on the client’s unique needs, goals and preferences. The client and/or the client’s Advisor can select any number of performance parameters, which can then be hierarchically arranged and weighted, in order to score and rank thousands of existing investment choices. In your view, the transparency of the process – the fact that clients can see and directly participate in selection, arrangement, and weighting of the factors important to them – empowers clients, engendering trust in the investment selection and performance monitoring processes.

In its original design and recommended application, DAT begins with the broadest possible universe of investments, which are those products for which data can be gathered from the largest publicly available databases covering both mutual funds and money managers.

Application of DAT involves several steps:

Step 1: “Filtering 11 to “shape 11 the universe o[investment choices. First, an appropriate database is selected. This can be based upon the user’s preference- i.e., the database the Advisor is currently using or wishes to use, or the choice of database can be based on the client’s preference. At this juncture, “filtering” is applied to define the universe of investment choices relevant to the client. For example, if the client is seeking a domestic U.S. Large Cap Value mutual fund or separately managed account (“SMA”), filters are used to exclude any mutual fund or SMA that would not legitimately qualify as a domestic U.S. Large Cap Value mutual fund or SMA.

In your view, virtually all investment advisors utilize progressive “filtering,” which is the successive application of single factor-based filters to disqualify certain investment choices to arrive at the final recommendation. For example, if the 5-year average annual return above a ce1iain level is the factor in question, all investment options that do not meet this criterion are filtered out of the universe of potential investment recommendations. In your view, this “single factor disqualification” can too often exclude otherwise strong performing investments choices – choices that may have exceptional performance characteristics in other areas that would (in total) be potentially stronger choices that the client would logically wish to see.

With DAT, the client can select from a menu of filters that can be applied to “shape” the investment universe – that is, to define the asset class by eliminating all choices that would not legitimately qualify for inclusion. Some examples of applicable filters are: excluding investment choices where the amount being managed is less than $500 million, excluding investments where sector focus is greater than 50, identifying an investment with a certain ticker symbol, and identify investments that are socially responsible. “Qualified” or “relevant” investment products remain (i.e., the relevant universe of choices is “defined”) after the filters are applied. Filters are selected by the Advisor and/or the investor client, and may be added, removed, and/or changed at any time.

Step 2: The selection, hierarchical arrangement and weighting ofperformance parameters within each asset class. The construction of an investment portfolio necessitates the selection and blending of various classes of investments in order to achieve the highest rate of return, taking into account the client’s risk tolerance. Each class of assets selected is expected to produce and contribute a particular “investment effect” to overall investment performance as desired by the client. Thus, with respect to each asset class in the portfolio, the client would ideally wish to know which of the investment choices (within any such asset class) had been the best at producing the desired composite investment effect (within that asset class) over time. In your view, DAT provides a way to objectively and transparently determine this.

At the outset, the Advisor and/or investor client will be provided with a default hierarchical arrangement of weighted performance parameters and/or other distinguishing characteristics.

These default settings are based on DAT’s experience with patterns of client preferences, i.e., typical patterns in the ways in which investors arrange and weight such factors, as well as the results typically produced by such patterns. These default settings can be adjusted by the Advisor and/or client to better reflect that client’s unique investment profile, that is, the client’s individual financial situation, goals, risk tolerance, and preferences. This step is often done interactively with the Advisor, but can be completed by the client independently.

Note that an Advisor typically obtains the client’s investment profile in advance of Step 2.

Examples of performance parameters include risk tolerance (e.g., willingness to tolerate moderate short-term declines in the portfolio): I-year ASD, 3-year ASD, 5-year ASD; desired degree of emphasis on return-related parameters: I-year average return, 3-year average return, and 5-year average return; up market and/or down market capture (i.e., how the product has performed in the last up or down market); etc. These performance parameters are then hierarchically arranged and weighted by the Advisor and/or investor client based on their relative importance to the investor client. The greater the percentage weight assigned to the parameter, the greater the importance to the client and the greater influence it has on the ultimate investment ranking generated by DAT. Increasing the weight of any performance parameter will result in a corresponding decrease of other parameters. The parameters’  respective hierarchical position and weight, and the performance parameters themselves, may be added to, removed and/or changed at any time.

Step 3: Scoring and ranking o(all o(the qualified investment choices. Using the hierarchically arranged and weighted performance parameters as indicated by the Advisor and/or investor user, DAT scores and ranks all the qualified investment choices identified in Step 1. It is here, according to DAT, that the best investment products for the investor client from all qualified investment choices are identified and ranked.

The top-ranked choices, based on the application of the selected filters and the hierarchical arrangement and relative weights of the client’s performance parameters, will be ranked as “1,” and remaining choices will be ranked in descending order. The highest-scoring product with respect to each performance parameter will also be identified. In other words, after products are scored and ranked, the investor client will see which mutual funds and managers have been the most effective at producing the desired composite “investment effect” over time.

According to you, the scoring and ranking of investment choices that best meet the client’s performance parameters, based purely on their merit, effectively filters out any conflicts of interest, both known and unknowable, on the part of the Advisor, and renders them moot.

In your view, the order in which the Advisor performs due diligence on investment products is critical to creating beneficial efficiencies for both the Advisor and client. Rather than performing laborious qualitative due diligence on hundreds of available investment choices (in an effort to produce a “vetted” list of investment choices from which to recommend), which is the more prevalent practice, the Advisor using DAT can apply the Advisor’s due diligence process at this stage to a more tightly targeted group of scored and ranked investment choices (e.g., to the top three to five most highly scored and ranked products). Thus, this step does not replace the qualitative due diligence examination that must be performed by the Advisor on the investments identified at this step; it simply makes it much more efficient. Moreover, with such a process, qualitative due diligence no longer becomes the limiting factor on universe size – the principal factor cited as justifying smaller universes from which a client must select.

Step 4: Repeated application of DAT each quarter. Application of DAT to comparatively evaluate, score and rank all existing investment choices on a quarterly basis will demonstrate how previously selected investments have performed relative to their peers since their selection and, specifically, how their rankings may have declined or improved.

The top-ranking choices within each asset class, based on the client-specific filters and blended weighted performance parameters, appear in a Quarterly Investment Review report (“Report”) that is delivered to the investor client. According to you, the Report is unique in that it provides valuable information to the Advisor and investor client – an answer to the question: “How did our fund and/or fund manager perform relative to all the others that could have been selected?”

Placing such results side-by-side for four consecutive quarters, enables the Advisor and investor client to see information that appears to have never before been available to either. If the investor client’s mutual fund or manager begins to drop in relative rank, the Report will reveal those that are rising in the rankings, in the same asset class, with the same investment goals, and in the same market conditions. This can help prevent what DTC believes to be one of the most common causes of chronically poor investment performance, characteristic of even the largest of pension funds (both public and Taft-Hartley) and that is the holding of poor performing choices for far too long.

In most instances, retaining poor performing investment(s) for too long is a result of the lack ofreadily accessible information on the part of the Plan Fiduciary as to better performing alternative funds or managers. New fund manager searches are often time-consuming and expensive. DAT’s review process provides a readily available and functional equivalent of information obtainable only through new fund manager searches, which it provides every quarter. Because information as to mutual funds and managers that are rising in rankings is provided by DAT, investors and Plan Fiduciaries can make investment replacement decisions far more rapidly and with a much higher degree of confidence.

III.       LEGAL STANDARDS

  1. PRUDENT MAN STANDARD OF CARE UNDER ERISA

Title I of ERISA requires fiduciaries of employer-sponsored retirement plans to act in accordance with a “Prudent Man Standard of Care.”4 It provides, in part, that a fiduciary shall discharge his duties solely in the interest of participants and beneficiaries and (i) for the exclusive purposes of providing benefits to participants and beneficiaries; and defraying reasonable expenses in administering the plan; (ii) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character with like aims; (iii) by diversifying investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so. Thus, a fiduciary must carry out its duties prudently with regard to all aspects of the retirement plan.

With regard to an investment or an investment course of action taken by the fiduciary, longstanding “U.S. Department of Labor” (“DOL”) regulations provide that a fiduciary is deemed to comply with the statutory duty of prudence if the fiduciary gives “appropriate consideration” to the facts and circumstances that the fiduciary knows or should know are relevant with respect to a particular investment or investment course of action, and has acted accordingly.5  “Appropriate consideration” includes, but is not limited to, making a determination that the particular investment or investment course of action is reasonably designed, as part of the portfolio, to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action. Factors that a fiduciary should take into consideration include (i) the composition of the portfolio with regard to diversification; (ii) the portfolio’s liquidity and cmrent return relative to the plan’s anticipated cash flow requirements; and (iii) the portfolio’s projected return relative to the plan’s funding objectives.6

  1. TIBBLE’S ONGOING DUTY TO MONITOR INVESTMENTS

In Tibble v. Edison International, plaintiff 401(k) plan participants alleged that defendants violated their fiduciary duties with respect to three mutual funds added to the plan in 1999 and three mutual funds added to the plan in 2002. They argued that defendants violated their duty of prudence (i.e., the Prudent Man Standard of Care) by offering six higher-priced retail-class mutual funds as plan investments when materially identical lower-priced institutional-class mutual funds were available. The U.S. Supreme Court noted in its 2015 decision that the Prudent Man Standard of Care is “derived from the common law of trusts” and that “in determining the contours of an ERISA fiduciary’s duty, courts must often look to the law of trusts.”7 The Supreme Court concluded that under trust law, a fiduciary has a continuing duty to monitor trust investments and to remove imprudent ones.8 This means that the trustee must systematically consider all investments of the trust at regular intervals to ensure they are appropriate.9 The case was ultimately remanded to the U.S. District Court of the Central District of California to consider whether there was a breach of fiduciary duty in light of the ongoing duty to monitor investments as articulated by the Supreme Court.

In finding for the plaintiffs, the District Court observed that “[i]n order to determine whether an investment decision is prudent, a fiduciary has a duty to investigate, and may secure independent advice from financial advisors or other experts in the course of the investigation.

However, the fact that a fiduciary secured independent advice does not necessarily indicate that he acted prudently.”10

  1. REGULATION BEST INTEREST

On June 5, 2019, the SEC released, among other guidance, Regulation Best Interest (“Regulation BI”), which imposes a standard of conduct on registered broker-dealers and their Reps when making a recommendation to a retail customer of any securities transaction or investment strategy involving securities.11 In general, it requires the broker-dealer or Rep to act in the retail customer’s best interest at the time the recommendation is made and not place its own interests ahead of the retail customer’s interests (“General Obligation”)12•  The SEC declined to expressly define “best interest” in Regulation BI.13 Instead, the SEC clarified that the specific Component Obligations expressly set forth what it means to “act in the best interest” of the retail customer. 14 The four Component Obligations are: (i) the Disclosure Obligation, (ii) the Care Obligation, (iii) the Conflict oflnterest Obligation, and (iv) the Compliance Obligation. The failure to meet any one of the Component Obligations constitutes a violation of Regulation BI.15 Whether a broker-dealer or Rep has acted in the retail customer’s best interest under the General Obligation will turn on an objective assessment of the facts and circumstances of how these specific components of Regulation BI are satisfied at the time the recommendation is made (and not in hindsight). 16

Regulation BI has a compliance date of June 30, 2020.

  1. Component Obligations

Below is a general description of the Component Obligations of Regulation BI.

Disclosure Obligation. The broker-dealer or Rep, prior to or at the time of the recommendation, must provide to the retail customer, in writing, “full and fair disclosure” of (i) all material facts related to the scope and terms of the relationship with the retail customer, including (a) that the broker-dealer or Rep is acting as a broker dealer or Rep with respect tot he recommendation; (b) the material fees and costs that apply to the retail customer’s transactions, holdings, and accounts; and (c) the type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer; and (ii) all material facts relating to conflicts of interest that are associated with the recommendation.”17 The SEC defined a “conflict of interest” as “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker-dealer – consciously or unconsciously – to make a recommendation that is not disinterested.”18

Care Obligation. Under the Care Obligation, a broker-dealer or Rep, in making a recommendation, must exercise reasonable diligence, care and skill to (i) understand the potential risks, rewards and costs associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers; (ii) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation, and does not place the financial or other interest of the broker-dealer or Rep ahead of the interest of the retail customer; and (iii) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile, and does not place the financial or other interest of the broker-dealer or Refs making the series of recommendations ahead of the interest of the retail customer. 9

Conflict oflnterest Obligation. The broker-dealer is required to establish, maintain, and enforce written policies and procedures reasonably designed to (i) identify and at a minimum disclose or eliminate all conflicts of interest associated with its or the Rep’s recommendation; (ii) identify and mitigate any conflicts of interested associated with its or the Rep’s recommendations that create an incentive for it or the Rep to place its or the Rep’s interest ahead of the retail customer’s interest; (iii)(a) identify and disclose any material limitations placed on the securities or investment strategies that may be recommended to retail customers and any conflicts of interest associated with such limitations, and (b) prevent such limitations and associated conflicts of interest from causing it or the Rep to make recommendations that place its or the Rep’s interest ahead of the retail customer’s interest; and (iv) identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities within a limited period of time.20

Compliance Obligation. The broker-dealer must establish written policies and procedures reasonably designed to achieve compliance with Regulation BI as a whole.21 This obligation does not articulate specific requirements that must be included in their policies and procedures. Each broker-dealer should instead consider the scope, size, and risks associated with the operations of the firm and the type of business in which the firm engages when adopting policies and procedures.22 The SEC has stated that a reasonably designed compliance program generally would also include controls, remediation of noncompliance, training, and periodic review and testm•

  1. Retail Customer

A “retail customer” is owed the standard of conduct set forth in Regulation BI. A “retail customer” is a natural person, or the legal representative of such natural person, who: (i) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (ii) uses the recommendation primarily for personal, family, or hous_ehold purposes.24 The preamble to Regulation BI makes clear that the definition of a retail customer would cover participants in plans covered by ERISA.25

The SEC interprets “legal representative” to mean non-professional legal representatives of a natural person.26 Institutions and certain professional fiduciaries are not covered for purposes of Regulation BI.27

Furthermore, “personal, family, or household purposes” would include retirement accounts because retirement savings is a personal, household or family purpose.28 Accordingly, the definition of a retail customer will include a natural person receiving a recommendation for the customer’s own retirement account, including but not limited to IRAs and individual accounts in workplace retirement pans, such as 401(k) plans and other tax-favored retirement plans.29 For example, plan participants receiving recommendations about whether to take a distribution from a 401(k) plan or other work lace retirement plan and how to invest that distribution would be covered as retail customers. 0 Similarly, a plan participant receiving a recommendation for the participant’s individual account held in a 401(k) plan or other workplace retirement plan would be a retail customer for purposes of Regulation BI.31

  1. CONLUSIONS
  1. USING DTC’S DECISION ASSISTANCE TECHNOLOGY TO MEET PRUDENT MAN STANDARD OF CARE

As stated above, the Prudent Man Standard of Care is the governing principle for Plan Fiduciaries as they carry out plan responsibilities. With respect to an investment or an investment course of action, the Prudent Man Standard of Care requires that the fiduciary give “appropriate consideration” to the facts and circumstances that the fiduciary knows or should know are relevant with respect to a particular investment or investment course of action and has acted accordingly. This includes making a determination that the particular investment or investment course of action is reasonably designed, as part of the portfolio, to further the purposes of the plan. Investment tools and technology that have not been designed with the Prudent Man Standard of Care in mind may fail to give appropriate consideration to the relevant facts and circumstances and to whether the recommended investment or investment course of action is reasonably designed to further the purposes of the plan, thus causing the Plan Fiduciary (or its delegate) to be in breach of their fiduciary responsibilities.

ERISA is silent with respect to the use of any particular type of investment process or tool to satisfy the Prudent Man Standard of Care. DTC’s DAT ranks and scores a universe of investment choices that has been shaped and filtered, using blends of performance parameters that have been hierarchically arranged and weighted solely based on the client’s needs, investment goals, risk tolerance, and performance preferences, among other factors. In our view, use of DAT by fiduciary  Advisors  or Plan Fiduciaries  would assist the fiduciary  Advisors and Plan Fiduciaries  in giving, and in demonstrating  (to regulators  and  in court proceedings) that they have given, appropriate consideration as to whether a plan’s investments or the investment course of action taken is reasonably designed to further the objectives of the ERISA plan.

  1. USING DTC’s DECISION ASSISTANCE TECHNOLOGY TO SATISFY THE ONGOING DUTY TO MONITOR INVESTMENTS

In Tibble v. Edison International, the U.S. Supreme Court concluded that, under trust law, a fiduciary has a continuing duty to monitor trust investments and to remove imprudent ones.32 This means that the trustee must systematically consider all investments of the trust at regular intervals to ensure they are appropriate.33 On remand, the District Court observed that “[i]n order to determine whether an investment decision is prudent, a fiduciary has a duty to investigate, and may secure independent advice from financial advisors or other experts in the course of the investigation. However, that fact that a fiduciary secured independent advice does not necessarily indicate that he acted prudently.”34

Tibble does not expressly describe the manner in which the ongoing duty to monitor plan investments must be met. Engaging an independent investment professional for the provision of investment advice with respect to ERISA plan investments, does not necessarily mean that a Plan Fiduciary has acted prudently. DTC recommends the repeated use of the DAT four-step process every quarter to comparatively evaluate how previously selected investments have since performed, not just to a “benchmark index” but relative to all other qualified choices within each asset class. The hiring of an Advisor alone, without a means to properly evaluate the investment advice given by the Advisor, may not meet the Plan Fiduciary’s or the Advisor’s duty of prudence in the monitoring of plan investments.   DAT’s comparative evaluation of investments by scoring and ranking them based on the client’s objectives may provide the oversight and means by which trustees can “vet” their Advisor’s investment recommendations – a protective “second opinion,” if you will – as encouraged by Tibble. In our view, repeated use of DAT by fiduciary Advisors or Plan Fiduciaries, on a quarterly basis or other appropriate periodic intervals, to comparatively evaluate the performance of an ERISA plan’s investments, will help them satisfy (and help them demonstrate that they have satisfied) their fiduciary duty to monitor investments and identify chronically underperforming or imprudent ones so that they can be removed.

  1. USING DTC’S DECISION ASSISTANCE TECHNOLOGY TO SATISFY THE CARE OBLIGATION UNDER REGULATION BEST INTEREST

Under the Care Obligation, a broker-dealer or Rep has a three-part obligation. The Rep, in making a recommendation, must exercise reasonable diligence, care and skill to (i) understand the potential risks, rewards and costs associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers; (ii) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation, and does not place the financial or other interest of the broker-dealer or Rep ahead of the interest of the retail customer; and (iii) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together, in light of the retail customer’s investment profile, and does not place the financial or other interest of the broker-dealer or Rep making the series of recommendations ahead of the interest of the retail customer.35

Reps must obtain and analyze sufficient customer information to form a reasonable basis to believe that the recommendation is in the client’s best interest.36 This information is typically obtained by the Rep through an investment profile or questionnaire. The SEC has declined to provide an exhaustive list of factors to be used in an investment profile, instead opting to give Reps the flexibility to consider a broad range of factors based on the unique nature of its particular securities products, investment strategies, and retail customers.37

Regulation  BI is silent with respect  to the  use of any  particular  process or type of interactive tool to satisfy the Care Obligation.  When using DAT, the Rep will apply client­ specific factors (perhaps even those selected by the client) to “shape” and identify the qualified universe of investment choices that will eventually be scored and ranked. The Rep will then use client-specific investment  performance  parameters  and hierarchically arrange them and weigh them in order to reflect each parameter’s relative importance to the investor  client.  These factors and parameters will indicate, demonstrate and likely be consistent with the information gathered from the client’s investment profile, and any inconsistencies will prompt further productive discussions between the Rep and the client about the client’s investment objectives, financial circumstances, risk tolerance, performance preferences, etc. Assuming a Rep obtains an adequate investment profile of the retail customer, the use of DAT will assist the Rep in complying with two of the components of the Care Obligation. Specifically, DAT will assist the Rep in exercising reasonable diligence, care and skill to (i) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on the retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation, without placing the financial or other interest of the broker-dealer or Rep ahead of the interest of the retail customer; and (ii) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile, and does not place the financial or other interest of the broker-dealer or Rep making the series of recommendations ahead of the interest of the retail customer.

  1. USING DTC’S DECISION ASSISTANCE TECHNOLOGY TO MEET THE CONFLICT OF INTEREST OBLIGATION OF REGULATION BEST INTEREST

Under the Conflict of Interest Obligation, the broker-dealer is required to establish, maintain, and enforce written policies and procedures reasonably designed to (i) identify and, at a minimum, disclose or eliminate all conflicts of interest associated with its or the Rep’s recommendations; (ii) identify and mitigate any conflicts of interested associated with its or the Rep’s recommendations that create an incentive for it or the Rep to place its or the Rep’s interest ahead of the retail customer’s interest; (iii)(a) identify and disclose any material limitations placed on the securities or investment strategies that may be recommended to retail customers and any conflicts of interest associated with such limitations, and (b) prevent such limitations and associated conflicts of interest from causing it or the Rep to make recommendations that place its or the Rep’s interest ahead of the retail customer’s interest; and (iv) identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities within a limited period of time. 38

With respect to (iii), above, examples of limitations placed on the securities or investment strategies that may be recommended to retail customers include providing a limited product menu or offering only proprietary products.39 Whether the limitation is a “material limitation” will depend upon the facts and circumstances as to the extent of the limitation.40 The SEC believes that the conflicts associated with the establishment of a product menu are most likely to affect recommendations made to retail customers and have the greatest potential to result in recommendations that place the interest of the broker-dealer or Rep ahead of the interest of the retail customer.41

DAT scores and ranks investment products based on the performance parameters selected, hierarchically arranged and weighted specific to individual clients according to their relative importance to the client. DTC recommends, and use of its DAT provides, a practical means to consider a broader universe of investments than just those limited by the broker-dealer’s or Rep’s inventory or product menu. Considering a broader pool of investment products than simply those that are available from the broker-dealer’s or Rep’s often limited inventory or investment menu, and comparatively evaluating the choices based solely on how well they meet the client’s criteria, may reduce the likelihood that recommendations made to retail customers place the interest of the broker-dealer or Rep ahead of the interest of the retail customers. Indeed, the use of DAT to comparatively evaluate the full range of available investment choices, based purely upon objective client-specific performance parameters, should effectively “filter out” or eliminate conflicts of interest that might otherwise encourage or incentivize recommendations of

one investment choice over another and should enable the broker-dealer and Rep to demonstrate

(to customers, regulators and court proceedings) that such conflicts of interest have in fact been eliminated. In our view, the use of DAT by Reps when advising retail customers will be helpful in complying with components (i), (ii) and (iii) of the Conflict of Interest Obligation (and demonstrating such compliance to regulators and in court proceedings). In addition, the use of DAT can be referenced in the broker-dealer’s reasonably designed policies and procedures as a means of reducing the likelihood that conflicts of interest would unduly influence Reps, including those conflicts of interest associated with more limited product menus.

  1. USE OF DTC’s DECISION ASSISTANCE TECHOLOGY IS CONSISTENT WITH BEST PRACTICES

In general, ERISA looks to the decision-making process employed by a fiduciary in order to determine the extent of fiduciary liability. As such, it does not focus on the outcome of a decision by a fiduciary – it does not require omniscience or that a fiduciary be right in all cases. Instead, ERISA focuses on whether the process utilized by a fiduciary to gather information and to make reasonable determinations is prudent and in the best interest of plan participants and beneficiaries.42 This process is referred to as “procedural prudence.”

A “best practice” is defined as a procedure that has been shown by research and experience to produce optimal results and that is established or proposed as a standard suitable for widespread adoption.43

DAT is an investment selection process that can, in its original and recommended form, take into account the broadest possible universe of investment products, and not only those investment products that are available to a particular Advisor (although it can also be used to objectively comparatively evaluate even limited product universes). By applying investor’s preferences thereafter to “shape” the available investment universe (whether broader or limited) and then applying a composite blend of hierarchically arranged and weighted performance parameters that specifically reflect the needs, goals and preferences of individual investors, the investment selection and performance monitoring processes may be improved. It may also result in improvement in investment performance and thus could make actual achievement of investment and retirement goals more likely. With the above described capabilities and effects, DAT’s method approaches best practice. In our view, when all this is taken together with prudent policies and procedures, the use of a tool such as DAT may be an evolving best practice for use in selecting and monitoring the performance of investments for ERISA­ plans.

  1. IMPENDING DOL PROPOSED FIDUCIARY RULE AND STATE ACTION

Although this opinion has largely focused on the SEC’s new Regulation BI, it is important to note that, as of this writing, the DOL has announced its intention to propose a new version of its “fiduciary rule”44 and that several states have adopted or are considering regulatory or legislative approaches to establish standards of care for investment advice as well. This may result in a patchwork of multiple and perhaps conflicting regulatory regimes that will be difficult for Advisors and other fiduciaries to navigate, especially for those with multi-jurisdictional exposure. However, to the extent that the intent and goal of each of these regulatory schemes is to require that investors’ “best interest” are protected, it is our opinion that the use of DTC’s DAT will likely be a helpful tool for the reasons stated above.

The opinions and views included in this letter represent our view of the outcome in a court of law if a challenge were to be made to the conclusions set out above and do not represent a guarantee as to the outcome. The legal analysis included herein is based on the facts presented and the existing laws and regulations in effect as of the date of this letter. It is important to note that there is no published interpretive guidance on Regulation Best Interest from the SEC, Financial Industry Regulatory Authority (FINRA), or the federal courts as of this date, and that our opinions and views with regard to Regulation Best Interest, therefore, are constrained by the lack of any formal authority. The addition of facts other than those described above and any material changes in the law or regulatory guidance may affect the legal analysis and conclusions set forth herein. Our opinions and views expressed in this letter are furnished to you solely for your benefit. Although we understand that you may wish to provide copies of this letter to third parties for their information only, to which we provide our consent, the opinions and views expressed in this letter may not be relied upon by any person other than you without our prior consent.

1 Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33318 (July 12, 2019).

2 On September 10, 2019, two suits were filed in the Southern District of New York challenging the SEC’s Regulation Best Interest. In the first, eight attorneys general filed suit against the SEC for failing to institute a uniform fiduciary standard and meet basic investor protections as required by the Dodd-Frank Wall Street Reform

3 In reference to FINRA Rule 2090, “Know Your Customer.”

4 ERISA Section 404(a)(l).

5 Section 2550.404a-l(b)(l) ofDOL Regulations.

6 Section 2550.404a-(l)(b)(2) ofDOL Regulations.

7 Tibble v. Edison International, 135 S.Ct. 1823 (2015).

8 Id.

9 Id.

10 Tibble v. Edison International, No. CV 07-5359 SVW (AGRx), 2017 WL 3523737, at *I 1-12 (C.D. Cal. Aug. 16, 2017).

11 Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33318 (July 12, 2019).

12 Id. at Section II.A.

13 Id. at 33333.

14 Id. at 33333.

1s Id.

16 Id. at 33325.

17 Regulation best Interest, paragraph (a)(2)(i).

18 Regulation Best Interest, paragraph (b)((3).

19 Regulation Best Interest, paragraph (a)(2)(ii).

20 Regulation Best Interest, paragraph (a)(2)(iii).

21 Regulation Best Interest, paragraph (a)(iv).

22 84 Fed. Reg. 33397 (July 12, 2019).

23 Id. at 33398.

24 Regulation Best Interest, paragraph (b)(l).

25 84 Fed. Reg. 33325 (July 12, 2019).

26 Id. at 33342.

21 Id.

28 Id. at 33343.

29  Id.

30 Id.

31 Id.

32 Id

33 Id

34 Tibble v. Edison International, No. CV 07-5359 SVW (AGRx), 2017 WL 3523737, at* 11-12 (C.D. Cal. Aug. 16, 2017).

35 Id. at 33372.

36 Id. at 33379.

31 Id.

38 Id. at 33385.

39 Id. at 33393.

40 Id. at 33394.

41 Id. at 33393.

42 Donovan v. Mazzola, 716 F2d 1226 (9th Cir. 1983); See also GIW Industries, Inc. v. Trevor, 895 F2d 729 (11th

Cir. 1990).

43 “Best Practice.” Merriam-Webster.com. Merriam-Webster, n.d. Web. 12 September 2019.

44 81 Fed. Reg. 20946 (April 8, 2016), which has been vacated.

Eric Smith, J.D. is President and an Investment Advisor Representative of Trustee Empowerment & Protection, Inc.,
A Registered Investment Adviser.  He is also Chairman & CEO of Decision Technologies Corporation.

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