Numerous studies have concluded that when it comes to investing, American are functionally financially illiterate. Despite these findings, ERISA, the primary legislation regulating American pension plans does not require that plan participants be provided with any sort of investment education.
When the time comes to retire, federal regulators tout laws that allegedly require those advising such retirees to always put the “best interest” of such retirees. And yet, such protections are effectively neutralized by a loophole that allows advisers to restrict their recommendations to the often overpriced and consistently underperforming investment products of their broker-dealer’s “preferred providers,” who pay for the right to have access to the broker-dealer’s brokers.
Fortunately, investors who can perform basic math such as subtraction, can easily protect their financial security by using a metric I created, the Active Management Vaue Ratio™ (AMVR). In many cases, the actual basic calculation process takes less than a minute. The basic information needed to use the AMVR is freely available online.
Personal Retail Investment Accounts The AMVR is based primarily on the research and concepts of investment experts such as Nobel lauerate Dr. William F. Sharpe, Charles D. Ellis, Burton L. Malkiel. I simply combined their concepts and presented them in a visual context so that they would be easier to understand.
An example of an AMVR forensic analysis is shown below. As Dr. Sharpe suggested, an AMVR analysis always compares an actively managed mutual fund with a comparable index fund. The AMVR then calculates the cost-efficiency of the actively managed fund relative to the index fund by dividing the actively managed fund’s incremental costs by the fund’s incremental returns.
In interpretting an AMVR analysis, an investor only has to answer two simple questions:
Did the actively managed fund provide a positive incremental return?
If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs?
If the answer to either question is “no,” the actively managed fund is not cost-efficient relative to the comparable index fund and is therefore a poor investment choice.
In this example, The answer to both questions is “no.” An investor should continue searching or simply invest in a cost-efficient index fund.
The AMVR analysis also provides two additional points. Actively managed retail mutuall funds often charge investors a “load” at the time of their initial purchase of the funds. These loads are essentially a commission and reduce the amount of an investor’s actual investment in a fund. In this example, the load would have significantly reduced an investor’s end-return from 20.88 percent to 19.48 percent.
The column marked “AER” goes beyond the basic AMVR and is often not needed to determine that an actively managed is not cost-efficient. AER refers to Ross Miller’s Active Expense Ratio. Miller explained the importance of the AER as follows:
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.
In this case, the correlation of returns between the two funds happened to be 97 percent. High incremental costs combined with a high correlation of return between ttwo funds always significantly increases expenses that an investor effectively pays, often with no corresponding benefit in return. The investor here could have received a much better return by simply paying the index fund’s expense ratio. The incremental cost of the actively managed fund was just wasted money.
The financial services attempt to avoid any discussion of the cost-inefficiency of their products. Why?
99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.
Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.
Ellis provides additional support for the importance of cost-efficiency, noting that
[T]he incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!
The media also seems to avoid informing the public of the cost-inefficiency issue. However, as the saying goes, “facts do not cease to exist becuase they are ignored.”
Pension Plans and Retirement Accounts The importance of evaluating cost-efficiency is equally applicable to 401(k) plans and other retirement plans. A key point is that actively managed mutual funds in pension plans should never charge a plan participant a load of any type. Unfortunately, other than that difference, the overwhelming majority of actively manged mutual funds in pension and other retirement prove to be equally cost-inefficient.
The AMVR analysis compares an actively managed mutual fund commonly used in pension and retirement accounts with a comparable index fund. Once again, the answer to the two required questions is “no.” Therefore, the actively managed fund is cost-inefficient, or imprudent, relative to to the comparable index fund.
Unfortunately, this an all too common scenario with regard to investments options within and investment advice provided to pension plans and retirement accounts. This is why there continues to be so much litigation involving these plans and accounts. This situation could, and should, be easily resolved were it not for the greed of the inestment industry and the fact that many plan sponsors do not understand their true fiduciary duties under ERISA.
Once again, we see the impact of high incremental costs and funds with high correlation of return, here 98 percent. A large percentage of U.S. equity funds have a correlation of returns, or r-squared, number of 95 or above. This results in extremely high implicit fees that investors in actively managed funds are paying, often with no commensurate return.
Jack Bogle, the founder of The Vanguard Group mutual fund company, had two sayings he often quoted -“Cost Matter” and “You get what you don’t pay for.” The General Accounting Office has noted that each additional 1 percent in fees and costs reduces an investor’s end-return by approximately 17 percent over twenty years. Cost-efficiency matters.
Going Forward John Langbein served as the official Reporter for the committee that drafted the Restatement (Second) of Trusts (Restatement). Shortly after the release of the revised Restatement, Langbein wrote a law review article on the new Restatement. At the end of the article, he made a bold prediction:
When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.
I would suggest that that day has arrived and that the AMVR will be an indispensable tool in helping both investors and investment fiduciaries maximize their wealth management opportunities through prudent investment choices.
Copyright InvestSense, LLC 2022. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought
Annuity peddlers would have the public believe that all God’s children need an annuity. Plan sponsors are now confronted with the potential issues of including annuities and crypto currencies within a 401(k) plan. I believe that both assets are inappropriate for most investors, as there are other options that are available that address the same needs without the high expenses and without requiring investors to give up their hard-earned money so that annuity issuers, not the investor’s heirs, benefit from their work.
Annuities While an exhaustive analysis of annuities is beyond the scope of this post, I want to address three of the most common types of annuities and the fiduciary issues involved with each. One of the fiduciary issues involved with annuities is their complexity. The analyses herein will be based on the simple, garden variety of each of the three annuities.
1. Immediate Annuities (aka Income Annuities) These annuities are often recommended to provide supplemental income in retirement. In most cases, immediate annuities can be used to provide income for life or for a certain period of time, e.g., 5, 10, 15 or 20 years.
The key question in evaluating annuities, or any other investment, should always be “at what cost?” With annuities, you generally have annual costs as well as additional optional costs for various “bells and whistles.” While costs vary, a basic average annual cost for immediate annuities seems to be 0.7 percent. The average costs for various additional options with all annuities seems to be an additional 1.0 percent. However, it is a plan sponsor’s duty to always ascertain the exact costs.
Plan sponsors need to always remember this mantra – “Costs matter.” Costs do matter, a lot. The General Accounting Office has stated that each additional 1 percent in costs/fees reduces an investor’s end-return by approximately 17 percent over a twenty year period. 3
Peter Katt was an honest and objective insurance adviser. During my compliance career, he was my trusted go-to resource. While he passed away in 2015, the lessons I learned from him will always be invaluable. I strongly recommend to investors and investment fiduciaries that they Google his name and read his articles, especially those he wrote for the AAII Journal.
Katt’s thought on immediate annuities include:
The immediate annuity is for people who want the absolute security that they can’t outlive their nest egg. The problem is that there is nothing left over for your heirs.4
While annuities often offer options to address this issue, such options often result in reduced monthly payments and/or additional costs.
Katt always said to get the annuity salesmen to provide a written analysis providing the breakeven analysis for an annuity, the estimated time that would be required for an annuity owner to recover their original investment in the annuity. He told me that breakeven periods of twenty years or more are common, making it unlikely that the annuity owner will ever recover their original investment. And remember, with a life-only immediate annuity, once the annuity owner dies, the balance in the annuity goes to the annuity issuer, not the annuity owner’s heirs.
He also told me to always ask the annuity salesman for the APR that was used in calculating the breakeven point. The APR is the interest rate that annuity issuers typically use in determining an annuity’s payments.
One of the drawbacks with immediate annuities is that once an interest rate is set, that will be the applicable interest rate for the period of the annuity. Again, some annuities may offer options to avoid this inflexibility…at an additional cost.
The inflexibility of an annuity’s interest rate results in purchasing power risk for an annuity owner. This risk increases as the period of the annuity increases. Purchasing power risk refers to the risk that the annuity’s payments will lose their buying power over the years due to inflation. Some annuities provide for “step-ups” in rates…at an additional cost.
Katt’s advice-anyone considering an immediate annuity should first build a balanced portfolio consisting of stocks and bonds to ensure flexibility, and then invest augment that portfolio with a reasonable am0unt in the immediate annuity. While some annuity salesmen will argue for an “all or nothing” approach in order to maximize their commission. Prudent investors will follow Katt’s advice.
Perhaps the strongest argument against including immediate in 401(k) and other pension plans comes from a study by three well-respected experts on the subject.# In analyzing when a Single Premium Immediate Annuities (SPIAs), probably the most popular type of immediate annuity, would make sense, the three experts stated that
Results suggest that only when the possibility of outliving 70 percent or more of a cohort exists, and then only at elderly ages. For ages younger than 80, assets are best kept within the family, because both inflation and possible future market returns have time to do better than SPIA lifetime sums.5
Based upon my experience, very few 401(k) plans have plan participants aged 80 or older. I predict that plan sponsors who decide to offer immediate annuities, in any form, in their plans can expect to see that quote again, especially if I am involved in the litigation.
2. Fixed Indexed Annuities (fka Equity Indexed Annuities) From what I have read and heard, the annuity industry’s plan to focus on including annuity options within 401(k) plans by imbedding fixed indexed annuities options within target data funds.
Target date funds are controversial investments that attempt to create investment portfolios that are appropriate based on the investor’s estimated retirement, or target, date. Target date funds have typically designed portfolios consisting of equity and fixed income investments.
From the reports I have read, the annuity industry plans to imbed a fixed income annuity aspect into target date fund, and then gradually increasing the percentage of the allocation to the annuity sector within the target date fund. When the target date is met, the annuity issuer would reportedly offer the plan participant the option to actually purchase the fixed indexed annuity.
So what would be wrong with that? Dr. William Reichenstein, finance professor emeritus at Baylor University sums the primary issue perfectly.
The designs of equity index annuities (EIAs) and bond indexed annuities ensure that they must offer below-market risk-adjusted returns compared with those available on portfolios of Treasurys and index funds. Therefore, this research implies that indexed annuity salesmen have not satisfied and cannot satisfy SEC requirements that they perform due diligence to ensure that the indexed annuity provides competitive returns before selling them to any client.6
While EIAs/FIAs are technically insurance products, not securities, Dr. Reichenstein’s analysis is still applicable with regard to a fiduciary’s duties of loyalty and prudence. If the design of these products ensures that they cannot offer competitive returns to those of alternative investments, then how does a plan sponsor, or any fiduciary for that matter, plan to meet their fiduciary duty of loyalty and prudence?
As regulators emphasize, before an insurance agent can sell an annuity, he or she must perform due diligence to ensure that the investment offered ex ante competitive returns. Therefore, it is appropriate to compare the net returns available in an equity-indexed annuity to those available on similar-risk investments held outside an annuity.7
[By] design, indexed annuities cannot add value through security selection ….[T]he hedging strategies [used by equity-indexed annuities] ensure that the individuals buying equity-indexed annuities will bear essentially all the risks. Conseqently, all (ital) indexed annuities must (ital) produce risk-adjusted returns that trail those offered by readily available marketable securities by their spread, that is, by their expenses including transaction costs.8
The reference to design refers to the fact that managers of indexed annuities buy Treasury securities and index options, but do not engage in individual security selection. Furthermore, indexed annuities typically impose restrictions on the amount of return that an investor can actually receive. Therefore, the combination of the design of these products and the restrictions on returns typically imposed by EIAs/FIAs ensure a fiduciary breach.
So, even though the annuity industry markets these indexed annuities by emphasizing stock market returns, the majority of fixed indexed annuity owners are guaranteed to never receive the actual returns of the stock market. While some annuity firms are marketing so-called “uncapped” fixed indexed annuities, they may still impose restrictions, and such “uncapped” returns…come with additional costs.
The restrictions and conditions that fixed indexed annuities naturally vary. During my time as a compliance director, the fixed indexed annuities I saw imposed a 8-10 percent cap and an participation rate of 80 percent. What that meant was that regardless of the applicable market index, with a cap of 10 percent, the most the annuity owner could receive was 10 percent of the index’s return.
As if that was not unfair enough, that 10 percent return was then further reduced by the annuity’s participation rate. So, with a participation rate of 80 percent, the maximum return an investor could receive in our example was 8 percent.
Reichenstein points out even more inequities, noting that
Because interest rates and options’ implied volatilities change, the insurance firm almost always retains the right to set at its discretion at least one of the following: participation rate, spread, and cap rate.9
The one question that I always asked of fixed indexed annuity wholesalers, but still remains unanswered, was what happened to the excess return generated from the index options after the caps and participation rates were applied. Still waiting for an answer
And finally, a simple explanation of how fixed indexed annuity companies further manipulate returns to ensure that they protect their interests first.
From AmerUS Group financial statements, ‘Product spread is a key driver of our business as it measures the difference between the income earned on our invested assets and the rate which we credit to policy owners, with the difference reflected as segment operating income. We actively manage product spreads in response to changes in our investment portfolio yields by adjusting liability crediting rates while considering our competitive strategies….’ This spread ensures that the annuity will offers noncompetitive risk-adjusted returns.10
Equity-indexed annuities generally do not credit owners with the dividends paid on the index used in calculating equity returns. Many indexed owners are not aware of this fact, or its significance. For example, historically over 40 percent of the S&P 500 Index’s compounded returns has come from dividends paid on its underlying stocks.
I could go on to discuss additional issues as single entity credit risk and illiquidity risks, but I think investment fiduciaries get the picture. The evidence against fixed index annuities establishes that they are a fiduciary breach simply waiting to happen. I strongly recommend that plan sponsors and other investment fiduciaries read Reichenstein’s analysis before deciding to offer fixed indexed annuities, in any shape or form, in their plans or to clients.
3. Variable Annuities Any fiduciary that sells, uses, or recommends a variable annuity has breached their fiduciary duty…period. Katt summed it up perfectly:
Variable annuities (VAs) are flawed because they covert capital gains into ordinary income and have considerably higher expenses compared with comparable mutual funds. For this reason they are quite unsuitable for most investors.11
Exhibit A Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.
[T]he fee [for the death benefit] is included in the so-called Mortality and Expense (M&E) risk charge. The M&E risk charge is a perpetual fee that is deducted from the underlying assets in the VA, above and beyond any fund expenses that would normally be paid for the services of managed money.12
[T]he authors conclude that a simple return of premium death benefit is worth between one to ten basis points, depending on purchase age. In contrast to this number, the insurance industry is charging a median Mortality and Expense risk charge of 115 basis points, although the numbers do vary widely for different companies and policies.13
The authors conclude that a typical 50-year-old male (female) who purchases a variable annuity—with a simple return of premium guaranty—should be charged no more than 3.5 (2.0) basis points per year in exchange for this stochastic-maturity put option. In the event of a 5 percent rising-floor guaranty, the fair premium rises to 20 (11) basis points. However, Morningstar indicates that the insurance industry is charging a median M&E risk fee of 115 basis points per year, which is approximately five to ten times the most optimistic estimate of the economic value of the guaranty.14
Excessive and unnecessary costs violate the fiduciary duty of prudence. The value of a VA’s death benefit is even more questionable given the historic performance of the stock market. As a result, it is unlikely that a VA owner would ever need the death benefit. These two points have resulted in some critics of VAs to claim that a VA owner needs the death benefit like a duck needs a paddle.”
Exhibit B Benefit – VAs provide a death benefit to limit a VA owner’s downside risk.
At what cost? VAs often calculate a VAs annual M&E charge/death benefit based on the accumulated value within the VA, even though contractually limit their legal liability under the death benefit to the VA owner’s actual investment in the VA.
As a result, over time, it is reasonable to expect that the accumulated value within the VA will significantly exceed the VA owner’s actual investment in the VA. This method of calculating the annual M&E, known as inverse pricing, results in a VA issuer receiving a windfall equal to the difference in the fee collected and the VA issuer’s actual costs of covering their legal liability under the death benefit guarantee.
As mentioned earlier, fiduciary law is a combination of trust, agency and equity law. A basic principle of fiduciary law is that “equity abhors a windfall.” The fact that VA issuers knowingly use the inequitable inverse pricing method to benefit themselves at the VA owner’s expense results in a fiduciary breach for fiduciaries who recommend, sell or use VAs in their practices or in their pension plans.
The industry is well aware of this inequitable situation. John D. Johns, a CEO of an insurance company, addressed these issues in an article entitled “The Case for Change.”
Another issue is that the cost of these protection features is generally not based on the protection provided by the feature at any given time, but rather linked to the VA’s account value. This means the cost of the feature will increase along with the account value. So over time, as equities appreciate, these asset-based benefit charges may offer declining protection at an increasing cost. This inverse pricing phenomenon seems illogical, and arguably, benefit features structured in this fashion aren’t the most efficient way to provide desired protection to long-term VA holders. When measured in basis points, such fees may not seem to matter much. But over the long term, these charges may have a meaningful impact on an annuity’s performance.15
In other words, inverse pricing is always a breach of a fiduciary’s duties of both loyalty and prudence, as it results in a windfall for the annuity issuer at the annuity owner’s expense, a cost without any commensurate return, which also violates Section 205 of the Restatement of Contracts.
Exhibit C Benefit – VAs allow their owners the opportunity to invest in the stock market and increase their returns.
VAs offer their owners an opportunity to invest in equity-based subaccounts. Subaccounts are essentially mutual funds, usually similar to the same mutual funds that investors can purchase from mutual fund companies in the retail market.
While there has been a trend for VAs to offer cost-efficient index funds as investment options, many VA subaccounts are essentially same overpriced, consistently underperforming, i.e., cost-inefficient, actively managed mutual funds offered in the retail market. As a result, VA owners’ investment returns are typically significantly lower than they would have been when compared to returns of comparable index funds.
Exhibit D Benefit – VAs provide tax-deferral for owners.
So do IRAs. So do any brokerage account as long as the account is not actively traded. However, dividends and/or capital gain distributions are taxed when they occur.
The key point here is that IRAs and brokerage accounts usually do not impose the high costs and fees associated with annuities. This is especially true of VAs, where annual fees of 3 percent or more are common, even higher when riders and/or other options are added.
Remember the earlier 1/17 note? Multiply 3 by 17 to see the obvious fiduciary issues regarding the fiduciary duties of loyalty and prudence.
Although not an issue for plan sponsors, another “at what cost” fiduciary issue has to do with the adverse tax implications of investing in non-qualified variable annuities (NQVA). Non-qualified variable annuities are essentially those that are not purchased within a tax-deferred account, e.g., a 401(k)/403(b) account, an IRA account.
When investors invest in equity investments, they typically are not taxed on the capital appreciation until such gains are actually realized, such as when they sell the investment or, in the case of mutual funds, when the fund makes a capital gains distribution.
In many cases, investors can reduce any tax liability by taking advantage of the special reduced tax rate for capital gains. However, withdrawals from a NQVA do not qualify for the lower capital gains tax. All withdrawals from a NQVA are considered ordinary income, and thus taxed at a higher rate than capital gains. An investment that increases its owner’s tax liability by converting capital gains into ordinary income is hardly prudent or in an investor’s “best interest.”
Bottom line – there are other less costly investment alternatives available that provide the benefit of tax deferral. In fact, Katt showed me several ways that investors can create various types of “synthetic” annuities that provide the same type of income and protection at a much lower costs and allow an investor’s wealth to go to their heirs, not the annuity issuer/insurance company. While they may not offer exactly the same guaranteed income, they provide other significant benefits, while avoiding some of the risks associated with VAs, e.g., reduced flexibility, purchasing power risk, higher taxes.
Exhibit E Benefit: Annuity owners do not pay a sales charge, so more of their money goes to work for them.
The statement that variable annuity owners pay no sales charges, while technically correct, is misleading. Variable annuity salesmen do receive a commission for each variable annuity they sell, such commission usually being in the range of 6-7 percent of the total amount invested in the variable annuity.
While a purchaser of a variable annuity is not directly assessed a front-end sales charge or a brokerage commission, the variable annuity owner does reimburse the insurance company for the commission that was paid. The primary source of such reimbursement is through a variable annuity’s various fees and charges, particularly the M&E charge.
To ensure that the cost of commissions paid is recovered, the insurance company typically imposes surrender charges on a variable annuity owner who tries to cash out of the variable annuity before the expiration of a certain period of time. The terms of these surrender charges vary, but a typical surrender charge schedule might provide for an initial surrender charge of 7 percent for withdrawals during the first year, decreasing 1 percent each year thereafter until the eighth year, when the surrender charges would end. There are some surrender charge schedules that charge a flat rate, such as 7 percent, over the entire surrender charge period.
Cryptocurrency Fidelity Investments recently announced that it would begin offering a new fund that would allow 401(k) plans to offer a cryptocurrency option within the plan. The reaction was immediate and divided. And now news that Bitcoin and other cryptocurrencies have suffered a cumulative $200 billion dollar loss.
Since there are still a number of issues that need to be address ed, especially the concerns raised by regulators, including the Department of Labor16 and the Securities & Exchange Commission17, I will simply suggest that plan sponsors and other investment fiduciaries should wait until the regulators have issued guidelines on this topic.
One thing I will address is the notion that because investors may want to invest in cryptocurrency is no reason for a plan sponsor or other investment fiduciary to do so. First, a plan sponsor has no obligation, legal or otherwise, to include an investment option in a plan simply because one or more plan participant wants to invest in such an option. A plan sponsor, a trustee, or any other investment fiduciary has two primary duties, the duty of loyalty and the duty of prudence.
With all the acknowledged concerns about cryptocurrency, from susceptibility to hacked accounts resulting in significant losses, the volatility of such investments, and questions regarding the concept/ structure of such investments, prudence is the best course for all fiduciaries at this point. For plan participants that want to invest in cryptocurrencies, they are free to open up retail brokerage accounts and trade in such investments.
Going Forward Ever since Fidelity made its announcement regarding cryptocurrency, I have been asked by clients and the media for my opinion on what I see for fiduciary law and 401(k) litigation. My answer-an increase in litigation.
What too many investment fiduciaries fail to recognize and appreciate is the fact that those recommending investment products generally are not doing so in a fiduciary capacity and, therefore, arguably have no potential fiduciary liability. Plan sponsors, trustees and other investment fiduciaries that follow such advice will typically have unlimited personal liability exposure.
Plan sponsors and other investment fiduciaries have a duty to independently investigate, evaluate, select and monitor the investment options they select or recommend.
Over and above its duty to make prudent investments, the fiduciary has a duty to conduct an independent investigation of the merits of a particular investment….A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.18
The failure to make any independent investigation and evaluation of a potential plan investment” has repeatedly been held to constitute a breach of fiduciary obligations.19
A determination whether a fiduciary’s reliance on an expert advisor is justified is informed by many factors, including the expert’s reputation and experience, the extensiveness and thoroughness of the expert’s investigation, whether the expert’s opinion is supported by relevant material, and whether the expert’s methods and assumptions are appropriate to the decision at hand. One extremely important factor is whether the expert advisor truly offers independent and impartial advice.
Defendants relied on FPA, however, and FPA served as a broker, not an impartial analyst. As a broker, FPA and its employees have an incentive to close deals, not to investigate which of several policies might serve the union best. A business in FPA’s position must consider both what plan it can convince the union to accept and the size of the potential commission associated with each alternative. FPA is not an objective analyst any more than the same real estate broker can simultaneously protect the interests of “can simultaneously protect the interests of both buyer and seller or the same attorney can represent both husband and wife in a divorce.20
These fiduciaries duties are inviolate. There are no “mulligans” or “do overs” in fiduciary law. As the courts have repeatedly pointed out, “A pure heart and an empty head’ are no defense to allegations of the breach of one’s fiduciary duties.21
If anything positive comes out of the current debate over the inclusion of annuities and/or cryptocurrencies in 401(k) plans, hopefully it will be a greater recognition and appreciation of the importance of one’s fiduciary duties by plan sponsors and other investment fiduciaries.
Resources There are a number of resources available online that can be used to analyze annuities in terms of breakeven analysis. Google “annuity breakeven analysis” to find them. In my practice, I often use the Annuity Break-Even Calculator — VisualCalc program, which compares an annuity with an alternative equity investment. The graphic makes the results easier to understand.
The article by Frank, Mitchell, and Pfau provides detailed instructions on how to perform annuity breakeven analyses using Microsoft Excel.
Notes 1. Meinhard v. Salmon, 249 N.Y. 458, 464 (1928). 2. Tibble v. Edison International, 135 S. Ct 1823 (2015). 3. Pension and Welfare Benefits Administration, “Study of 401(k) Plan Feess abd Expenses,” (“DOL Study”). http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study”), http://www.gao.gov/new.item/d0721.pdf 4. Peter C. Katt, “The Good, Bad, and Ugly of Annuities,” AAII Journal, November 2006, 34-39 5. Larry R. Frank, Sr., John B. Mitchell, and Wade Pfau, “Lifetime Expected Income Breakeven Comparison Between SPIAs and Managed Portfolios,” Journal of Financial Planning, April 2014, 38-47. 8. Reichenstein, 302. 9. Reichenstein, 303. 10. Reichenstein, 309. 11. Katt, 35. 12. Moshe Miklevsky and Steven E. Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds,” Journal of Risk and Insurance, Vol. 68, No. 1 (2009), 91-126, 92. 13. Milevsky and Posner, 94. 14. Milevsky and Posner, 122. 15. John D. Johns, “The Case for Change,” Financial Planning, September 2004, 158-168. 16. Department of Labor, “Compliance Assistance Release No. 2022-01” 17. https://www.sec.gov/speech/gensler-remarks-crypto-marketds-040422. 18. Fink v. National Saving & Loan, 772 F.2d 951 (D.C. Cir. 1985); Donovan v. Cunningham, 716 F.2d 1455, 1467; Donovan v. Bierwirth, 538 F.Supp. 463, 470 (E.D.N.Y.1981). 19. Liss v. Smith, 991F.Supp. 278 (S.D.N.Y. 1998). 20. Gregg v. Transportation Workers of Am. Intern, 343 F.3d 833, 841-842 (6th Cir. 2003) 21. Cunningham, 1461.
This article is for informational purposes only and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
The financial services industry likes to use charts…a lot of charts. Attorneys do not like charts. Charts can be confusing and misleading, sometimes deliberately so. One judge told me that after I had argued the connection between charts and “weaseleze,” in a trial, he always grinned when an attorney tried to introduce a chart.
I tend to use the terms “weasel words” and “weaseleze” a lot. The terms come from Scott Adams’ book, “Dilbert and the Way of the Weasel.” Adams defines weaseleze as
Words that make perfect sense when individually, but when artfully arranged, they become misleading or impenetrable. Weaseleze is often used in advertising, legal work, employee performance reviews, and dating.1
One of the services I provide is fiduciary oversight services. Part of those services includes a forensic fiduciary audit. I tend to see a lot of weaseleze during such audits, often in connection with charts and diagrams. Lee Munson, author of “Rigged Money,” best described the use of weaseleze in connection with charts and diagrams with his phrase “the lie of the pie,”2
During a recent fiduciary audit of a 401(k) plan, the chairman of the investment committee politely questioned my findings, stating that they had followed the recommendations of their plan adviser.
I asked to see the documentation that the plan adviser had provided to the plan. I immediately recognized an ad that the adviser had provided in support of his recommendations. The ad is one used by a major mutual fund company claiming that their funds have beaten S&P 500 Index funds over an extended period of time.
I reminded the investment committee that they have a fiduciary duty to conduct their own objective investigation and evaluation of the funds chosen for their plan. Then I explained why mutual fund companies choose ads comparing their funds to market indices, rather than comparable index funds, knowing that they are arguably misleading.
First, the S&P 500 Index is technically classified as a large cap blend index. Prior to the Hughes v. Northwestern University (Northwestern) decision, the 401(k) industry, the investment industry, and even some courts objected to any comparison between actively managed funds and index funds, claiming that such comparisons were improperly comparing “apples and oranges.”
The Northwestern finally discredited such arguments. However, the use of the S&P 500 Index, or any other market index, to benchmark funds that are inconsistent with a fund’s classification is obviously comparing “apples and oranges.” This often results in misleading comparisons and potential liability exposure for plan sponsors and other investment fiduciaries.
Second, I have seen ads where the mutual fund company’s ads compare their funds to the S&P 500 Index’s returns without including the reinvestment of the Index’s dividends. Historically, over 40 percent of the Index’s returns can be attributed to the reinvestment of its dividends.
Excluding dividends in performance illustrations obviously creates misleading comparisons.
Over the ten-year period 2012-2021, the total return of the S&P 500 Index without the reinvestment of dividends was 251.67 percent (13.40 percent annualized) versus 325.33 percent with reinvestment of dividends (15.57 percent annualized).
Over the twenty-year period 2002-2021, the total return of the S&P 500 Index without the reinvestment of dividends was 301.13 percent (7.193 percent annualized) versus 488.87 percent with reinvestment of dividends (9.27 percent)
One mutual fund company is known for consistently engaging in this practice. Fortunately, their charts immediately raise red flags for attorneys and fiduciaries to investigate.
Finally, the decision to benchmark against market indices rather than comparable market indices suggests that the fund company is trying to prevent plan sponsors and other investment fiduciaries from performing a cost-efficiency evaluation of their funds.
Section 90 of the Restatement sets out several relevant cost-efficiency standards in determining whether a fiduciary has fulfilled its fiduciary duty of prudence, including
A fiduciary has a duty to be cost-conscious.3
In selecting investments, a fiduciary has a duty to seek either the highest level of a return for a given level of cost and risk or, inversely, the lowest level of cost and risk for a given level of return.4
Due to the impact of costs on returns, fiduciaries must carefully compare funds’ costs, especially between similar products.5
Due to the higher costs and risks typically associated with actively managed mutual funds, a fiduciary’s selection of such funds is imprudent unless it can be shown that the fund is cost-efficient.6
The fact that mutual fund companies and plan advisers would attempt to avoid cost-efficiency comparisons is not surprising. Studies have consistently concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient.
99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.7
Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.8
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.9
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.10
What is troubling from a legal standpoint is that a plan adviser would knowingly try to expose their client, the plan, to unnecessary fiduciary liability exposure. While they typically feign surprise when they are confronted with this evidence, they known exactly what they are doing.
More often than not, their advisory contract with the plan also includes a fiduciary disclaimer clause. Fortunately for plans, the Supreme Court has ruled that such clauses do not prevent plans from suing plan advisers.
The Active Management Value Ratio™3.0 For all the foregoing reasons, I advise my fiduciary compliance clients to simply ignore any and all mutual fund ads and perform their own fiduciary compliance analyses using the Active Management Value Ratio (AMVR).
Based upon the Restatement and the studies of investment icons such as Nobel laureate Dr. William F. Sharpe and Charles D. Ellis, I created a simple metric, the Active Management Value Ratio™ (AMVR), that allows investors, investment fiduciaries and attorneys to quickly determine the cost-efficiency of an actively managed mutual fund.
In analyzing an investment option, Nobel laureate William F. Sharpe has noted that
[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.11
Building on Sharpe’s theory, investment icon Charles D. Ellis has provided further advice on the process used in evaluating the cost-efficiency of an actively managed mutual fund.
So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns.
When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!12
The AMVR metric provides extremely useful information regarding the cost-efficiency of an actively managed mutual fund using just a fund’s nominal, or publicly reported, costs and returns. However, an investor’s analysis should not end there if they want a truly accurate cost-efficiency analysis of an actively managed mutual fund.
There is a direct, negative relationship between a fund’s r-squared correlation number, a fund’s incremental costs, and the fund’s cost-efficiency. Morningstar states that “r-squared reflects the percentage of a fund’s movements that are explained by movements in its benchmark index, [rather than any contribution by the fund’s management team.]”13
Professor Ross Miller did a study on the impact of closet indexing, focusing primarily on the relationship between an actively managed mutual fund’s R-squared number, “closet index” status, and the resulting overall financial impact of the two. “Closet index” funds are actively managed funds whose returns are essentially the same as a comparable index fund, but who charge much higher fees than the index fund. The higher an actively managed fund’s r-squared number, the greater the likelihood that the actively managed fund can be classified as a closet index fund.
An r-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s returns could be attributed to the performance of a comparable index fund rather than the active fund’s management team.
In fairness, Professor Miller has noted that there is not a one-to-one correlation between an actively managed fund’s r-squared number and the percentage of the active management provided.
There is no universally agreed upon level of r-squared that designates an actively managed mutual fund as a closet index fund. I use an R-squared correlation number of 90 as my threshold indicator for closet index status.
Miller’s findings were extremely interesting, namely that
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.11
As a result of his study, Ross Miller, created the Active Expense Ratio (AER) metric. A fund’s AER number is based on a fund’s r-squared number.
Since many investors are unfamiliar with the AER metric, a frequent question I receive is why even calculate an AER-adjusted AMVR. One of the benefits of calculating an actively managed fund’s AER number is that the calculation process results in calculating the actual percentage of active management provided by the actively managed fund in question. Miller refers to this measurement as a fund’s “active weight.14
Deriving a fund’s “active weight” number provides valuable insight into the amount of active management provided by a fund purporting to provide active management, especially since such funds higher fees are based on the purported benefits of active management. However, Miller claims the primary benefit of calculating a fund’s AER number is that the AER provides investors with a quantitative analysis of the implicit cost of the fund’s active management component. The AER accomplishes this by simply dividing an actively managed fund’s incremental cost by the fund’s active weight number.
In many cases, once a fund’s r-squared correlation number is factored in, the fund’s AER is significantly higher than the fund’s stated expense, often as much as 400-500 percent higher. Investors and investment fiduciaries should remember John Bogle’s advice on investment costs, “you get what you don’t pay for,” as well as the fact that simple mathematics proves that each one percent in fees and expenses reduces an investor’s or fiduciary’s end-return by approximately seventeen percent over a twenty-year time period.
Once AMVR is calculated for an actively managed fund, the investor or fiduciary only needs to answer two simple questions:
(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?
(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?
If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and unsuitable/imprudent according the the Restatement’s prudence standards and should be avoided. The goal for an actively managed fund is an AMVR number greater than “0” (indicating that the fund did provide a positive incremental return), but equal or less than “1” (indicating that the fund’s incremental costs did not exceed the fund’s incremental return).
Prudent plan sponsors and other investment fiduciaries do not knowingly waste money by offering and/or investing in cost-inefficient investments. It may require a little more work, but by using the AMVR metric, alone or in combination with Miller’s AER metric, investors can better protect their financial security and investment fiduciaries can hopefully avoid unnecessary personal liability exposure.
Facts do not cease to exist because they are ignored. Aldoux Huxley
As one commentator noted in 1976 after the Restatement (Second) Trusts was released made the following observation:
When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.15
Over forty years later, the First Circuit echoed such sentiments in the Brotherston decision, when it offered the following advice:
Moreover, any fiduciary of a plan such as the plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”16
One of the rewarding things about my posts is receiving constructive feedback from readers. A member of a plan investment committee recently wrote me a very nice email, including the following questions and comment:
In your opinion, should our advisor provide [AMVR] calculations as part of their service?
[The AMVR] should be THE comparison that every investor uses to evaluate a fund.
My response as to requiring plan advisors to provide AMVR analyses on their recommendations has, and always be, yes. Why would any plan adviser refuse to provide such simple analyses unless they are not committed to putting a client’s best interests first?
However, insist that they follow the AMVR format used by InvestSense, including risk-adjusted returns and correlation-adjusted costs, using the Active Expense Ratio. In most cases they will provide the calculations based on nominal returns and costs, but they refuse to provide the adjusted data.
As for the AMVR being THE leading metric for protecting investors and maximizing wealth management and accumulation, let’s just say I’m obviously biased. For what it is worth, investment fiduciaries and attorneys are reportedly using the metric.
Copyright InvestSense, LLC 2022. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought
In college, my minor was psychology. My thesis was on heuristics, cognitive biases, and the decision-making process. I have always been fascinated by the way the mind works.
Nobel Laureate Daniel Kahneman’s best seller, “Thinking Fast and Slow,” offers a valuable insight into how we make decisions. Click here to view a 2-minute analysis of Kahneman’s thoughts.
When I created the Active Management Value Ratio™ (AMVR) metric, it was based on these same principles. The goal was to provide a metric that could help investors, including plan participants, make meaningful investment decisions.
Based on my 30+ years in the investment industry, initially as a securities compliance director for both broker-dealers and registered investment advisers, and now as a securities and ERISA attorney and consultant, I believe that the two primary reasons some investors make poor investment decisions is a lack of information/education, and misplaced reliance on illusory investment returns and investment advice.
Psychology and Decision-Making The reference to investment “illusion” refers to various misconceptions about investment returns and investment advice. In many cases, those misconceptions are the result of the influence of psychological heuristics and cognitive biases.
Heuristics are mental shortcuts that people take in making decisions. The bat/paddle and ball analogy in the Kahneman video is an excellent example of how we use heuristics to simplify the decision-making process, the intuitive or “fact thinking” process.
The problem that a decision-maker must consider is that heuristics can often result in errors due to the influence of cognitive biases that may influence a decision-maker’s judgment. Common cognitive biases that influence decisions include
Confirmation bias – the tendency to give greater weight to information that confirms our existing beliefs.
Anchoring bias – the tendency to put greater emphasis on and credibility to the first piece of information that we hear.
Authority bias – the tendency to blindly rely on any and all advice and recommendations provide by those appearing to have expertise on a topic.
“Halo effect” – the tendency for an initial impression of a person to influence the overall and ongoing opinion we have of them.
Based on my experience, these four cognitive biases often come into play in the investment decision-making process. In my opinion, the most damaging example of this problem is the authority bias. Far too often, investors blindly rely on investment advice and recommendations that they believe are objective and in their best interest, from a “trusted adviser,” someone they believe is far more experienced and knowledgeable in such matters. Unfortunately, in far too many cases, the reality in many cases is that the “trusted adviser” is simply someone simply trying to sell an investment product, or as one expert said, “someone whose job it is to make money on you, not for you.”
Psychology and the Active Management Value Ratio™ As I mentioned, heuristics and cognitive biases were a primary consideration when I created the AMVR metric. As the video points out, the influence of large numbers is a well-known cognitive bias.
What would be your initial reaction if I were to recommend this investment to you?
In many cases, the intuitive/fast thinking model would notice the 22.73 percent return with an expense ratio of “only” 78 basis points. 22.73 vs. 0.78. The initial intuitive reaction would most likely be very positive.
Now, what would be your reaction if you were presented with the following AMVR forensic analysis slide on the same investment?
Hopefully, an investor’s rational, “slow thinking” decision-making side would quickly convince them that the is not be the “bargain” it first appeared to be relative to a comparable index fund. This opinion is supported by the opportunity to consider the two investments based on a cost-efficiency comparison.
The actively managed fund not only failed to provide a positive benefit, or incremental return, but also had a significant incremental cost. Costs matter. A simple rule of thumb for investors to remember is that over a twenty-year period, each additional 1 percent in investment costs/fees reduces an investor’s end-return by approximately 17 percent.
The Illusion of Investment Returns While the “illusion” of investment returns refers to the errors in judgment resulting from issues with heuristics and cognitive biases, it also refers to errors in evaluating investments due to the failure to properly assess the effective costs of actively managed mutual funds.
The chart above shows cost-efficiency in terms of a fundamental cost/benefit analysis, incremental costs relative to incremental returns. The actively managed fund failed to produce a positive incremental return. As a result, the prudence analysis was easy.
A common error in evaluation occurs when the actively managed fund does provide a positive incremental return. The AMVR analysis below shows such a situation.
The chart is significant in two ways. First, it shows that an investor could achieve approximately 99.5 percent of the actively managed fund’s return at a much lower cost, 5 basis points. A basis point equals .01 percent of 1 percent; 100 basis points equals 1 percent.
Second, that means that we are effectively paying 72 basis points, the incremental cost, for just 5 additional basis points of return, the incremental return. Paying a cost/fee fourteen times the benefit/return received is obviously an issue in terms of prudent investing.
Advanced Cost-Efficiency At the end of each calendar quarter, I prepare an AMVR “cheat sheet” for my investment fiduciary consulting clients, such as pension plan sponsors and trustees. The “cheat sheet” for the first quarter of 2022, for six of the most popular investment options in U.S. defined contribution plans, e.g., 401(k) plans, is shown below.
I provide two sets of data, one based on the funds’ publicly stated, or nominal, information, the second based on incremental risk-adjusted returns and incremental correlation-adjusted costs. For more information about why I provide the adjusted returns and costs, click here.
Comparing the funds on a nominal cost/nominal return basis, five of the six funds failed to even outperform the comparable index fund, making them an imprudent investment choice. The fact that they paid additional costs for such underperformance only makes matters worse. One fund, Dodge & Cox Stock would have been cost-efficient, as its nominal incremental return (1.62) exceeded it nominal incremental cost (0.47).
Comparing the funds on an adjusted cost/adjusted return basis results in the similar scenario, with the same five funds still proving to be imprudent investment choices. However, using the adjusted numbers, Dodge & Cox Stock also proves to be an imprudent investment choice, as its incremental correlation-adjusted cost (8.77) significantly exceeds its incremental risk-adjusted return (0.34).
The Dodge & Cox Stock scenario provides a perfect example of why investors should consider risk-adjusted returns and correlation-adjusted costs in making investment decision. Dodge & Cox’ Stock’s relatively high expense ratio combined with its high r-squared, or correlation, number to drive up its effective expense ratio. Invest Sense calculates a fund’s incremental correlation-adjusted cost using Miller’s Active Expense Ratio.
Many online investment sites include a fund’s r-squared number. Investors considering actively managed mutual funds should always note a fund’s r-squared number for two reasons. First, it helps warn investors about potential “closet index” funds. Closet index funds are funds that tout the advantages of active management, but in reality provide end-returns similar to, in many cases worse, than the end-returns of comparable, but less costly, index funds.
Second, a fund’s r-squared number indicates the likelihood that an actively managed fund will be able to outperform a comparable index fund. Actively managed funds operate at an inherent disadvantage to index funds due to their higher fees and expenses, e.g., management fees and trading costs. A high r-squared number means that the actively managed fund closely mirrors the performance of a comparable index or index fund, making it unlikely that the actively managed fund will be able to make up for such higher expenses.
Going Forward People often indicate that they are confused and intimidated by the investment process. That was another reason that I created the Active Management Value Ratio™ metric and made it as simple as possible. While many investors focus only on returns, returns without accompanying cost-efficiency are essentially meaningless, as it indicates that an investment’s incremental investment costs exceed its incremental investment returns. Cost exceeding returns is never a sound investment strategy.
The information needed to perform an AMVR analysis on a nominal basis is freely available online. The AMVR “cheat sheet” analysis showed that in many cases, an AMVR analysis based on a fund’s nominal costs and returns alone is enough to expose cost-inefficient mutual funds.
Investors willing to go online, find the cost and return information, and perform what one judge described as “third grade math” can easily calculate the cost-efficiency of their existing and prospective investments and hopefully improve their investment success and financial security.
Studies have consistently shown that people are more likely to understand and retain information that is conveyed visually rather than verbally or in print. I regularly receive requests for copies of the Powerpoint slides. So for those of you that have never seen one of my presentations on the value of InvestSense’s proprietary metric, the Active Management Value Metric (AMVR) 3.0, here is a simple explanation of how the AMVR can help you detect cost-inefficient actively managed mutual funds in your personal portfolios and 401(k) plan accounts and better protect your financial security.
The Active Management Value Ratio Metric (AMVR) 3.0 Active Management Value Metric (AMVR) 3.0 is based on combining the findings of two prominent investment experts, Charles Ellis and Burton Malkiel, with the prudent investment standards set out in the Restatement (Third) Trusts’ “Prudent Investor Rule.”
[R]ational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index.” – Charles Ellis
Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover. – Burton Malkiel
Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs,…If the extra costs and risks of an investment program are substantial, those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;… – Restatement (Third) Trusts [Section 90 cmt h(2)]
The following slide is based on the returns and risk data of a popular actively managed mutual fund over a five-year period, compared to the returns and risk data of a comparable Vanguard index fund. When InvestSense does a forensic AMVR analysis, we examine both a five and a ten-year period to analyze consitency of performance. The actively managed fund charges a front-end load, or purchase fee, of 5.75 percent. The Vanguard index fund does not charge a front-end load.
Nominal Returns Mutual funds ads and brokerage accounts often provide a fund’s returns in terms of its nominal, or unadjusted returns. In our example, the actively managed fund does even produce a positive incrremental return, resulting in an additional cost, an opportunity, cost for an investor. This is a common scenario due to additional costs and fees, e.g., higher expense ratio, higher trading costs, typically associated with actively managed mutual funds.
Had the actively managed fund actually produced a positive incremental return, the question would be whether the actively managed fund’s incremental costs exceeded the fund’s incremental returns. If so, this would result in a net loss for an investor, making the fund cost-inefficient and a poor investment choice.
Load-Adjusted Returns However, Investors who invest in funds that charge a front-end load do not receive a fund’s nominal return since funds immediately deduct the cost of the front-end load at the time of an investor’s purchase of the fund. Since there is less money in the account to start with, an investor naturally receives less cumulative growth in their account when compared to a no-load fund with the same returns. This lag in cumulative growth will continue for as long as they own the mutual fund.
The calculation of a fund’s load-adjusted returns can be somewhat confusing. Several online sites provide load-adjusted return data, including marketwatch.com and the fidelity.com site.
In our example, once the impact of the front-end load is factored into the fund’s returns, the fund further underperforms the benchmark, the comparable Vanguard index fund. This double loss clearly makes the fund even noire cost-inefficient and a poor investment choice.
Risk-Adjusted Returns A final factor that should be considered is the risk-adjusted return of a fund. When comparing funds, it is obviously important to know if a fund incurred a higher level of risk to achieve its returns relative to another fund since investors may not be comfortable with such risk. As the quote from the Restatement points out, at the very least, investors would expect a higher return that would compensate them for a higher level of risk.
In our example, the actively managed fund assumed slightly less risk than the Vanguard index fund. As a result, the actively managed fund’s returned improved slightly, but not enough to avoid the same double loss suffered in the load-adjusted scenario. Once again, this double loss clearly makes the fund cost-inefficient and a poor investment choice.
The investment industry will often downplay unfavorable risk-adjusted results, saying that “investors cannot eat risk-adjusted returns.” However, the combined impact of additional fees and under-performance should not be ignored by an investor. Each additional 1 percent in fees results in approximately a 17 percent loss in end return for an investor over a twenty-year period. Historical under=performance can be considered an additional cost in evaluating a fund’s cost-efficiency since investor’s invest to make positive returns and enjoy the benefits of compounding of returns.
Interestingly enough, funds that may criticize risk-adjusted performance numbers have no problem touting favorable “star” ratings from Morningstar, which bases its “star” rating on, you guessed it, a fund’s risk-adjusted returns. Risk-adjusted return data for a fund can be found on the “Taxes” tab, which factors load-adjusted returns into their calculation
In my legal and consulting practices, we add two additional screens. The first screen is designed to eliminate “closet index” funds. Closet index funds are actively managed mutual funds that essentially track a market index or comparable index fund, but charge fees significantly higher, often 300-400 percent or higher, than a comparable index fund. Conseqently, closet index funds are never cost-efficient.
The second screen InvestSense runs is a proprietary metric known as the InvestSense Fiduciary Prudence Rating (FPR). The FPR evaluates an actively managed mutual fund’s efficiency, both in terms of cost and risk management, and consistency of performance.
Conclusion The Active Management Value Ratio™ 3.0 (AMVR) is a simple, yet very effective, tool that investors and investment fiduciaries can use to identify cost-inefficient actively managed mutual funds and thus better protect their financial security. All of the information needed to perform the AMVR calculations is freely available online at sites such as morningstar.com, fidelity.com, and marketwatch.com.
For those willing to take the time to do the research and the calculations, the rewards can be significant. For fiduciaries, the time spent can be especially helpful in avoiding unwanted personal liability, as plaintiff’s securities and ERISA attorneys are becoming increasingly aware of the forensic value AMVR analysis provides in quantifying fiduciary prudence and investment losses. As a result, more securities and ERISA attorneys are incorporating AMVR analysis into their practices.
On the 5-year cheat sheet, only one fund, Dodge & Cox Stock (DODGX), posted positive incremental returns on both nominal and risk-adjusted returns. While DODGX passed the AMVR screen on nominal returns, the fund failed to pass the AMVR screen on a risk-adjusted basis due the combination of a relatively high standard deviation (15.99) and a high r-squared/correlation number (97), resulting in an extremely high correlation -adjusted/Active Expense Ratio score (8.77).
InvestSense calculates AMVR using a fund’s correlation-adjusted incremental costs (using Ross Miller’s Active Expense Ratio metric) and risk-adjusted incremental returns (using Morningstar’s risk-adjusted return methodology), based upon the belief that such data provides a more accurate evaluation of a fund’s prudence.
The same results hold true on the 10-year AMVR cheat sheet. The results on both cheat sheets illustrate the importance of factoring in r-squared/correlation of returns. Using DODGX as an example, its r-squared of 97 suggests that a fiduciary could achieve 97 percent of DODGX’s return for the much lower cost of the benchmark index fund, in this case Vanguard’s Large Cap Growth Index Fund, Admiral shares. As a result, a fiduciary would be effectively paying a much higher expense ratio for the risk-adjusted incremental return, as shown in both charts.
The data shown covers the respective time periods, ending on 3/31/2022. The benchmarks used are the Admiral shares of the Vanguard funds comparable to the referenced funds’ Morningstar asset category: Vanguard Large Cap Growth Index Fund (VIGAX), Vanguard Large Cap Value Index Fund (VVIAX), and Vanguard Large Cap Blend Index Fund (VFIAX).
At the end of each calendar quarter, InvestSense publishes the 5 and 10-year Active Management Value Ratio (AMVR) scores of the non-index funds in “Pensions & Investments” annual survey of the most used mutual funds in U.S. defined contribution plans. Currently there are six such funds.
One of the interesting things about the 2021 survey is the continued growth of investments in index funds. The P&I survey ranks funds based on amount of assets invested in each fund, not the actual performance of the fund. The #1 fund overall is the Fidelity S&P 500 Index Fund. The fund is far and away the leader, holding almost 80% more DC assets than the #2 ranked fund.
The AMVR calculates the cost-efficiency of an actively managed mutual fund relative to a comparable index fund. Section 90 of the Restatement (Third) of Trusts emphasizes the importance of cost-efficicency. In announcing the adoption of the Securities and Exchange Commission’s new Regulation Beast Interest, former SEC Chairman Jay Clayton noted the importance of cost-efficiency, stating that
A rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes expected utility.
The AMVR is essentially the basic cost/benefit analysis taught in economic classes, with a fund’s incremental costs and its incremental return as the input values (incremental costs/incremental returns). An AMVR score greater than 1.0 indicates that the actively managed fund is cost-inefficient, as its incremental costs exceed its incremental returns.
Since the six funds funds currently in=the “cheat sheets” are all large cap funds, we use three Vanguard index funds (VIGAX, VFIAX and VVIAX) for benchmarking. While some people use nominal costs and nominal returns, sucb data can often be misleading. For that reason, InvestSense calculates AMVR scores using an actively managed fund’s incremental correlation-adjusted costs (ICAC) and incremental risk-adjusted returns (IRAR).
The impact of a fund’s r-squared, or correlation, number is gaining greater recognition as issues such as “closet indexing” receive increased attention. InvestSense uses Miller’ Active Expense Ratio in computing a fund’s (ICAC). As Miller explained,
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.
So, with that background, the new 4Q 2021 AMVR cheat sheets are shown below:
Two key numbers to look for in using the AMVR is a fund’s r-squared/correlation number and its expense ratio. As you look at the two charts, you can see how dramatically the combination of a high r-squared number and a high expense impacts a fund’s overall cost-efficiency. This is the main reason InvestSense uses incremental correlation-adjusted costs instead of nominal costs, to get a truer evaluation of a fund’s cost-efficiency.
In analyzing the data, the two key questions are:
1. Did the actively-managed fund provide a positive incremental return? 2. If so, did the fund’s incremental return exceed the fund’s incremental costs?
If the answer to either of these questions is “no,” the actively-managed fund is not cost-efficient, and an imprudent investment choice, relative to the benchmark fund.
As to the 5-year AMVR chart, using the ICAC/AER and IRAR data, none of the six fund’s would be prudent relative to the benchmark.
As to the 10-year AMVR chart, using the ICAC/AER and IRAR data, only the Vanguard PRIMECAP Fund’s Admiral shares would be prudent relative to the benchmark, here the Admiral shares of Vanguard’s S&P 500 Fund.
Two funds deserve particular mention. The significant difference in Dodge& Cos Stock Fund’s return data is due to the fact that they had a relatively high standard deviation (19+). The T. Rowe Price Blue Chip Growth Fund usually produces relatively good returns, but the fund’s unusually high expense ratio negates such performance, especially when the fund’s r-squared number is considered.
Some people have told me that the concept of the AMVR and its calculation process are easier to understand by reviewing some of my PowerPoint presentations and the worksheet examples. Those are available at https://www.slideshare.net. Search under “Active Management Value Ratio” to view all of the available presentations.
This article is for informational purposes only and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
Financial planning, when done properly, can be a valuable process to consumers. So say yes to the process of financial planning. However, when it comes to financial plans, avoid the inherent issues of “black box” financial planning and “canned” financial plans by performing a quality check using certain guidelines.
Various financial planning firms offer financial planning/retirement planning/asset allocation plans (hereinafter “financial plan(s)”). The price typically ranges from a couple of hundred dollars to thousands of dollars. What the public is not told and does not realize is that the quality of such plans may vary significantly. At best, such plans are a simple snapshot of a client’s situation at that particular time. At worst, they can mislead a client and cause serious financial.
Technically speaking, the quality of such plans depends on the accuracy of the assumptions and other data entered into the software program used to produce a plan. Most of such programs are highly unstable, where slight errors can produce significant errors. As William Jahnke has stated, “the instability of the return-generating process rips the theoretical guts out of the practice of static asset allocation.”1 Furthermore, many of these programs are based upon Microsoft Excel, which was never intended to handle the numerous interrelated calculations used by most financial planning softwar
When I am asked to review a financial plan, the first thing I do is review the data and assumptions that were used in preparing the plan. The second thing I do is to reverse engineer the complete plan to see where errors were made in the calculations and/or advice provided by he plan. After thirty years of dealing with financial planning quality of advice issues, most errors that clients would miss are readily apparent and easy to discern to me.
Financial plans assume a constant rate of growth for investments. This simply does not portray reality. Historically, the stock market suffers one down year for every two positive years. Losses suffered during bear markets such as the 2000-2002 and 2008 definitely one’s financial situatio
Financial plans use either past performance or projected performance, or “guesstimates,” of investments to prepare the financial plan. The problem with past performance data is that, as the required disclosure for investments states, “past performance is no guarantee or future returns.” The problem with projected performance, or “guesstimates,” is that they are just that, guesstimates, which can be easily manipulated to convince clients to make decisions that benefit the party that prepared the financial plan more than the best interests of the client.
An investor should always ask the planner who prepared the plan to provide the investor with all the data and assumptions that were used in preparing the plan. One common scenario we see is the choice of the assumptions to ensure that certain investment purchases are mad
One common example of this involves small cap investments. Most people have portfolios that are heavily invested in large cap, blue chip stocks. One reason for this scenario is that blue chip stocks are often stocks that people are familiar with (e.g., AT&T, Coke, McDonald’s). Since most financial planning software favors investments with certain characteristics (e.g., high returns and low risk/standard deviation), a planner can ensure that the plan recommends such products by using assumptions meeting such criteria. So, if a planner wants to ensure that purchases of small cap products are recommended to produce commissions for the planner, they can manipulate the data to ensure such results without the investor suspecting anything.
Another common scenario I encounter is where the planner blindly relies purely on the financial planning software’s output and lacks the knowledge and or experience to identify software mistakes or poor advice. a situation commonly referred to as “black box” financial planning. As Harold Evensky, one of the nation’s most skilled and respected financial planners has opined,
One of the most frequent criticism of wealth manager optimization is the use of a complex computer program, frequently referred to as a black box. This pejorative description suggests that the wealth manager is implementing an asset allocation policy without understanding how the allocations were determined. The presumption is that the black box, not the wealth manager, is making the decision. Unfortunately, this is often a valid criticism.2
As usual, Mr. Evensky is right on point. Whenever I question planners about the quality of their plans and the advice provided, more often than not the first response is the “deer in the headlights” look, followed with an admission of simply following whatever the software produced and/or a meritless, legally insufficient explanation based on inaccurate interpretations of financial theories such as Modern Portfolio Theory. The quality of advice issues with regard to some financial plans is so bad that Nobel laureate Dr. William F. Sharpe has deemed the situation to be “financial planning in fantasyland.”3
What investors need to understand is that proper financial planning involves more than a financial plan. Proper financial planning is a process, an ongoing process, not a product. CFP® professionals are taught a specific process that includes
(1) determining your current financial situation (2) developing financial goals (3) identifying alternative courses of action (4) evaluating alternatives (5) creating and implementing a financial action plan, and (6) reevaluating and revising the plan.
Given the limitations and issues inherent in “canned”, cookie-cutter, financial plans, more and more true financial planners are foregoing the formal financial plan in some cases and focusing more on an effective financial planning process using a modular financial planning process. Given the need to reevaluate and revise the plan as needed, this puts the focus on the client’s best interests and allows the planner and client to focus on building a meaningful and trusting relationship.
If you are a client who has already had a financial plan prepared, I issue the same challenge to you that I make in my wealth preservation challenges. Review the various spreadsheets and check the accuracy of the calculations of the first ten rows on the spreadsheet. Unfortunately, the other forms of deception used in connection with financial plans are often subtle and difficult for the public to detect without the help of someone experienced in such matters.
For what it’s worth, whenever I point out the calculation errors in a financial plan, the planner and his company often respond by saying that they were simply calculating future value, so the last line of the spreadsheet only needs to be correct. When I ask if the customer, who paid for the plan, was informed that the planner knew that most of the numbers were wrong and were simply to fool the customer into thinking a lot of work went into the plan, I usually get more blank stares.
Likewise, when I ask whether the customer was informed of whether past performance or “guesstimates” were used in making the asset allocation recommendations, as well as the inherent issues with either approach, I often get more blank stares or a defense that the plan disclaimed liability the contents of the plan. So the planner asked the customer to pay for the plan, then basically added a disclaimer to the effect that the planner and his company were not liable for the quality of advice provided within the plan . So much for developing a relationship of trust. Your honor, the prosecution rests
So, once again, financial planning, when done properly, can be a valuable process to consumers. As a CFP® professional for over 33 years, I am proud of our commitment to providing consumers with quality advice and our efforts to protect the public. Unfortunately, others holding themselves out as being “financial planners and/or providing “financial planning services” do not share that same commitment, with “financial planner” simply being seen as a marketing tool for selling questionable investment and/or insurance products.
So again, say yes to the lifelong, ongoing process of financial planning. However, when it comes to financial plans, understand the inherent issues and perform a quality check using the guidelines discussed herein.
Notes 1. Gary Marks, “Rocking Wall Street: Four Powerful Strategies That Will Shake Up The Way You Invest, Build Your Wealth, and Give You Your Life Back,” John Wiley & Sons, Hoboken, NJ (2007): 159-160 2. William Jahke, “Getting a Grip,” Journal of Financial Planning, April 2002, 28-30. 3. Harold Evensky, Stephen M. Horan, and Thomas R. Robinson, “The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets,” John Wiley and Sons, Hoboken, NJ (2011): 187 4. William F. Sharpe, “Financial Planning in Fantasyland,” available online at http://www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm
This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
When InvestSense prepares a forensic analysis for a 401(k)/403(b) pension plan, a trust, an attorney, or an institutional client, we always do an analysis over five and ten-year time periods to analyze the consistency of performance. Since so many social media followers have asked this question, we are providing a forensic analysis for both time periods for our quarterly “cheat sheet” covering the third quarter of 2021.
At the end of each calendar quarter, we provide a forensic analysis of the top non-index mutual funds currently being used in U.S. 401(k) defined contribution plans. The list is derived from the annual survey conducted by “Pensions & Investments” and currently consists of six funds. Our forensic analysis is based on our proprietary metric, the Active Management Value Ratio™ 4.0 (AMVR).
The AMVR allows investors, fiduciaries and attorneys to determine the cost-efficiency of a fund relative to a comparable index fund. We typically use comparable Vanguard index funds for benchmarking purposes. People often ask why we do not use actual market indices like Morning star and actual funds. Actual market indices do not have costs, so they cannot be used to calculate a fund’s cost-efficiency.
In calculating a fund’s AMVR score, InvestSense compares a fund’s incremental risk-adjusted return to its incremental correlation adjusted costs. Five of the six funds do not qualify for an AMVR score, as they failed to provide a positive incremental return. While Dodge & Cost Stock did provide a positive incremental return, its, incremental correlation-adjusted costs exceeded its positive incremental risk-adjusted return. As a result, it would be deemed cost-inefficient under the AMVR.
Once again, five of the six funds do not qualify for an AMVR score, as they failed to provide a positive incremental return. While Dodge & Cost Stock did provide a positive incremental return, its, incremental correlation-adjusted costs exceeded its positive incremental risk-adjusted return. As a result, it would be deemed cost-inefficient under the AMVR.
People often ask about our uses of incremental risk-adjusted returns and incremental correlation-adjusted costs. As for our use of incremental returns, that is consistent with industry standards. While the financial services industry prefers to ignore risk-adjusted returns, “you can’t eat risk-adjusted returns,” it has no problem boasting about a good rating under Morningstar “star” system. I have to assume that the industry is not aware that Morningstar uses risk-adjusted returns in awarding its coveted stars.
The other justification for relying on risk-adjusted returns is that risk is generally thought to be a factor in return. As Section 90, comment h(2) 0f the Restatement (Third) of Trusts states, the use and/or recommendation of actively managed funds is imprudent unless it can be objectively determined that the active funds can be expected to provide investors with a commensurate return for the additional costs and risks associated with actively managed funds.
As for our use of correlation-adjusted costs, it allows us to use the AMVR to screen for “closet index” funds. Actively managed funds that have a high correlation to comparable, less-expensive are often referred to as “closet index” funds. Closet index funds are actively managed funds that tout the benefits of active management and charge higher fees than comparable index fund, but whose actual performance is actually similar to the comparable index funds. To be honest, “closet index” funds typically underperform comparable index funds.
Ross Miller created a metric, the Active Expense Ratio (AER), that allows investors and investment fiduciaries to determine the effective fee that they pay for actively managed mutual funds with high correlation, or R-squared, numbers. Miller explained the value of the AER:
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funds engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.
Martijn Cremers, creator of the Active Share metric, commented further on the importance of correlation of returns between actively managed mutual funds and comparable index funds, saying that
[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices…. Investors in a closet index fund are harmed by for fees for active management that they do not receive or receive only partially…. Such funds are not just poor investments; they promise investors a service that they fail to provide.
With those quotes in mind, it is interesting to note that all six of the actively managed funds on the 3Q cheat sheet all have R-squared/correlation numbers in the mid to high 90s.
Going Forward Those that follow me on Twitter and/or LinkedIn know that I have posted a lot on those sites regarding the upcoming Supreme Court hearings in the Hughes v. Northwestern University 401(b) case. The oral arguments in the case are scheduled for December 6, 2021.
I will be posting more about the case as we get closer to the oral arguments. However, for now, I will just say that if the Court rules in favor of the plaintiff, it would essentially require plans to prove that the investment options they chose for a plan were prudent when they chose them.
Based on my experience with the AMVR and numerous forensic analyses for clients, I believe plans would be hard pressed to carry that burden. While the simplicity of the AMVR is often credited for its growing acceptance and use, the AMVR is still a powerful tool in 401(k)/403(b) litigation and pension plan risk management.
The late David Swensen was the well-known Chief Investment Officer of Yale University. He was also an outspoken advocate for investor protection.
While performing some research for a brief, I ran across this op-ed, “The Mutual Fund Merry-Go-Round,” that David wrote for the New York Times. Time has diminished neither its accuracy, relevance or importance.
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Financial planning, when done properly, can be a valuable process to consumers. So say yes to the process of financial planning. However, when it comes to financial plans, avoid the inherent issues of “black box” financial planning and “canned” financial … Continue reading →
Posted on October 3, 2021 by jwatkins When InvestSense prepares a forensic analysis for a 401(k)/403(b) pension plan, a trust, an attorney, or an institutional client, we always do an analysis over five and ten-year time periods to analyze the … Continue reading →
The late David Swensen was the well-known Chief Investment Officer of Yale University. He was also an outspoken advocate for investor protection. While performing some research for a brief, I ran across this op-ed, “The Mutual Fund Merry-Go-Round,” that David … Continue reading →