Promoting “Financial Wellness” and “Retirement Readiness”

Two of the hot buzzwords today in the financial media are “financial wellness” and “retirement readiness.” While many people consider financial and investing matters confusing and intimidating, the truth is that people can simplify most matters and still be successful.

The byline for this blog states our mission and belief – the power of the informed investor. The following information can provide a good foundation for establishing one’s financial wellness and retirement readiness.

1. Care – Far too many people just give up and do not even try to take steps to protect their financial security. Others just blindly accept what ever advice they read about or hear. Decide to care and take steps to become truly proactive in protecting your financial affairs by becoming better educated in basic, financial strategies and developing your personal “investsense,” which is defined as the art of combining sound, proven investment strategies with ordinary common sense.

2. Learn – Again, take the time to make use of some of the valuable resources available       online. Obviously, we recommend reading the various white papers and posts on this blog. Other valuable resources include the Vanguard, Kiplinger’s, Money, Forbes, MarketWatch, Morningstar and Yahoo!Finance sites.

3. Use – The last step is to actually apply one’s new-found knowledge into one’s financial affairs. With regard to investments, the adage “simplicity is the new sophistication” is truly applicable. Studies consistently show that the overwhelming majority of actively managed mutual funds fail to outperform their less expensive passively managed peers, more commonly known as index mutual funds. Studies have also shown that funds that are cost-efficient in terms of their annual expense ratio and their turnover costs perform better than less cost-efficient mutual funds.

Our free metric, the Actively Managed Value Ratio™ 2.0 (AMVR), allows an investor to quickly and easily assess the cost-efficiency of an actively managed mutual fund using only basic math skills. For more information about the AMVR, click here.

The importance of cost-efficiency is also shown by the long-term impact of investment         costs on an investor’s end return. Each additional 1 percent of investment fees and costs       reduces an investor’s end return by approximately 17 percent over a twenty year               period. This fact is why variable annuities, which typically charge annual cumulative fees of 2-3 percent, or more, are rarely a good investment choice since investors can  easily lose over 50 percent of their return due to the various fees charged by most variable annuities.

One final point on cost-efficiency has to do with avoiding so-called “closet index” funds. Closet index funds are generally defined as actively managed mutual funds that closely track the performance of stock market indices and index mutual funds, but charge significantly higher fees that a comparable index mutual fund.

A quick and simple way to determine whether an actively managed mutual fund is a closet index fund is to check the fund’s R-squared score on under the”Risks” tab.  While there is no universally accepted score for closet index fund status, InvestSense use a R-squared score of 90 or above as our guideline, indicating that 90 percent of a fund’s return can be properly attributed to the performance of an underlying market index rather than the fund’s management team. Unfortunately, most 401(k) and 403(b) plans primarily offer actively managed equity-based mutual funds that are cost-inefficient, as they have high R-squared scores and thus qualify as “return robbing” closet index funds.

4. Be Proactive and Defensive – Far too many investors lose money from trying to “chase returns.” As Charles Ellis points out in his seminal book, “Winning the Loser’s Game,” investing is properly a defensive process. By attempting to avoid significant losses, an investor can fully participate in market gains and reap the full benefits of compound returns. As I like to tell clients, “you’ll never get ahead if you have to spend all your time catching up.”

Many people like to promote a static approach to investing, often pointing out that “market timing” does not work. The key here is the definition of market timing. The classic definition of market timing is an all-or-nothing approach, moving one’s money so that it is either 100 percent in the stock market or 100 percent in cash. Such an approach is not recommended due to the potential costs of such an approach and the proven difficulty to perfectly predict the stock market.

A proactive approach to wealth management does not require, or recommend, such a radical approach. A sound proactive wealth management strategy would simply involve re-allocating a portion of one’s portfolio based on changes in the stock market or the overall economy in order to reduce the risk of large losses, using an investor’s financial goals and needs as guidelines for such re-allocations.

Posted in Absolute Returns, Asset Protection, Integrated Estate Planning, Investment Advice, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Variable Annuities, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , ,

Special Report: Empowering Teachers for Retirement Readiness

Let’s get straight to the point – teachers at all levels have gotten, and continue to get, inequitable treatment when it comes to options to allow them to become “retirement ready.” My sister-in-law was an assistant principal in a local education system. First thing I told her – NO VARIABLE ANNUITIES! Variable annuities are one of the leading reasons  for customer complaints to regulators every year, and for good reason. They are one of the most oversold, least understood and most abused investment products sold to the public. The high costs and generally poor investment options forced on variable annuity owners are one of the main reasons for a popular saying among investment professionals – annuities are sold, not purchased.

Investment fees and other costs matter. Each additional 1 percent in fees and other costs reduce an investor’s end-return by approximately 17 percent over a twenty year period. Given the fact that variable annuities often charge annual cumulative fees of between 2-3 percent, a variable annuity could reduce a variable annuity owner’s end return by 33-51 percent. And guess who gets that money? Right the variable annuity company that sold you the horrible investment in the first place. For a more comprehensive analysis of the issues involved with variable annuities, click here.

But it’s not just variable annuities that have been unfairly forced on teachers. The retirement business in connection with educators has essentially been controlled by a small group of investment companies, TIAA-CREF, Valic and Fidelity investments. TIAA-CREF has been the proverbial 600-lb gorilla in the college/university sector, with Valic being the dominant entity at the elementary/high school level.

The main product that both companies have traditionally tried to peddle has been variable annuities. Why? They pay some of highest commissions of any investment product, sometimes as much as 7 percent compared to the 4-5 percent paid by many actively managed mutual funds.

TIAA-CREF, Valic and Fidelity also offer teachers a variety of mutual funds. However, overall, the funds offered by these companies fail to pass a simple prudence analysis due to the combination of poor performance and high fees and costs.

Studies have shown  that the proper way to analyze actively managed mutual funds, the most common type of funds offered by teachers’ retirement plans, is to compare the incremental, or additional, costs they charge to the incremental, or additional return they provide compared to less expensive, passively managed, or index funds. Other studies have shown that the two best predictors of a mutual fund’s performance is a mutual fund’s annual  expense ratio and trading costs, as both directly impact a fund’s bottom line and an investor’s end-return.

Based on those two facts, I created a simple cost/benefit metric, the Active Management Value Ratio™ 2.0 (AMVR), that incorporates those elements to determine the cost efficiency of an actively managed mutual fund. In short, approximately 80-85 percent of actively managed mutual funds are not cost efficient when compared to comparable passively managed mutual funds. In some cases the actively managed funds are significantly cost inefficient, with costs 1-2 percent higher, in some cases even higher. Again, 1-2 percent in additional investment costs translates to a 17-34 percent reduction in end-return. For more information about the AMVR, click here.

The last issue about teachers’ retirement abuse has to do with the management of one’s retirement account. Some “financial advisors” will advise teachers to establish an investment portfolio and never make any changes in the portfolio except perhaps to periodically re-balance the investments in the portfolio to restore the portfolio’s original allocation percentages.

Those same “financial advisers” will often attempt to justify such advice with statements such as “market timing does not work. What they often fail to disclose is that they often receive an annual payment from a fund company, generally referred to as 12b-1 fee, for each year you continue to own one of the fund company’s funds. So much for being a “trusted adviser.”
History has shown that true market timing does not work due to the difficulty in successfully predicting the stock market and the costs with making investment trades. However, the key is determining exactly what constitutes “market timing.” Classical “market timing” involves trying to predict the stock market and employing ans “all in” approach to investing, positioning one’s investments 100 percent in the stock market or 100 percent in cash, with no other options.

Such an approach is clearly imprudent from both a cost and risk standpoint. However, the “re-balance only,” also known as the “buy, forget and regret” approach is also imprudent and ignores the fact that history clearly shows that the stock market is cyclical. Given that fact, one should heed the wise words of the Chines philosopher Lao Tzu, who said that “the best way to manage anything is by making use of its nature.”

Since the market has proven to be cyclical, Lao Tzu would suggest that the best approach to managing one’s investment portfolio is to adopt a more proactive, yet prudent, approach to managing one’s retirement accounts. Noted investment icon, Charles D. Ellis would concur with this approach to investment management, as he has warned investors that investing “is, and always should be, a defensive process” and “the secret to successful investing is to avoid significant investment losses.”

This defensive approach makes even more sense for managing investment accounts. Advocates of the “buy-and-hold” approach often try to justify their position to pointing to the trading costs and potential tax problems that can result from making changes in an investment portfolio. However, retirement accounts are tax-deferred accounts, so changes can be made in a retirement account without any tax consequences.

The buy-and-hold” advocates second argument is also without merit. The goal in adopting a proactive, defensive approach is not to perfectly time the stock market and does not need to be in order to provide an investor with significant benefits. When an investor suffers an investment loss, that constitutes an opportunity cost for an investor, who must then use the eventual market to simply restore their retirement account to its original value. As I people. “you will never get ahead if you have to spend all your time catching up>

Many investors underestimate the opportunity cost created by significant investment losses. When I speak to groups I often ask them this simple question – If I suffer a 50 percent loss in my portfolio in year 1, then earn a 50 percent gain in year 2, what is the value of my portfolio?

Most people say that my portfolio is back to its original value. But the correct answer is that my portfolio is still 25 lower than it original value since the 50 percent return in year 2 was on the reduced value of my portfolio as a result of loss in year 1. To fully recover from the year 1 loss, my portfolio has to eventually earn a 100 percent return on the value of  my portfolio after the year 1 loss.

During the bear market of 2008, many investors suffered losses of 40 percent or more. An investor would have to earn a return of 67 percent just to recover from the original 40 percent loss. The investor also suffers an opportunity cost, as the return required for recovery does not go to growing his account even larger than its original value.

In suggesting that teachers and other investors adopt a proactive, yet defensive and prudent approach to managing their retirement accounts, I am not suggesting the use of some complicated mathematical formula. For instance, prior to the 2008 bear market, the market’s price/earnings ratio was at historical levels, suggesting that the level was unsustainable and ripe for a market correction or worse. By taking a profit and re-allocating the assets in their retirement account to whatever level they felt comfortable with, teachers and other investors could have minimized their exposure to the significant loss that was to follow, again with no additional tax and probably minimal, if any, trade costs, as many fund companies allow retirement account owners to make a certain number of free trades annually.

Teachers provide a valuable service to society. Yet their pay rarely reflects the value of their contributions. Even worse, they have been saddled for years with an inequitable retirement system that primarily serves the companies that peddle their inferior investment products rather than the teachers and other plan participants. This point can be easily proven by using the Morningstar web site ( and the Active Management Value Ratio™ 2.0 to analyze the mutual funds offered within their 403(b) or other retirement plan.

Don’t even take the time to evaluate the variable annuities these companies peddle, as their high fees disqualify the overwhelming majority from any serious consideration. The various investment subaccounts, or mini-mutual funds, that a variable annuity owner is given to choose from generally suffer from similar high fees and a history of under-performance relative to less expensive passively managed, or index, funds.

403(b) and 457(b) plans at private collages and universities have recently become the target of litigation, as they are subject to the strong fiduciary requirements of ERISA. Unfortunately, state-run schools are not subject to ERISA, so there has not been similar litigation against such schools, despite the obvious inequities in the current system used by such schools. However, teachers in state-run schools may soon get the much-needed relief they deserve, as state-run schools may soon face the same litigation private schools are now facing using state laws and regulations to provide teachers with the relief that they desperately need and deserve.

© Copyright 2016 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or 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 adviser should be sought


Posted in Asset Protection, ERISA, Fiduciary, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, pension plans, Portfolio Construction, portfolio planning, Retirement, Retirement Plan Participants, Retirement Planning, Variable Annuities, Variable Annuity Abuse, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , ,

Wells Fargo, Bank Cross-Selling and Your Right to Privacy

By now, most people are familiar with Wells Fargo and the illegal activities they engaged in by creating fictitious accounts to misrepresent their financial operations. What Wells Fargo did is wrong for a number of reasons, including inflating the price of the stock on the basis of the false representations and improperly using the personal information of the customers that they used in creating the fictitious accounts, which constitutes a blatant violation of those customers’ right to privacy.

Now word comes out that federal and state regulators, including law enforcement agencies, are going to launch a wide-spread investigation of banks and other financial institutions to determine if such entities engaged in similar copycat illegal activity. Given the wide-spread use of cross selling by financial institutions, it would not be surprising to find such copycat illegal activity, albeit not to Wells Fargo’s extent.

Legally, the law allows banks and similar financial institutions to engage in internal cross-selling between the various divisions within their company. For instance, my personal bank would routinely send me solicitations for insurance that they sold. Despite repeated requests from me to stop such activity, the bank only stopped when I threatened legal action based on the fact that I had exercised my right to “opt out” of such activity.

While the law allows banks and similar financial institutions to cross-sell to its customers, the law does not allow them to share their customers’ personal information with non-related third parties. More importantly, banks and financial institutions that do engage in internal cross-selling are required to notify their customers of their right to opt out of such cross-selling altogether and provide a simple means for customers to do so. In most cases, the banks and financial institutions provide a means of opting out of cross-selling on their website, usually clicking a link on the web site.

Consumers should opt out of such cross-selling programs to protect their right to privacy. Banks and other financial institutions are already making money on your accounts, so there is no reason to allow them to use your personal information for further gain. Opting out of such cross-selling activity also ensures that a customer can legally enforce their right to privacy when it is discovered that their bank has engaged in Well Fargo like illegal activity.

Customers who do opt out of cross-selling should be sure to document the fact that they exercised their right to opt out of such activity. In cases where the right to opt out is provided online, usually at the bank’s web site, the site will immediately acknowledge that the customer has exercised their right to opt out. If the customer’s act of opting out is not acknowledged at the time the right is exercised, the customer should follow-up with a certified letter to the bank or other financial institution notifying them of the customer’s exercise of their opt out rights and asking the bank to acknowledge receipt of such opt out exercise.

Identity theft is one of the largest illegal activities in the U.S. Having been a victim of identity theft twice, I can personally attest to the inconvenience and problems created by identity theft. I have never engaged in financial transaction online, yet have still been victimized. Law enforcement officials have explained to me that there are various computer programs that can run random and unlimited “Monte Carlo” type searches while the identity theft perpetrator sleeps and document when a “hit,” or bank account information has been obtained.

Hopefully, one of the results of Well Fargo crime will be new rules and regulations restricting or prohibiting cross-selling programs by banks and other financial institutions or ,at a minimum, requiring such entities to actually obtain permission from a customer to involve them in such activity, rather than the “negative consent” approach currently approved which requires a customer to be aware of such activity and understand how to protect their privacy via their right to opt out of such cross-selling programs.

Posted in Asset Protection, Consumer Protection, Consumer Rights, Investment Advice, Investor Protection, Life Advice, Right to Privacy, Variable Annuities, Wealth Management, Wealth Preservation | Tagged , , , , , , ,

CommonSense InvestSense – Account Management 2016

“Don’t gamble. Take all your savings and buy some good stock and
hold it ’til it goes up then sell it. If it don’t go up, don’t buy it.
Will Rogers

If only it were that easy. While no one can guarantee how an investment will perform, there are certain precautions an investor should take to protect their financial security.

1.  Always keep copies of all forms and documents that are filled out and/or signed. Documents have been known to disappear or change when questions come up.

2.  Never sign blank documents, leaving it to someone else to fill the document in.

3.  Never give anyone discretionary control over investment accounts. Abuse of discretion is one of the leading complaints regarding stockbrokers and investment advisors. The potential risks simply outweigh any alleged benefit. If an investor is asked to sign a trading authorization so that a brokerage firm can accept orders from the investor’s broker or advisor, the investor should write “NO DISCRETION” on the form to avoid any confusion as to the power being authorized.

4.  Read all account statements and correspondence received from a brokerage firm, a broker or an advisor. If wrongdoing is going on in an account and is reflected in the account statements or correspondence, failure to promptly notify the brokerage firm and to object to such questionable activity may prevent an investor from recovering any losses resulting from such activity.

5.  Ask questions. Ask the financial adviser whether they will be serving in a fiduciary capacity in advising you or managing your portfolio.  If they indicate that they will be acting in a fiduciary capacity, ask them if they are willing to put that in writing and sign the document.

Ask why certain investments are being recommended. Ask whether a purchase of a recommended investment product would result in a commission for the broker or the advisor making the recommendation and, if so, what the amount of the commission would be. Ask whether the recommended investment product is a proprietary product of the company that the broker or the advisor is affiliated with and, if so, ask whether the broker or the advisor can recommend similar non-proprietary products.

Ask whether the recommended product has ongoing fees and, if so, how much those fees are. Even if an investor is turning the management of their investment account over to a money manager, the investor should continually ask questions in order to protect against losses due to “black box” asset allocation.

6.  Consider all aspects of an investment. Some investors only look at the historical or projected return of an investment before making an investment decision. Investors should always consider factors such as the risk/volatility of an investment, the fees associated with an investment, and the tax aspects of an investment. This is particularly true when considering the purchase of an annuity. (See “Common Sense InvestSense…Variable Annuities”) Calculate the Active Management Value Ratio on all investment recommendations before you actually invest in order to ensure that your investments are cost efficient.

7. Avoid “closet index” funds. Closet index funds are actively managed mutual funds that closely track the performance of their underlying market index, thus their designation as “index huggers.” The problem with closet index funds is that you basically get the same return as with a typical index fund, but at a much higher cost, often 300-400 percent higher than the index fund’s annual fee. Since each additional 1 percent in fee and other costs reduce an investor’s end return by approximately 17 percent over a twenty year period, closet index funds are an imprudent investment choice.

7.  Be alert to brokers and advisors possibly “working their book.” When business is slow, brokers and advisors may be advised to “work their book.” This may explain unexpected phone calls suggesting that an investor review their investment portfolio and reallocate their assets, switch mutual funds to buy funds from a different fund family, or perform an annuity exchange.

It is illegal for a broker or an investment advisor to make investment recommendations for the purpose of generating commissions. Certain practices should raise red flags for investors. Recommendations that an investor sell funds of one mutual fund company and buy the same or similar type funds of another mutual fund company should be questioned. Recommendations that an investor sell funds of one mutual fund company and buy different types of funds from another mutual fund company should be questioned if the original mutual fund company offers the same or similar type funds as those being recommended, as most mutual fund companies allow an investor to make internal fund exchanges without incurring new commissions.

Recommendations that an investor exchange one annuity for another annuity should always be questioned since the exchange will result in new commissions for the broker or the advisor. Recommending that an annuity owner exchange annuities is especially suspicious when the current annuity is still subject to surrender charges, as the client would lose money as a result of having to pay surrender charges for the exchange. An investor who becomes aware of such practices should promptly notify the appropriate regulatory organizations.

8.  Use breakpoints, when possible, to reduce the commissions on mutual fund purchases. Most mutual fund companies offer investors a discount on front-end sales charges once an investor has invested a certain amount of money in their mutual funds. Most mutual funds begin to offer such discounts once an investor has invested a cumulative total of $50,000 in their funds, with additional discounts for certain levels of additional investments. Recommendations spreading investments among a multitude of asset classes may be cause for questioning, especially when large amounts of money are being invested and/or the recommended amounts are just below breakpoint levels.

9.  Choose appropriate classes of mutual fund shares to reduce expenses. In most cases, A shares and B shares are the only type of mutual fund shares most investors should consider. Many investors immediately lean toward B shares since they do not require the investor to pay front-end sales charges, or commissions. B shares, however, may not be the best choice for the long-term investor due to the higher annual fees associated with B shares.

Generally speaking, A shares are often a better deal for a long-term investor due to the fact that annual fees for A shares are typically less than the annual fees charged by B shares. If an investor has a large amount of money to invest, A shares often offer breakpoints to reduce any applicable sales charges. Breakpoints are not generally offered on B shares. B shares are often a better deal for short-term investors, since B shares do not impose a front-end sales charge.

While B shares generally carry higher annual fees and often impose deferred sales charges if an investor redeems the shares within a specified period of time, the holding period during which deferred sales charge are applicable is usually relatively short. The investor’s ability to redeem B shares without penalty within a short period of time also allows the investor to minimize the effect of the higher annual fees of the B shares. Some mutual fund companies offer to convert B shares into A shares after a certain period of time has elapsed. Each investor must evaluate their own situation to determine the choice that is best for them.

Investors with managed accounts should always check to see whether their advisor is using A shares or B shares in the management of their account. In most cases, it is generally agreed that advisors should only use A shares in managed accounts due to the lower annual fees charged by A shares and the fact that most mutual funds offer to waive sales charges for A shares held in managed accounts. Another factor favoring the choice of A shares over B shares in managed accounts is the deferred sales charges on B shares. Since managed accounts often involve frequent re-allocations of the account’s assets, holding B shares in a managed account may ensure that the value of the investor’s account is reduced by the payment of deferred sales charges.

If your financial adviser recommends C shares, walk away, as your financial adviser is putting their financial self-interests ahead of your best interests. C shares are essentially the same mutual fund as A and B shares. The difference is that C shares typically charge investors an annual 12b-1 fee of 1 percent or more.

12b-1 fees are charges that funds typically charge for a financial advisors ongoing serving of an account and for the fund’s marketing services. As a former compliance director, I can personally state that C shares  are nothing more than an attempt by unethical financial advisors by avoid registration as an investment adviser and the strict fiduciary standard impose on investment advisers, namely to always put an investor’s best interests ahead of the financial advisor’s financial interests. Evidence of that is the fact that the 1 percent 12b-1 fee charged by funds is the standard fee charged by investment advisory firms.

10.   Don’t be lulled into a false sense of security by an advisor’s credentials or designations. The number of letters after an advisor’s name does not ensure the skill or the integrity of the advisor. The most widely respected and recognized designation in the financial planning industry is the CFP® designation conferred by the CFP Board of Standards. The CFP® designation signifies that an individual has a certain level of experience in financial planning, has completed an extensive examination, and has complied with continuing education requirements.

Always ask for both Parts I and II, and all schedules, especially Schedule F, of an investment advisor’s Form ADV. Take the time to read the material to find out about the planner’s background and qualifications. Although registered investment advisors are allowed to use a disclosure brochure instead of their Form ADV, insist on the investment advisor’s Form ADV. Most disclosure brochures are nothing more than glorified marketing brochures, while the Form ADV contains the information the investment advisor filed with regulatory officials. Also check the planner’s records at FINRA’s web site (

11.   Get more than one opinion. Medical patients are often advised to get a second opinion on major medical decisions. Decisions affecting one’s financial security are equally important. Unsuitable investment advice can drastically affect one’s life. Unfortunately, some people holding themselves out as financial planners and investment advisors may be more interested in selling insurance and investment products than in the quality of the financial advice they are providing.

12.  Avoid the variable annuity trap. Without question, variable annuities are one of the most over-hyped, most oversold, and least understood investment products. FINRA and the SEC are investigating various complaints regarding the sale of these investment products and have already imposed sanctions in some cases. The high fees and expenses associated with variable annuities, along with their lack of liquidity and their negative tax aspects, make them an unwise investment choice for most investors. Annuities can also have devastating effect on an investor’s estate plan, resulting in most of the investor’s money going to the company issuing the annuity rather than the investor’s heirs and loved ones.

13.  Don’t buy life insurance for investment purposes. A popular mantra among insurance agents is that variable life insurance is the “swiss army knife of financial planning.” Anyone who hears such advice should look for another financial adviser. If an investor needs life insurance, then they should buy life insurance that guarantees the amount of protection they need, which is the intended purpose of insurance.

Life insurance is neither intended for or appropriate for investment purposes. The high fees and expenses associated with insurance are totally inconsistent with one of the basic tenets of investing, namely to minimize loss of principal so as to maximize the amount of money working for the investor. While it is illegal for an insurance agent to misrepresent the nature of an insurance product, recent cases involving the alleged misrepresentation of life insurance as retirement/ investment programs demonstrate the need for investors to get advice from more than one investment advisor to better protect their interests.

© 2016 InvestSense, LLC. All rights reserved.

This article is not designed or 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.

Posted in Absolute Returns, Asset Protection, Closet Index Funds, Common Sense, Investment Advisors, Investment Portfolios, Investor Protection, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Variable Annuities, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , ,

New eBook Now Available

My new eBook, “CommonSense InvestSense: New Strategies for Accumulating and Preserving Wealth,” is now available at

Posted in Common Sense, Investment Advisors, Investment Portfolios, Investor Protection, IRA, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Distribution Planning, Retirement Plan Participants, Retirement Planning, Variable Annuities, Variable Annuity Abuse, Wealth Accumulation, Wealth Distribution, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , ,

Three Return “Secrets” to Improved Investment Performance: Interpreting Investment Returns

A 2007 study by Schwab Institutional estimated that approximately 75 percent of investor accounts they studied were unsuitable as being inconsistent with either an investor’s financial goals or financial needs.  While one might expect widespread denial of the study’s findings, an  Investment News article reported one professional’s response – “we’ve always known it.”(1)

Based on my personal experience, I think the 75 percent number is actually low if one considers factors such as cost-effectiveness and the excessive effective fees charged by “closet index” funds. Once such factors and other similar factors are considered, I believe that the number of unsuitable investment portfolios, including both imprudent investments and investment recommendations, would come closer to 90 percent.

In many cases investors lack the experience and knowledge to properly address the quality of their investments and the investment advice they receive. The purpose of this post is to address three screens that investors can use to evaluate their actual investments and/or investment advice they receive in hopes of better protecting their financial security.

“Relative” vs. “Absolute” Returns
A common marketing ploy is to boast about their actual, or absolute, returns when the stock market is enjoying favorable market conditions. When the stock market is suffering through down periods, mutual fund companies and other investment companies resort to using advertisements comparing their performance to the performance of their competitors, so-called relative performance ads, e.g., “we’re #1 in our category.”

The problem with relative returns is that they potentially allow mutual funds and other investment companies to hide periods of poor performance, poor absolute returns. Even if a fund has a year when it suffers a 20-30 percent loss, it can still run its “we’re #1” ads as long it beat the performance of it competitors.

The simplest way to avoid potentially misleading “relative performance ads” is to make sure to check a mutual fund’s actual performance by researching a fund at one of the free online sites, such as, and

“Closet Index” Funds
Closet index funds, aka market index huggers,are one of the investment industry’s best kept secrets. In addressing the issue of closet index funds, Morningstar stated that

‘Closet indexing’ is the common term used to describe funds that claim to be actively managed but in fact are not sufficiently differentiated from the benchmark to support that claim. There are a few ways to spot funds that mimic their benchmark. Tools such R-squared and tracking error describe a portfolio’s deviation from the benchmark index in statistical terms based on its past returns.(2)

Closet index funds often underperform a comparable true index fund due to the facts that closet index funds often charge annual fees that are 300-400 higher than comparable true index funds. Therefore, from an investor’s perspective, closet indexing is often viewed negatively due to the fact that investors can generally achieve similar, in many cases better returns, simply by choosing an index fund with significantly lower fees.

As the Morningstar quote indicates, one of the most commonly used tools for detecting closet index funds is a fund’s R-squared rating. provides a fund’s R-squared ratings on the fund’s Morningstar report page. (“Funds” tab>”Risks and Ratings”>”MPT Statistics”)

Morningstar defines R-squared as a metric that

measures the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 100….It is simply a measure of the correlation of the portfolio’s returns to the benchmark’s returns.

An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark….Conversely, a low R-squared indicates that very few of the portfolio’s movements can be explained by movements in its benchmark index. An R-squared measure of 35, for example, means that only 35% of the portfolio’s movements can be explained by movements in the benchmark index.

While there is no universally accepted R-squared rating that officially designates a mutual fund as a closet index fund, Morningstar’s position is that a R-squared rating of 100-70 indicates a high correlation of returns between a fund and its applicable market index. From a legal perspective, a R-squared rating of 95-90 is commonly used in classifying a fund as a closet index fund.

To emphasize the negative impact of closet index funds, Professor Ross M. Miller created the Active Expense Ratio. Using a fund’s R-squared rating, Professor Miller found that in most cases the combination  of the higher annual expense ratio of closet index funds, combined with their high R-squared rating, often resulted in an effective annual expense ratio 6-8 times greater than its advertised annual expense ratio. Definitely not in the best interests of investors.

Cost Effectiveness Analysis Using Incremental Costs/Returns
The final screen involves a metric I personally created, the Active Management Value Ratio™ 2.0 (AMVR). The AMVR is actually based on the simple cost/benefit analysis most economics major learn in first-year Econ 101, with a mutual fund’s incremental costs and incremental return being used as the input data.

The AMVR is based on the studies of investment icons Charles D. Ellis and Burton L. Malkiel. Ellis introduced the concept of analyzing mutual funds based on their incremental costs and incremental returns. His argument is that index mutual funds have become, in essence, commodities,  and that the proper way to evaluate any commodity is in terms of their incremental, or added, costs and returns. Malkiel’s contribution to the AMVR is his research finding that the two most reliable indicators of a mutual fund’s future performance are the fund’s annual expense ratio and its trading costs.

By focusing on a fund’s incremental cost and incremental returns, investors can get a better idea of the true value, if any, added by an actively managed mutual fund’s management team. What many investors find is that active management often adds very little, if any, positive returns over and above the returns of a comparable, yet less expensive, passively managed index fund. Furthermore, even when an actively managed mutual fund does provide a positive incremental return, that return is negated by the fact that the actively managed fund’s incremental costs exceed the fund’s positive incremental return.

Calculating an actively managed mutual fund’s incremental returns only requires that the annualized return of a benchmark/index fund is subtracted from the annualized return of the actively managed mutual fund. I prefer to use the funds’ five year annualized returns in order to get at least one period of down or negative returns and, thus,  a better picture of the funds performance patterns. In some cases I will also analyze rolling five-year returns to verify the funds’ historical trends.

In calculating the funds’ incremental returns, I rely on Malkiel’s findings and combine a fund’s stated annual expense ratio with its trading costs. Since mutual funds are not required to disclose their actual trading costs, I use a proxy developed by John Bogle, former chairman of the Vanguard family of funds. Bogle simply doubles a fund’s stated turnover ratio and then multiples that number by 0.60 based on historical data re trading costs. While the trading cost number may not exactly match a fund’s actual trading costs, the application of a uniform factor to get a proxy number is acceptable and helpful in getting a better picture of a fund, as trading costs for an actively managed mutual fund are often higher than a fund’s annual expense ratio and both reduce an investor’s end return.

The calculation process only require a couple of pieces of data, all of which are freely available online at sites such as and As an investor, fiduciary or attorney becomes more familiar with the calculation process, the entire calculation process takes two minutes or less per fund.

As I mentioned earlier, the simplicity of interpreting a fund’s AMVR score in terms of prudence and “best interests” is one of the metric’s strengths. An example will help demonstrate this fact.

Fidelity Contrafund is a well-known actively managed fund whose K shares appear in many 401(k), 457(b) and 403(b) plans . In fact, the fund was the number one fund in the “Pensions and Investments” article. Will Danoff, the fund’s manager has a stellar performance record and is often mentioned as one of the mutual fund industry’s best all-time managers. But does it currently pass the fiduciary prudence and “best interests” test?

Morningstar classifies Fidelity Contrafund K (FCNKX) as a large cap growth fund. For comparative purposes, we will use one of Vanguard’s leading large cap growth funds, the Growth Index fund. Using the same process as before, the analysis shows Contrafund has incremental costs of 86 basis points . Based on the funds’ stated annualized five-year returns, Contrafund does not produce any positive incremental returns (12.80 percent vs. Growth Index’s 13.14 percent) or other benefits to an investor above and beyond those provided by the comparable, and less expensive, index fund.

Contrafund also demonstrates why a fund performance should be evaluated on both its nominal and risk-adjusted returns. Ellis originally suggested that in calculating incremental returns, the risk adjusted returns of funds should be used. If we substitute the two funds’ risk adjusted returns in the calculation process, Contrafund actually produces a positive incremental return of 0.69 percent, or 69 basis points (12.85 percent versus Growth Index’s 12.16 percent). However this would still not allow Contrafund to pass the prudence or “best interests” test since an investor would lose money by investing in the fund since Contrafund’s incremental costs exceed it’s risk-adjusted incremental returns.

A third way of interpreting the cost effectiveness of a fund’s AMVR score is by comparing the percentage of returns produced by a fund to the fund’s incremental costs as a percentage of the fund’s total costs. In the immediate example, the incremental. or added costs, of the actively managed fund equal 87.5 percent of the fund’s cost (1.40/1.60), yet such costs are only adding an additional 1 percent of return. Again, hard to argue that such results indicate a prudent investment that is in the client’s “best interests,” especially given the other findings that indicate that the comparable index fund is a better investment choice.

For further information about the AMVR, click here.

Far too often investors get stuck holding unsuitable investment and investment portfolios simply because they lack the experience and knowledge to detect imprudent investment advice from a stockbroker or other financial adviser. Incredibly enough, the law allows such “professionals” to put their own financial best interests ahead of their customers’ best interests.

In this post we discussed three simple, yet effective screens that investors can use to evaluate the quality of their investments and the investment advice they receive. By incorporating all three screens, investors can better protect their financial security by avoiding unnecessary investment risk and excessive investments fees.

1. Brooke Southall, “Wirehouse accounts don’t match client goals,” InvestmentNews, March 12, 2007, 12.

2. “Watch Out For Closet Index Funds,” available online at

© Copyright 2016 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or 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.

Posted in Absolute Returns, Closet Index Funds, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , ,

Is Your 401(k) or 403(b) Really Protecting Your Best Interests?

Facts do not cease to exist because they are ignored.
Aldous Huxley

I have seen a number of articles recently online and in the trade publication I receive talking about “retirement readiness,”how to better prepare a plan’s participants for a successful retirement. Most of the articles focus on increasing employee participation in a company’s plan, in some cases forcing enrollment through automatic enrollment, and increasing the amount of employee contributions to a plan.

Very few of the articles address the issue of the quality of the plan itself, even in the face of ongoing decisions and multi-million dollar settlements of cases alleging excessive fees and/or imprudent investment options within a plan. The obvious question is whether it is fundamentally unfair to force employees in a fatally flawed 401(k) or 403(b) plan?

The excessive fees cases typically focus on issues such as revenue sharing, with mutual funds in the company’s plan returning some of the money received from 12b-1 fees and other fees to a plan to help pay for a plan’s bookkeeping and other administrative costs. A Wall Street Journal article reported that one organization estimated that a two wage earner family would lose approximately $155,000 over their lifetime to a plan’s fees. While the fees for such services typically vary according to such factors as the size of a plan, most experts have told me that such costs should not be more than approximately more than $35 per plan participant in most cases.

While the excessive fees cases generally target the amount of the bookkeeping and administrative fees themselves,  the impact of 12b-1 fees, and the evidence supporting the justification for the excessive fees, is also a consideration. If a mutual fund within a plan charges an annual 12b-1 fee, the fee is typically 0.25 percent of the total amount invested in the fund. Many people see the small percentage amount and simply dismiss the fee as insignificant, and that’s exactly what the mutual fund wants investors to do. But is it really insignificant?

It is not unusual to see millions of dollars in various investments within a plan. The cumulative impact of an “insignificant” 0.25 percent 12b-1 fee provides a much different picture.  An 0.25 percent 12b-1 fee on a fund with $5 million invested in would produce $12,500 per year for that fund. Multiply that by the number of other funds in a plan charging a 12b-1 fee, and it is easy to see why 12b-1 fees are not insignificant at all.

Pension plan service providers, mutual funds and plan sponsors attempt to justify 12b-1 fees as helping plan participants by avoiding having to make plan participants pay for a plan’s bookkeeping and other administrative costs. Interestingly,very few plans allow the plan participants to decide if they would rather pay their portion of such costs instead of paying 12b-1 fees.

If we assume an annual bookkeeping fee of $35 per participant in a plan with 100 participants, the total cost for the plan would only be $3,500, much less than the $12,500 hit from just the one fund 12b-1 fee. At 100 employees, that $12,500 12b-1 fee would translate into a $125 fee per plan participant, a fee approximately 257 percent higher for the same services.

That’s exactly why you have seen, and will continue to see. the numerous lawsuits against 401(k) plans. The evidence of such abusive practices is so clearly in violation of ERISA’s fiduciary duties that the decision to bring an action is a no-brainer, the proverbial “low hanging fruit” as business schools like to teach.

Bottom line, check the prospectus for each investment option within your 401(k), 403(b) or other pension plan and do the math for yourself. If you and other plan participants find such abusive practices in your 401(k) or 403(b) plan, ask your plan’s sponsor and administrator to eliminate funds charging a 12b-1 fee from the plan and allow plan participants to pay their pro-rate portion of a reasonable annual bookkeeping and administrative fee. A refusal to allow this request could constitute a breach of the plan sponsor’s fiduciary duties of loyalty and prudence.

Another key issue in most of the cases that have been filed against 401(k) plans is the quality. or lack thereof, of the investment options provided by the plans. the primary investment option in most pension plans are mutual funds. In most cases, the lawsuits cite both the fees charged by such funds and the persistent under-performance of such funds.

Historically, most of the mutual funds offered within 401(k) and 403(b) plans were actively managed mutual funds, this despite the fact that history has proven that the overwhelming majority of actively managed equity-based mutual funds have proven to be inefficient in terms of both cost and performance. The most recent Standard & Poor’s SPIVA report stated that in 2015, 74.81 percent of all domestic equity-based mutual funds under-performed the broad-based S&P Composite 1500 Index. The five and ten-year performance of said funds were equally bad, with an under-performance record 88.43 percent and 83.18 percent, respectively. The poor performance record was consistent among individual categories (large cap, mid cap and small cap) as well.

What makes the poor performance record of such plan investments even worse is the fact the actively managed funds typically charge much higher annual fees than passively managed, or index, mutual funds. As Rex Sinquefield, one of the founders of Dimensional Funds, once noted,

We all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it.

Poor performance and costs reduce a mutual fund’s end return to investors. Each additional 1 percent of fees and expenses reduce an investor’s end return by approximately 17 percent. Under-performance is an opportunity cost in that it further reduces the return an investor could have earned in a prudent investment alternative.

I recently performed a forensic analysis of the 403(b), 457(b) and Optional Retirement plans of a major American university. Out of a total of 128 mutual funds, only 16 passed my prudence screen based on their nominal five-year annualized returns. That number shrank to only six when the funds were evaluated on their five-year risk adjusted return.

Those findings are fairly consistent with my findings from other forensics analyses of the investment options offered within 401(k), 403(b) and 457(b) retirement plans. The findings are surprising not only in terms of the high percentage of poor investment options, but also because plan sponsors face unlimited personal liability for any breach of their fiduciary duties under ERISA, including the failure to select and maintain prudent investment options within their plan.

A quick and simple method of evaluating the prudence of the investment options within a plan is to use the Active Management Value Ratio™ 2.0 (AMVR), a metric I created for both my law and investment education practices. The AMVR is the same cost/benefit analysis that many of us learned in our first year Econ 101 class. The only difference is that the AMVR uses an actively managed mutual fund’s incremental cost and incremental return to determine the fund’s cost efficiency. The AMVR only requires a limited amount of data,all of which is available for free online, and takes only a few minutes per fund analyzed. Further information about both the AMVR and the steps required in calculating the metric are available here.

The ongoing trend of cases against 401(k) plans indicates two main things for retirement plan participants. First, a significant number of 401(k) plans and other retirements are not providing plan participants with a meaningful opportunity to become retirement ready, the opportunity to invest in investment options that are efficient both in terms of cost and performance.

Second, since a number of plan sponsors are not taking the proper actions to correct the problems within their plans, it is incumbent on plan participants to learn how to evaluate their plans and to take the time to do so. Fortunately, the AMVR can perform a meaningful analysis of a fund in one or two minutes. When plan participants detect an imprudent investment option or excessive fee in their plan, they should get together and address the situation with their plan’s sponsor. Since plan sponsors face unlimited personal liability for any breaches of their fiduciary duties under ERISA, one would hope that they would be receptive to such requests.

Posted in Common Sense, ERISA, Fiduciary, Investment Advice, Investment Portfolios, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Retirement, Retirement Plan Participants, Retirement Planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , ,