Transparency Is the Best Disinfectant: Four Key Questions Every Investor and 401(k) Plan Participant Should Ask

Sunlight is the best disinfectant. – Justice Louis Brandeis

The ongoing attempts by the Department of Labor (DOL) and Congress to delay or completely reverse the DOL’s fiduciary rule sends a clear message to pension plan sponsors and plan participants – we care more about Wall Street and the overall investment industry than we do about you.

The arguments put forth by Wall Street and the investment industry thus far have been nothing more than self-serving rhetoric and speculation, totally devoid of any legally admissible evidence. And yet, both the DOL and Congress have gone out of their way to agree to any requests for further delays in full implementation of the DOL’s new fiduciary rule.

The DOL recently agreed to delay the effectiveness of the full DOL rule for eighteen months, even though a private foundation estimated that the delay would result in an $11 billion loss to pension plan participants. The DOL agreed to the additional delay even though CEOs for some of the nation’s leading broker-dealers have publicly stated that no delay is necessary, that they were completely prepared for a full and immediate implementation of the DOL’s rule.

So what does this all mean for plans, plan sponsors and plan participants, the primary beneficiaries of the DOL’s fiduciary rule? It means that they need to become more proactive in order to protect their financial security or, in the case of plan fiduciaries, to protect against any unwanted potential personal liability.

In my legal and fiduciary consulting practices, I use five core questions to establish the failure of a meaningful due diligence process by a financial adviser and resulting unsuitable/imprudent advice, in both ERISA and non-ERISA situations. The five core questions that I use in my practices analyze the true nature of the effective returns that investors receive once certain factors are considered. The four factors that I consider in my forensics analyses are: nominal, or stated, annualized returns;  load-adjusted annualized returns; risk-adjusted annualized returns, and potential “closet index” returns, using both Ross Miller’s Active Expense Ratio metric and my Active Management Value Ratio™ 3.0 metric.

Nominal, or Stated, Returns
These are essentially a fund’s absolute returns, based on the difference between a fund’s beginning and ending value over a certain period of time, with no consideration of any other factors. A fund that started the year with a balance of $10,000 and a balance of $10,000 at the end of the year would have earned a return of 10 percent for the year. [(11,000-10,000)/10,000=1,000/10,000, or 10 percent.

Load-Adjusted Returns
The problem with using nominal returns in analyzing a fund’s performance is that it overstates a fund’s effective annualized returns if an investor paid a front-end fee, or load, when they purchased the fund. Front-end loads are immediately subtracted from a fund at the time they are purchased, putting an investor who pays a front-end load behind investors who do not pay a front-end load when they purchase their mutual fund shares.

All things being equal, a front-end load will always cause an investor paying same to lag behind an investor who did not pay any type of load. And the difference in cumulative returns grows larger over time. As a result, mutual funds often use various marketing techniques in an attempt to conceal the negative impact of front-end loads on returns.

Mutual funds are required by law to disclose a fund’s load-adjusted return in a fund’s prospectus. However, it is common knowledge that most investors do not read a fund’s prospectus. One common marketing technique that fund companies use in advertising to hide the negative impact of front-end loads on returns is to use a fund’s nominal returns rather than its lower load-adjusted returns in their ads.

Then, in an attempt to avoid any potential charges of violations of the Exchange Act or the Advisors Act, the fund will ad a footnote, in much smaller print, at the end of the article stating that they did not use the fund’s load-adjusted returns and that, had they done so, the fund’s return numbers would have been lower. They never say how much lower or provide the actual load-adjusted returns numbers. In my opinion, the use of such tactics by a fund or financial adviser is a clear indication of their business ethics and respect for investors, or their complete lack thereof.

Risk Adjusted Returns
Studies have suggested a direct relationship between the level of investment risk assumed and investment return. As the Restatement (Third) Trusts (Restatement) points out, the natural inclination of investors and the duty of investment fiduciaries is to seek the highest level of return for a given level of risk and cost.

The investment industry often downplays the evaluation of a fund’s risk-related returns, with the familiar quote, “investors cannot eat risk-related returns.” However, mutual funds certainly have no problem referencing the number of Morningstar “stars” one of their funds earned if the rating is favorable, even though Morningstar has publicly acknowledged that it bases a fund’s “star” rating on the fund’s relative risk-related returns.

“Closet Index” Returns
“Closet index” funds, also known as “index huggers,” have become an increasing issue with regard to wealth management. Closet indexing refers to situations where a mutual fund holds itself out as an actively managed mutual fund, and charging higher fees for such active management, but whose actual performance closely tracks that of a comparable, but less expensive, index fund. Therefore, such funds are not cost-efficient and violate a fiduciary’s duty of prudence.

One of the best ways to identify a closet index is by using a statistic called R-squared (or R2), which measures the percentage of a fund’s movements that can be explained by fluctuations in a benchmark index. The higher a fund’s R-squared number, the greater the likelihood that the funds can be designated as a closet index fund. R-squared  ratings for funds are available for free on various public internet sites, such as Morningstar, Yahoo!Finance and MarketWatch.

One commonly method commonly used to evaluate a fund’s potential closet index status is to use a fund’s R-squared number to compute a fund’s Active Expense Ratio (AER). A fund’s AER number provides investors and investment fiduciaries with a fund’s effective annual expense ratio given the fund’s reduced active management component. In my practice, I take a fund’s AER and use it in my proprietary metric the Active Management Value Ratio™ 3.o (AMVR). The AMVR allows investors and investment fiduciaries to quantify the cost-efficiency of an actively managed mutual fund.

The impact of such returns on the performance of a fund can be seen in the following example. Capital Group’s American Funds mutual funds are among the most commonly recommended funds to both ERISA and non-ERISA accounts. Financial advisors like the fact that American Funds pay one of the highest commission rates of any fund group, based largely on the 5.75 percent front-end load that American charges non-ERISA accounts. ERISA accounts typically do not charge investors a front-end load on their purchases.

In our example, we will compare the ten-performance of two of American Fund’s most popular funds, Growth Fund of America (retail AGTHX, retirement RGAGX) and Washington Mutual (retail AWSHX, retirement RWMGX) to their comparable fund at Vanguard. Morningstar classifies AGTHX/RGAGX as a large cap growth fund and AWSHX/RWMGX as a large cap value fund. We will use the Vanguard Growth Index Fund and the Vanguard Value Index Fund as benchmarks to evaluate the AGTHX/RGAGX and AWSHX/ RWMGX, respectively. Unless otherwise indicated, the return numbers reflect the ten-year period ending June 30, 2017

AGTHX VIGRX
Nominal 7.24 8.65
Load-Adj 6.93 8.65
Risk-Adj 7.05 8.65
AER 4.19

*AGTHX 10-year cumulative returns – $197,636
*VIGRX 10-year cumulative returns – $229,243

Here, AGTHX lags VIGRX both in terms of nominal and load-adjusted return. AGTHX has a high R-squared number, 93, which results in a significantly higher effective annual expense ratio of 4.19, versus its stated annual expense ratio of 0.66 percent, as compared to VIGRX’s annual expense ratio of 0.18. Based on these numbers, it would be hard to justify AGTHX as a suitable/ prudent investment choice over VIGRX.

A similar comparison on the retirement shares of both funds produces the following results.

RGAGX VIGAX
Nominal 7.54 8.80
Load-Adj 7.54 8.80
Risk-Adj 7.67 8.80
AER 4.07

*RGAGX 10-year cumulative returns – $209,385
*VIGAX 10-year cumulative returns – $232,428

Once again, RGAGX lags VIGAX both in terms of nominal and load-adjusted return. RGAGX has a high R-squared number, 93, which results in a significantly higher effective annual expense ratio of 4.07, versus its stated annual expense ratio of 0.33 percent, as compared to VIGAX’s annual expense ratio of 0.06. Based on these numbers, it would hard to justify RGAGX as a suitable/ prudent investment choice over VIGAX.

It should be noted that when using the AMVR, a fund that fails to provide any incremental return for an investor, or a fund whose incremental costs exceed a fund’s incremental return, is clearly unsuitable and imprudent since an investment in the fund would provide no positive benefit for an investor.

Turning to AWHSX and VIVAX, we find the following results.

 

AWSHX VIVAX
Nominal 6.42 5.69
Load-Adj 5.79 5.69
Risk-Adj 6.48 5.69
AER 4.24

*AWSHX 10-year cumulative returns – $187,361
*VIVAX 10- years cumulative returns – $173,915

Here, AWSHX has a better performance than VIVAX both in terms of nominal and load-adjusted return. AWSHX has a high R-squared number, 97, which results in a significantly higher effective annual expense ratio of 4.24, versus its stated annual expense ratio of 0.58 percent, as compared to VIVAX’s annual expense ratio of 0.18. Even with AWSHX’s higher incremental return (0.79), the incremental costs (4.06), based on AWSHX’s AER number, greatly exceeds AWSHX’s incremental return. Based on these numbers, it would hard to justify AWSHX as a suitable/ prudent investment choice over VIVAX.

Finally, a comparison of the retirement shares for each fund produces the following results.

RWMGX VVIAX
Nominal 6.68 5.83
Load-Adj 6.68 5.83
Risk-Adj 7.46 5.83
AER 1.76

*RWMGX 10-year cumulative returns – $205,337
*VVIAX 10-year cumulative returns – $176,233

RWMGX clearly has significantly higher returns than VVIAX. WMGX has a high R-squared number, 97, which results in a higher effective annual expense ratio of 1.76, versus its stated annual expense ratio of 0.30 percent, as compared to VVIAX’s annual expense ratio of 0.06. RWMGX’s higher incremental return (1.63) exceeds its  incremental costs (1.48). Based on these numbers, RWMGX could be considered a suitable and prudent investment choice for the period analyzed.

Conclusion
Based upon my experience, far too many investors and investment fiduciaries simply take a quick glance at a fund’s nominal return numbers and a fund’s standard deviation and make their decisions based on those numbers alone. Those numbers, alone, simply do not constitute an acceptable due diligence process or a meaningful analysis of a mutual fund.

Based upon my experience, four definite patterns emerge in analyzing mutual funds:

(1) All things being equal, no-load funds typically outperform funds that charge a front-end load and/or excessively high annual expense ratios, especially over the long-term. A front-end load simply puts an investor in a position that is difficult to overcome over the long-term.

(2) Actively managed mutual funds often have lower standard deviation numbers that index funds, showing one potential benefit of active management. However, the difference in standard deviation numbers is rarely enough to make up for the impact of a front-end load.

(3) Both fiduciary and non-fiduciary investors should look for cost efficient funds, funds whose incremental returns exceed a fund’s incremental costs, in order to maximize the benefit of compound returns. Losses, whether due to poor returns and/or excessive costs, deny an investor the benefits of compounds returns.

(4) Closet index funds are never cost-efficient, and therefore are never suitable or prudent investments. Funds with a high R-squared number and/or high incremental cost relative to a comparable index fund should always be avoided, as they are typically the prime candidates for closet index status.

It really is that simple. Investors and fiduciaries should always ask their financial advisors the four questions discussed herein. If an advisor cannot or will not supply all such information, it should raise a red flag as to the professionalism of your advisor, or lack thereof, and how he determined that the advice he has provided to you is suitable and prudent for you – based on your best interests or on the compensation he could receive.

When it comes to the question of suitability/prudence of actively managed mutual funds, the Restatement (Third) Trusts provides investors and investment fiduciaries with a simple test which incorporates the forensic standards discussed herein. After noting the additional costs and risks generally associated with actively managed funds, the Restatement simply states that

These added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves decisions by the trustee that gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…

I would strongly suggest the use of the four questions by both plan fiduciaries and plan participants, in fact investors in general, as the cornerstone of their own due diligence process. .  The questions can provide the transparency needed to properly evaluate a plan’s available investment options

As noted ERISA attorney Fred Reish likes to say, forewarned is forearmed.

Posted in Best Interests, Closet Index Funds, Common Sense, Consumer Protection, Consumer Rights, DOL fiduciary rule, ERISA, Fiduciary, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Retirement, Retirement Plan Participants, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , ,

Wealth Preservation and Retirement Accounts

When I tell people that I am a wealth preservation attorney, they often respond by saying that they do not have enough money to need such services. Then I ask them whether they have a 401(k) account, an IRA or some other type of retirement account. At that point we usually find a place to sit and discuss various wealth preservation issues that people overlook, issues that often reduce the effectiveness of such plans.

“Retirement readiness” is a popular buzzword today in the financial planning and 401(k) industries. Unfortunately, the increased attention to the subject has also highlighted some of the common problems that are preventing people from accumulating sufficient assets in their retirement accounts to achieve the level of “retirement readiness” they desire or need for their retirement.

Two of the wealth preservation concerns associated with retirement plans include investment options/selections with a plan and poor management of the account. Unfortunately, numerous legal action involving 401(k) plans has shown that the investment options with such plans are often less than optimal due to cost efficiency issues such as excessive fees and consistently poor performance.

Cost Efficiency Analysis
I created a metric a couple of years ago, the Active Management Value Ratio™ 3.0 (AMVR), that allows investors and investment fiduciaries such as 401(k) plan sponsors to easily evaluate the cost efficiency of a mutual fund. Anyone who can perform simple math calculations such as addition, subtraction, multiplication and division can use the AMVR. For more information about the AMVR, click here.

Another quick method of analyzing mutual funds in a pension plan is to check the fund’s R-squared rating. R-squared is a statistic that indicates to what extent a mutual fund tracks an appropriate stock market index or investment. Funds with a high R-squared rating are often referred to as “closet index” funds.

“Closet index” funds present a serious wealth preservation problem since they provide essentially the same performance of an index fund, but charge fees that are often 300-400 percent higher than those charged by a regular index fund. Avoiding unnecessary investment fees is crucial to working toward “retirement readiness” since each additional 1 percent in investment fees reduces an investor’s end return by 17 percent over a period of twenty years.

While there is no universally accepted threshold R-squared rating to designate a “closet index” fund, InvestSense uses a R-squared rating of 90 as an indication of “closet index” status. An R-squared rating of 90 would indicate that 90 percent of the fund’s performance is attributable to the performance of an appropriate stock market index instead of the fund’s management team. Other entities and analysts, including mutual fund analyst Morningstar, use lower R-squared ratings. Mutual fund R-squared ratings are available for free at several online investment sites such as morningstar.com. marketwatch.com, and the fund family’s web site.

Excessive fees are even more inequitable when a mutual fund consistently under-performs a less expensive index fund. InvestSense recommends that investors and fiduciaries analyze a fund’s historical performance over both a five and ten year period to assess both the fund’s absolute performance and consistency of performance. Funds are legally required to provide this information in their prospectuses. Morningstar also provides such information on its web site under their “Performance” tab.

Retirement Account Management
Another common wealth preservation issue involving retirement accounts has to do with proper management of the account, specifically with regard to risk management. Many “advisers” preach a buy-and-hold approach to investing, with the warning that you cannot “time” the market.

There are several problems with the “buy-forget-and regret” approach to investing.  As the Restatement (Third) Trust and investment icons such as Benjamin Graham and Charles Ellis have pointed out, risk management is the real key to successful investing.

One of the integral concepts of investment risk management is the avoidance of significant, and unnecessary, losses. Legendary investor Warren Buffett has two well-known rulesRule

Rule No. 1 – Never lose money.
Rule No. 2 – Never forget Rule No. 1.

History has proven that the stock market is cyclical, alternating between “bull” and “bear” markets. To ignore such evidence and fail to proactively manage their retirement accounts in such as way as to avoid significant losses simply makes no sense, especially since making changes in investments within a tax-deferred retirement account has no adverse tax consequences.

People often object to such an approach to investing, quoting the familiar mantra that “you cannot time the market,” and I totally agree. However, the classic definition of “market timing” is an all-or-nothing approach to investing, shifting assets so that an investor is either 100 percent in the stock market or 100 percent in cash. The folly, and danger, of such an approach to investing is obvious in terms of both risk and cost.

In his classic, “The Intelligent Investor,” Ben Graham advocated creating an initial investment portfolio divided equally between stocks and bonds. He then suggested reallocating the portfolio when market conditions or the economy suggested such a reallocation, but always maintaining no less than 25 percent in both stocks and bond and never more than 75 percent in either asset class. History has shown the wisdom in following such a simple, practical and prudent approach to investing.

I always find it interesting when strict buy-and-holders criticize a proactive approach to risk management such as Graham’s model portfolio as market timing. These are usually the same people who are proponents of rebalancing a portfolio to restore the portfolio’s original allocations based on a perception that market conditions justify the reallocations. An investor would surely not shift assets out of a successful sector in order to fund a sector not expected to perform as well…would they? If, as many strict buy-and-holders suggest, any reallocation or changes in an investment portfolio constitutes “timing,” then re-balancing would technically be “timing” as well.

Rather than dispute the merits of labels, wealth preservation properly focuses on using a sound, practical and proactive approach to risk management.  Simply put, principal lost in a market downturn cannot fully participate in the market’s recovery. Since an investor will have less money than before the market downturn, they will have to achieve a higher rate return during the market’s recovery than the percentage los they sustained, as shown below:

  • 11% return required to recover from a 10% loss
  • 25% return required to recover from a 20% loss
  • 42% return required to recover from a 30% loss
  • 67% return required to recover from a 40% loss
  • 100% return required to recover from a 50% loss.

Bottom line, you can never get ahead if you have to spend all of your time catching up!

Conclusion 
Contrary to popular belief, wealth preservation is not simply for high net worth individuals. Wealth preservation can provide valuable benefits by protecting and maximizing the value of retirement accounts such as 401(k) accounts and IRAs, including inherited 401(k) and IRAs. Wealth preservation strategies can also help investors create and maintain effective retirement accounts toward increased accumulation within such accounts.

Posted in Best Interests, Closet Index Funds, Consumer Protection, Estate Planning, Integrated Estate Planning, Investment Portfolios, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , ,

The New DOL Fiduciary Rule – Effective June 9, 2017

On June 9, 2017, the Department of Labor’s (DOL) new fiduciary rule (Rule), or at least parts of same, go into effect for retirement plans covered by the Employees’ Retirement Income Security Act, commonly known as ERISA.

The Rule was originally drafted to address perceived abusive marketing tactics that the investment industry was using in connection with advising retirement plans, such as 401(k) plans, and participants in such plans. One particular area that the Rule sought to address was the provision of advice to plan participants as they were retiring. In many cases, retiring workers will take their 401(k) funds and transfer them to an individual retirement account (IRA). These transfers from 401(k) plans to an IRA are commonly referred to as “rollovers.”

A common ploy by the investment industry was to try to convince retirees to take their retirement funds and put them into a variable annuity (VA). Salesmen would tout the fact that VAs allow an owner to benefit from tax-deferred investing.

What such salesmen would not tell customers is that IRAs also offer tax-deferred investing, often at a much lower cost. Many VAs charge minimum cumulative fees of around 2.5-3 percent a year, representing both the VA’s annual fees and the annual fees of the investment subaccounts Given the fact that each additional 1 percent of fees reduces an investor’s end return by approximately 17 percent a year over a twenty year period, an investor would be looking at a minimum loss of between 42-51 percent of their investment returns in the VA. Even more egregious is the fact that a landmark study by Moshe Milevsky found that in most cases, the VA issuer was charging an annual fee that was generally 10-15 times what it was worth to the VA owner.

So why would a financial adviser recommend such a product that was clearly not in the best interests of most investors? Financial advisers often earn substantial commissions on sales of VAs, often as much as 7 percent. Find a retiree with a nice nest egg, say $500,000, sell them a VA, and earn a commission of $35,000 on one sale. Forget the fact that the product will result in a substantial loss of end returns for the investor.

So that explains the “why” behind the Rule. The Rule was intended to promote fair treatment of pension plans and plan participants. In large part, the Rule was intended to address the inherent conflict of interests involved when a financial adviser recommends and sells investment products for a commission.

So what is the Rule’s “what”?

The Rule as passed basically has two sets of rules for anyone advising and making investment recommendations to pension plans and pension plan participants. The first set of rules require that as of June 9, 2017, anyone advising plans and plan participants will be held to a fiduciary standard and must adhere to the new so-called “Impartial Conduct Standards.” (Standards)

Stockbrokers and insurance agents would often argue that they were only selling products to pension plans and plan participants, not providing advice, so they were legally allowed to put their own financial best interests ahead of those of a plan or a plan participant. (FYI – that is still the applicable rule with many stockbrokers and insurance agents.)

That “dodge” will no longer work, at least when a financial adviser is working with an ERISA-covered pension plan or plan participant. All such financial advisers are now deemed “fiduciaries’ and must adhere to the Standards. There are three Standards:

  • The Best Interest Standard – The Best Interest standard is a combination of ERISA’s prudent man rule and a fiduciary’s duty of undivided loyalty. ERISA’s prudent man rule states that a fiduciary must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims…”
  • Reasonable compensation – The Reasonable Compensation standard requires a financial adviser to only offer pension plans and plan participants services and investment products that are reasonable in terms of market prices and the inherent value of the services and products being provided and recommended.
  • Misleading statements – The Misleading Statements standard prohibits a financial adviser from making materially misleading statements about the fees, investments, and any potential or actual material conflicts of interest regarding either their advice and/or product recommendations or other matters that would be material to the investment decision.

So, as of June 9, 2017, any financial adviser advising and making recommendations to plans, participants and IRAs must comply with all three of the Standards and always act in the plan’s or plan participants best interests. The investment industry knows that some, perhaps many; of their investment products do not currently and cannot meet these high standards. Some broker-dealers are totally prohibiting their financial advisers from advising plans, plan participants and IRAs. Some broker-dealers are restricting the advice and products that their financial advisers can use. Other investment firms are modifying their compensation programs when plan, plan participants and IRAs are involved.

Some investment firms are not making any significant changes in their approach to offering investment advice to IRAs. Those firms have made the decision to attempt to rely on one of applicable exemptions to the Rule, commonly known as the Best Interest Contract exemption, aka “BICE.” BICE is the second part of the Rule.

The BICE requirement does not apply to financial advisers who provide advice on a level-fee basis, e.g., hourly or monthly fees or based on the value of assets under management, since those types of compensation do not create the same sort of potential conflicts of interest issues that commissions and other types of variable compensation create.

Financial advisers and financial institutions that wish to receive variable compensation in connection with advising plan participants on IRAs and IRA rollovers must comply with all of the BICE requirements or face substantial fines and other severe penalties. Most of BICE’s requirement are disclosure oriented so that plans and plan participants are provided with “sufficient information to make informed decisions,” as guaranteed by ERISA.

At this, I am not going to go through all of the BICE requirements since the decision was made not to require the BICE contract and the various disclosures until 2018. However, as of June 9, 2017, the Impartial Conduct Standards will apply to any advice provided to plan participants regarding the use of IRAs and IRA rollovers as investment options, including product recommendations. Consequently, the protections afforded under the fiduciary “best interest” standard will go into effect on June 9, 2017 to cover advice and recommendations with regard to IRAs and IRA rollovers.

As mentioned earlier, one of the primary abusive marketing/sales tactics used by the investment industry was to convince retirees and the elderly to put their retirement funds in a variable annuity or its equally undesirable cousin, the fixed indexed annuity, aka equity indexed annuity. For a complete discussion about these products and how to decipher the various marketing spiels used in trying to sell them, please read my white paper, “Variable Annuities: Reading Between the Marketing Lines,” by clicking here.

For pension plans and plan participants that want to check-up on the prudence and overall quality of their plan’s investment options, my metric, the Active Management Value Ratio™ (AMVR) provides plan sponsors and plan participants with a quick and simple way to determine the cost efficiency of their plan’s investment options. For more information about the AMVR, click here.

Conclusion
The new DOL fiduciary rule is somewhat complicated, but a much needed law to address the abusive marketing tactics that the investment and insurance industries were using in connection with advising pension plan, plan participants and IRAs. It was estimated that such strategies were costing America’s pension plans and retirees in excess of $17 million dollars a year.

Although the need for the new rule is clear, the rule still faces challenges, as the new Secretary of the Department of Labor has already indicated his desire to “freeze” the Rule in its entirety, this

  • even before the study requested by the Trump administration has even been completed;
  • in direct opposition to Mr. Trump’s campaign problems to help protect the people; and
  • despite the fact that the investment industry and other opponents of the rule have put forth only rhetoric and speculation, neither of which will be admissible if the battle over the rule goes to court.

Many American workers depend heavily on their 401(k)/403(b) accounts to provide for their retirement income. The DOL’s new fiduciary rule does not prevent financial advisers and financial institutions from continuing to make money by advising pension plans and plan participants. The rule simply seeks to create a fair win-win situation by requiring financial advisers and their companies to always put a plan’s and plan participant’s best financial interest ahead of their own.

© 2017 InvestSense, LLC. All rights reserved.

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.

Posted in Best Interests, Common Sense, Consumer Protection, Consumer Rights, DOL fiduciary rule, Equity Indexed Annuities, ERISA, Fixed Indexed Annuities, Investment Advice, Investment Portfolios, Investor Protection, IRA, pension plans, portfolio planning, Retirement, Retirement Plan Participants, Retirement Planning, Variable Annuities, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , ,

The Investor Revolution: A “Best Interests” Checklist for Investors and Fiduciaries

The DOL recently announced that it will not seek to delay the effective date of the department’s new fiduciary law. Beginning June 9, 2017, anyone providing advice to pension plans and plan participants will be deemed to be a fiduciary, which means that the adviser must always act in the plan’s/participant’s best interests.

Registered investment advisers are already held to the fiduciary standard’s “best interests” standard. Stockbrokers and other financial advisers will often argue that they are not held to the fiduciary standard’s “best interests” requirement, but rather the less stringent “suitability” standard. However the releases of FINRA, the primary body regulating stockbrokers and broker-dealers, suggest otherwise, stating that

In interpreting FINRA’s suitability rule, numerous cases explicitly state that ‘a broker’s recommendations must be consistent with his customers’ best interests. The suitability requirement that a  broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests.(1)

Regulatory enforcement decisions have further established a broker’s obligation to always act in a customer’s best interests, stating that a broker violates the suitability rule “when he puts his own self-interest ahead of the interests of his customers.”(2)

All of these “best interests” rules and regulations are nice, but how does an investor know that their financial adviser is actually complying with such rules and regulations. As a securities and ERISA attorney, I can tell you that in too many cases financial advisers are not meeting  their “best interests” obligations to their customers, both individual investors and pension plan sponsors.

Recently, I was asked by a 401(k) to forensic analysis of the investments in their defined contribution plan. An example using two of the mutual funds in their plan will hopefully point out the challenges investors and plan sponsors face in assessing the prudence of an .actively managed mutual fund.

The two actively managed mutual funds in this example are two funds commonly found in investment portfolios and pension plans, such as 401(k) plans: Fidelity Contrafund (retail (A) shares – FCNTX; Retirement (K) shares – FCNKX), and American Funds Growth Fund of America (Retail (A) shares – AGTHX, Investor (R-6) shares – RGAGX). Both of these fund are classified as large cap growth funds by Morningstar, so I will use the Vanguard Growth Index fund as my benchmark in this analysis – Retail shares VIGRX, retirement/institutional shares – VIGIX).

Retail Share Analysis

Nominal Load Adj. Risk Adj
Return Return Return
5 & 10 5 & 10 5 & 10
AGTHX 13.70 & 7.62 12.37 & 6.99 11.02 & 4.33
FCNTX 12.48 & 8.77 12.48 & 8.77 11.32 & 6.46
VIGRX 12.76 & 8.85 12.76 & 8.85 11.28 & 6.09

In short, what I did was take the funds’ nominal (reported) returns. I then adjusted for any front-end loads imposed on an investor’s investment since the load immediately reduces the amount of money, and return dollars, in an investor’s account. Finally, I adjusted for risk in the fund, using the fund’s standard deviation. The risk adjusted returns are based on a fund’s load adjusted returns. I used a fund’s five/ten-year annualized returns and five/ten-year standard deviation numbers in these calculations to reduce the possibility of any skew in the statistics.

The data clearly indicates the impact of front-end loads, as American Fund’s Growth Fund of America has the worst returns of the three funds. The Restatement (Third) Trusts clearly states that being cost efficient is one of a fiduciary’s duties. Therefore, the next step in my analysis is to use the funds’ risk adjusted returns to calculate the cost efficiency of the funds using my proprietary metric, the Active Management Value Ratio™ 2.0 (AMVR).

Incremental Incremental
Costs Return AMVR
5 & 10 5 & 10 5 & 10
AGTHX .85 NA (IR<0) NA
FCNTX  .99 .04 & .37 NA (IC>IR)
VIGRX NA (Bmrk) NA (Bmrk) NA (Bmrk)

Since AGTHX failed to outperform the benchmark, it does not qualify for an AMVR rating since it would have resulted in a financial loss for an investor relative to the less expensive benchmark. While FCNTX did produce positive incremental returns, it does not not qualify for an AMVR rating since the fund’s incremental costs exceeded such incremental returns, resulting in a net loss for an investor.

The AMVR also allows investors and fiduciaries to evaluate the cost efficiency of an actively managed mutual fund from other perspectives. For instance, using AGTHX and FCNTX, the AMVR allows us to see that 100% of AGTHX’s annual fees and costs are being wasted, as the fund did not produce any benefit for an investor, i.e., any positive incremental return, for either the five or ten-year returns.

FCNTX did produce a positive incremental return for both the five and ten-year period. However, given the fund’s total costs using the AMVR (117 basis points, or 1.17%), and fund’s incremental costs (99 basis points), 84% of the fund’s total annual costs were producing less than 1 percent of the fund’s five-year annualized returns and only 5 percent of the fund’s ten-year annualized returns. Hardly cost efficient.

These figures are hardly surprising. In fact, a study by Robert Arnott, Andrew Berkin, and Jia Ye concluded that only 4 percent of actively managed mutual funds beat the Vanguard S&P 500 Index Fund (VFINX) on an after-tax basis. Of that 4 percent, the average annual margin of outperformance was only o.6 percent, while those funds that failed to outperform VFINX did so by a “wealth destroying” 4.8 percent annually.(3)

The final step in my forensic analysis is to address the potential “closet  index” issue for both AGTHX and FCNTX. “Closet index,” also known as “index hugger,” funds are actively managed mutual funds that closely track a market index or an index fund that track an index, yet charge investors significantly higher fees than comparable index funds.

To evaluate a fund’s “closet index” factor, I re-calculate the funds’ AMVR scores using Ross Miller’s Active Expense Ratio (AER) metric. The AER uses a fund’s R-squared number to calculate the effective expense ratio for an actively managed fund. AGTHX’s 5/10 AER scores were 1.83 and 2.83, respectively, FCNTX’s 5/10 AER scores were 1.51 and 2.70, respectively. Since the AER scores greatly exceed the incremental returns produced by both funds, they would be cost inefficient and do not qualify for an AMVR score.

Retirement Share Analysis

Nominal Risk Adj.
Return Return
5 & 10 5 & 10
RGAGX 14.08 & 7.91 12.81 & 5.24
FCNKX 12.60 & 8.88 11.44 & 6.57
VIGIX 12.93 & 9.03 11.56 & 6.26

Notice that there is not column for load adjusted returns for the retirement shares Due to the provisions of the Employees’ Retirement Income Security Act (ERISA), retirement shares classes should not impose a front-end load on investors. Investors share classes are allowed to imposes so-called 12b-1 fees on investors. Such fees are required to be disclosed in a fund’s prospectus. Investors should note if a fund imposes 12b-1 fees and generally reject such funds since any fee reduces an investors end-returns.

Again, the next step is to calculate the funds’ AMVR score based on their risk adjusted return.

Incremental Incremental
Costs Return AMVR
5 & 10 5 & 10 5 & 10
RGAGX .52 1.25 & NA .32 & NA
FCNKX .97 NA & .31 NA/(IC>IR)
VIGIX NA NA NA

Using RGAGX and FCNKX, the AMVR shows that 100% of RGAGX”s annual fees and costs are being wasted with regard to the fund’s ten-year annual return, as the fund did not produce any benefit for an investor, i.e., any positive incremental return, during that period. The five-year annualized return resulted in a very respectable AMVR score of .42 due to the combination of the fund’s high incremental return and low incremental costs. However, from another cost efficiency perspective, 34 percent of the fund’s annual fees and costs were only producing approximately 9.75 percent of the fund’s five-year annualized return.

FCNKX did not produce a positive incremental return for the fund’s five-year return, so the fees and costs for that period were totally wasted. FCNKX did produce a positive incremental ten-year return However, the fund did not qualify for an AMVR score since its incremental costs were approximately three times the fund’s incremental return. given the fund’s total costs and fund’s incremental costs, 84% of the fund’s total annual costs were producing approximately 4.7 percent of the fund’s ten-year annualized return. Hardly cost efficient.

Again, for the final step I re-calculate the funds’ AMVR scores using Ross Miller’s Active Expense Ratio (AER) metric. RGAGX’s 5/10 AER scores were 1.93 and 2.41, respectively, FCNKX’s 5/10 AER scores were 2.96 and 3.46, respectively. Since the AER scores greatly exceed the incremental returns produced by both funds, they would be cost inefficient and do not qualify for an AMVR score.

Conclusion
Investors and investment fiduciaries, such as 401(k) and other pension plan sponsors are often misled by mutual fund ads, which usually reports their funds’ returns based on the funds’ nominal returns. Such data may not provide a meaningful picture since nominal returns fail to factor in the impact of such issues as front-end loads, cost efficiency and potential “closet index” issues. As shown herein, such issues can reveal the true character of an actively managed fund, exposing the fund as an imprudent investment choice for an investor or pension plan.

Stockbrokers and investment advisers are legally required to perform a due diligence analysis on an investment prior to recommending the investment to anyone in order to ensure that the investment is appropriate and in best interest of their clients. Sadly, my experience as a litigator has shown that if a due diligence analysis is done at all, it is usually cursory at best, if done at all. When I produce my analysis, the usual response is the proverbial “deer in the headlights” look.

I’m not saying my approach is the only acceptable method of analysis. However, my analysis does address legally accepted and legitimate issues with regard to the quality of investment advice. Therefore, I routinely suggest to investors, pension plan sponsors and other investment fiduciaries that they ask their financial advisers if they have considered such issues in making their recommendations and if so, would they provide then with a copy of their findings. If the financial adviser indicates that they have not considered such factors, are not legally required to do so, and unwilling to do so for you, I would keep looking for a financial adviser more dedicated to better protecting your financial security and protecting you against unwanted personal liability,

Notes
1. FINRA Regulatory Notice 12-25.
2. Scott Epstein, Exchange Act Release 59328, 2009 LEXIS 217, at *42.
3. Robert Arnott, Andrew Berkin, and Jia Ye, 2000, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Journal of Portfolio Management, vol. 26, no. 4 (Summer):84–93.

© 2017 The Watkins Law Firm. All rights reserved.

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.

Posted in Best Interests, Closet Index Funds, Common Sense, Consumer Protection, Consumer Rights, DOL fiduciary rule, ERISA, Fiduciary, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , ,

Controlling the Controllable: Factoring Investment Costs Into the Prudence/Suitability Equation

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

In an earlier post, I discussed the benefits of controlling the controllable aspects of investing. Investors cannot control the performance of the markets. Investment fiduciaries are not held liable for the eventual performance of the markets. However, investors and investment fiduciaries can control certain elements of investing that play a significant role in determining an investor’s and/or pension plan participant’s success.

Costs associated with an investment are a key factor in determining whether an investment is a prudent and/or suitable choice. The Securities and Exchange Commission has consistently warned investors about the need to look beyond a mutual fund’s past performance numbers and to factor in a fund’s costs when selecting mutual  funds.1 A mutual fund’s annual expense ratio is an obvious cost that an investor should consider. However other less discussed, or “hidden,” costs are equally important and should always be considered in selecting investments.

American Funds’ Growth Fund of America and Fidelity Investments’ Contrafund are two popular mutual funds, both in terms of retail shares and retirement shares. Both funds are classified by Morningstar as large cap growth funds. Vanguard’s Growth Index Investors (retail)/Institutional (retirement) funds will serve as the benchmark fund in this analysis since it is also classified as a large cap growth fund.

Two cost-related metrics that allow investors and investment fiduciaries, such as 401(k) plan sponsors, to evaluate the cost efficiency of mutual funds are the Active Management Value Ratio (AMVR) and Professor Ross Miller’s Active Ratio (AER).

The AMVR
The AMVR is a metric created by InvestSense, LLC.  The AMVR is essentially the same simple cost/benefit metric that students learn in every Econ 101 class. The AMVR compares an actively managed mutual fund to a comparable passively managed/index fund. The AMVR then uses the actively managed fund’s incremental cost and incremental return, if any, as the variables in the calculation process.

In interpreting a fund’s AMVR score, the Optimum Wealth Zone is between zero and one. An AMVR score less than zero would indicate that the actively managed fund underperformed its relative benchmark, and thus provided no positive incremental return for an investor. An AMVR score greater than one would indicate that while the actively managed fund in question did provide a positive incremental return, the fund’s incremental costs exceeded such return, resulting in a loss for an investor or plan participant.

Retail Share Analysis
Analyzing the retail shares of the three mutual funds, based on the five-year annualized performance and cost data as of 12-31-2016, neither Growth Fund of America (AGTHX) nor Contrafund (FCNTX) provided any positive incremental return. Growth Fund of America’s nominal return would have provided an incremental return of +1.13 over Vanguard Growth Index Investor. However, since Growth Fund of America charges investors a front-end load of 5.75%, which is immediately deducted from an investor’s investment, the proper performance number to use in evaluating the fund is its load-adjusted return. Growth Fund of America’s load adjusted return underperformed the benchmark. Since both funds underperformed the relevant benchmark, neither fund would be considered a prudent or a suitable investment since an investor would have lost money.

Retirement Share Analysis
Analyzing the retirement shares of the three mutual funds, based on the five-year annualized performance and cost data as of 12-31-2016, Growth Fund of America’s R-6 shares (RGAGX, the least expensive of the fund’s six R share classes) produced a positive incremental return of +1.52. However, Contrafund’s K shares (FCNKX) failed to provide any positive incremental return. It should be noted that mutual fund companies do not charge front-end loads on retirement shares, as it would create violations of ERISA’s rules and regulations.

Since Growth Fund of America’s R-6 shares did produce a positive incremental return, the next step in the AMVR analysis is to compare the costs of the fund to the costs of the benchmark fund. Based on the studies of well-respected experts such as Burton Malkiel and Mark Carhart2, the AMVR combines a fund’s annual expense ratio and John Bogle’s trading cost metric3 in calculating a fund’s total costs. The total costs on Growth Fund of America’s R-6 shares was 1.03 basis points (a basis point equals .01 percent), while the benchmarks total costs were only 31 basis points. Since Growth Fund of America’s total costs exceeded those of the benchmark. Growth Fund would not be a prudent or a suitable investment since an investor would have lost money.

The AER
“Closet index”, or “index hugger,” funds are mutual funds that hold themselves out as actively managed funds, but are funds, in truth, that provide similar returns as passively managed index funds, albeit at significantly higher annual fees/costs. Using an actively managed fund’s R-squared rating, Professor Ross Miller of SUNY-Albany created a metric that allows investors and investment fiduciaries to calculate the effective annual expense ratio investors pay given the reduced contribution of active management. A fund’s R-squared number estimates the correlation of performance between a fund and a relative market index.

Calculating the AER scores for both the retail and retirement share previously mentioned, again based on the five-year annualized performance and cost data as of 12-31-2016, resulted in an AER fee of 2.98 for the Growth Fund of America shares and an AER fee of 2.90 for Contrafund.

AER Adjusted AMVR Analysis
In performing my forensic analyses, I then go back and recalculate a fund’s AMVR score using the fund’s effective AER fee as an actively managed fund’s incremental costs. I add this extra step to address the ongoing “closet index” issue. Contrafund can be eliminated based solely on its failure to produce any positive incremental return for an investor. However, both funds would be considered imprudent and unsuitable investments using their AER numbers, since the AER numbers for both funds exceeds the incremental returns numbers both funds.

Conclusion
In assessing the prudence of a fiduciary’s investment decisions, the courts often turn to the Restatement (Third) Trusts. The Restatement and the Securities and Exchange commission have both cautioned investors and investment fiduciaries that evaluating investment based solely on the investment’s past performance is not enough, that factors such as an investment’s associated costs should be considered in determining whether the investment is a prudent investment option.4

The AMVR and the AER are two simple, yet effective, metrics that allow investors and investment fiduciaries to determine the cost efficiency of actively managed mutual funds. By identifying and avoiding mutual funds that are not cost efficient, an investor and/or investment fiduciary can better protect their financial security and avoid potential personal liability issues.

Notes

1. Securities and Exchange Commission, “Mutual Fund Investing: Look at More Than a Fund’s Past Performance,”(SEC Report), available online at http://www.sec.gov/Consumer/mfperf.htm.
2. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460; Mark M. Carhart, “On Persistence in Mutual Fund Performance,” The Journal of Finance, Vol. 52, Issue No. 1 (March 1997), 57-82.
3. John Bogle’s metric for calculating an estimate of a fund’s trading costs is [2 x fund’s stated annual turnover] x 0.60.
4. SEC Report; Restatement (Third) Trusts, Section 90 cmt h(2) and cmt m.

Appendix A
The following performance and cost information was used in performing the calculations referenced herein

Growth Fund Of America:
Five-Year Annualized Return: Retail-13.68 (load-adjusted); Retirement-15.42
Costs: Retail-Expense Ratio-0.66; Turnover-31%
Costs: Retirement-Expense Ratio-.33; Turnover-31%
Five-Year R-squared rating-88 (for both retail and retirement shares)

Contrafund:
Five-Year Annualized Return: Retail-13.46; Retirement-13.58
Costs: Retail-Expense Ratio-0.68; Turnover-41%
Costs: Retirement-Expense Ratio-.58; Turnover-41%
Five-Year R-squared rating-85 (for both retail and retirement shares)

Growth Index Investors (retail)/Institutional (retirement) Fund:
Five-Year Annualized Return: Retail-13.90; Retirement-14.06
Costs: Retail-Expense Ratio-0.18; Turnover-11%
Costs: Retirement-Expense Ratio-.07; Turnover-11%

© 2017 InvestSense, LLC. All rights reserved.

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.

Posted in Asset Protection, Closet Index Funds, Fiduciary, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , ,

Investor Alert: Variable Annuities and Fixed Indexed Annuities

The Department of Labor announced the other day that it was delaying the effectiveness of certain part of their new fiduciary rule for 60 days. This delay was essentially requested by the Trump administration in order to evaluate the fairness of the DOL’s new fiduciary rule, a rule which simply requires that any financial adviser that provided advice to pension plans, such as 401(k) and 403(b), always act and provide investment advice that is in the customer’s/client’s best interests. While that does not seem to be particularly onerous or unfair, the investment industry thinks otherwise.

There are those, myself included, that believe that major reason for the investment/ financial services objection to the DOL’s fiduciary rule is that it effectively prevents them from recommending that retirees invest in variable annuities, which are often labeled as inherent unfair due to excessive fees, fees which can easily reduce an investor’s end return by over 50 percent. And guess who gets that 50 percent or more taken from variable annuities investors? The insurance company that sold the variable annuity to the investor.

There is a saying in the financial services industry – “annuities are sold, not bought.” And there are various reasons besides the excessive fees why the statement is true. Variable annuity salesmen and variable annuity ads often try to lure investors to purchase a variable annuity for the tax deferred growth it offers. But IRAs offer tax-deferred growth at a much lower cost.

Another tactic used by variable annuity salesmen, insurance companies and variable annuity ads is the “guaranteed lifetime income” and “you’ll never run out of money” spiels. What they do not explain is that to receive that guaranteed lifetime income, the owner of the variable annuity has to give up control of the money in the variable annuity to the insurance company that sold the investor the variable annuity.

Once the variable annuity owner opts to exercise the lifetime income guarantee, known as “annuitizing” the variable annuity, the variable annuity owner’s control over the money in the variable is gone forever. Even if the variable annuity owner were to die the day after annuitizing the variable annuity, the balance in the variable annuity belongs to the insurance company. That is why estate planning attorneys will tell clients that variable annuities can destroy their estate plans, as the funds that were going to help carry out the plan’s goals and wishes will be gone if the variable annuity owner annuitized the variable annuity.

As investors have learned about the issues with variable annuities, insurance companies and the financial services industrys have shifted their sales efforts to fixed indexed annuities. The marketing spiel here is that rather than the low-interest rates on regular fixed annuities and CD’s, the fixed indexed annuity provides investors with the opportunity to earn the higher returns of the stock market, as measured by a stock market index such as the S&P 500.

What the salesmen and insurance companies that peddle these investments do not explain is that fixed indexed annuities usually contain various restrictions that severely restrict an owner’s ability to receive much more than 7-8 percent a year, regardless of the stock market’s actual performance. While it is true that most fixed indexed annuities contain provisions that prevent the owner from ever suffering a loss if the market is down, there is a cost for such guarantees.

The newly announced delay in the DOL’s fiduciary rule also relaxed the rule requiring that those peddling variable annuities and fixed indexed annuities had to disclose any and all conflicts of interest they may have in selling such products, such as the significant commissions they receive from selling such products, usually in the range of 6-7 percent, sometimes even higher. Guess who’s actually paying for that commission? Right.

First, you have the annual fees charged by insurance companies in connection with such products. Say you eventually realize how bad the product actually is and to get out of, or surrender, the product. The insurance companies impose back-end fees, or surrender charges, if you try to get out of the product before they have recovered the cost of those commissions.

Some insurance companies use sliding scale surrender charges that are reduced each year, usually be 1 percent a year. The most common period for such sliding scale surrender charges is seven years. Other insurance companies charge the same surrender fee over a term of years. I have actually seen annuities with a consistent surrender charge over a term of 15 years!

If you currently own, or are considering purchasing, a variable annuity or fixed indexed annuity, sometimes referred to equity indexed annuities, please read our white paper, “Variable Annuities-Reading Between the Marketing Lines”, available here.

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 Asset Protection, Consumer Protection, Consumer Rights, Equity Indexed Annuities, Estate Planning, Fiduciary, Fixed Indexed Annuities, Investment Advice, Investment Advisors, Investor Protection, IRA, pension plans, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Variable Annuities, Variable Annuity Abuse, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , , ,

3 Key (But Often Overlooked) Mutual Fund Return Statistics

Anyone who knows me knows that the minute I see a “Top” or “Best” list with regards to financial advisers or investments, I immediately want to do a detailed forensic analysis to substantiate or disprove such claims. As a plaintiff’s securities/ERISA, my attention is always drawn to the criteria that was used, or not used, in awarding such designations.

With financial advisers, the first question I always have is a simple one – did a financial adviser have to pay anything to be considered for the list. If so, that list has no value in my opinion due to the obvious conflict of interest issues with any “pay-to-play” requirement. No matter how much the creator of the list may claim such payment had no impact on the decision regarding inclusion on the list, such claims ring hollow, otherwise why have the payment requirement at all.

With financial advisers, a second often used, but questionable/debatable factor, is the amount of the adviser’s assets under management (AUM). The rationale often given for considering an adviser’s AUM is that it shows the return that an adviser has produced for his clients. Not quite. If AUM says anything, it demonstrates how effective an adviser is marketing their practice since AUM includes money brought in by new accounts. A new multi-million dollar account (or two) definitely impacts AUM, but proves nothing with regard to an investment adviser’s money management skills. Far too often I see investment advisers placing a client’s money in actively managed mutual funds with excessive fees and/or a history of consistent underperformance relative to a comparable, yet less expensive, index fund. This leads to our first often overlooked, yet key, mutual fund static.

Load-Adjusted Returns

With investments, the decision is often based on criteria such as annualized return. Nothing wrong with using annualized return as a criteria for evaluation as long as the proper annualized return numbers are being used. Far too often, “top/best” list creators, as well as investors, plan sponsors and other investment fiduciaries, are not using the proper annualized return numbers, and they up with invalid evaluations.

Index funds do not charge a fee just to invest in their funds. Actively managed mutual funds do charge investors such a fee, commonly referred to as front-end load, just to invest in their funds. Some actively managed mutual funds offer other types of potential fees, such as back-end loads, that may or may not apply depending on whether an investor withdraws all or part of their investment in the fund prior to a specified period of time.

Funds that charge a front-end load immediately reduce an investor’s investment in the fund as soon as they make their investment. Consequently, an investor in such as fund starts in a hole, as they will always earn less than in investor investing the same initial amount in an index fund earning the same annualized return over the life of the investment.

Most investors and investment fiduciaries are not aware of the potential impact of a front-end load on a fund’s performance. Mutual fund ads for actively managed funds typically reference annualized returns that have not been adjusted for the impact of the fund’s front-end load in order for their performance to appear to be competitive with comparable, less expensive, index funds. Actively managed mutual funds are required to disclose their load-adjusted returns annually in their fund’s prospectus and summary prospectus. But, how many investor’s actually read either of these documents or calculate the difference in monetary returns? Exactly.

I recently read a post on LinkedIn from the CEO of one of the largest mutual fund companies in America. His company’s funds are typically named as among the most popular funds, in both pension and non-pension accounts. In his post, he was naturally extolling the value of his fund and historical performance.

But his retail funds charge one of the highest fees charged in the industry. As a result, I have to wonder whether he was basing his remarks on the funds’ load-adjusted or non-adjusted annualized returns. For example, his most popular retail fund reported 5-year unadjusted and load adjusted returns of 15.03% and 13.68%, respectively, over the period 2012-2016. Based on an initial investment of $100,000, this would have resulted in an ending balance for the investor of $201,398 to 189,854, respectively, over that time period.

Over that same period, an investment in a comparable large cap growth no-load fund, the Vanguard Growth Index Investor fund, had a 5-year annualized return of 13.90%, for a ending balance of $191,698. Over that same period, an investment in the Vanguard S&P 500 Investor fund, would have resulted in a ending balance of $196,715.

Over 10-year period 2007-2016, that same fund reported unadjusted and load-adjusted annualized returns of 6.94% and 6.31%, respectively. Based on an initial investment of $100,000, this would have resulted in an ending balance over that period of $195,614 and  $184,391, respectively

Over that same 10-year period, an investment in a comparable large cap growth no-load fund, the Vanguard Growth Index Investor fund, had a 10-year annualized return of 7.99%, for an ending balance of $215,692. Over that same period, an investment in the Vanguard S&P 500 Investor fund, with an 10-year annualized return of 6.82%, would have resulted in a ending balance of $193,430.

I apologize for all the numbers, but I know some readers use them to verify my arguments and in their personal practices. At least that’s what I have been told.

So, the first key statistic that investors and investment fiduciaries should look for is an actively managed fund’s annualized load adjusted return. As I mentioned earlier, mutual funds that charge front-end sales charges are required to report the fund’s load-adjusted returns for both the most recent 5 and 10-year periods. Most mutual fund update their prospectus around the middle of the year. Load adjusted returns can also be found by searching under such terms as “VFINX (for Vanguard’s S&P 500 fund) 2016 5-year load adjusted returns.”

R-squared

The second often over-looked key statistic for a mutual fund is the fund’s R-Squared number. R-squared has been defined as a “measurement of how closely a portfolio’s performance correlates with the performance of a benchmark index, such as the S&P 500, and thus a measurement of what portion of its performance can be explained by the performance of the overall market or index” instead of actively managed fund’s management team.

An actively managed fund’s R-squared number is often used to determine whether the fund qualifies as a “closet index,” fund, or an “index hugger.” A closet index fund is a fund that charges investor’s a relatively high annual expense fee, but essentially tracks the performance of a comparable, yet much less expensive, index fund. Actively managed funds started employing this strategy in order to avoid significant variances in performance which could result in their investors leaving for a comparable index fund.

While there is no universally accepted R-squared that denotes a closet index fund, most people use 90 or 95 as the line of demarcation, although others even use lower R-squared numbers. An R-squared number of 90, it can be argued, indicates that active management is only contributing to 10 percent of the fund’s performance, resulting in investors severely overpaying for the fund’s active management component.

A fund’s R-squared number is available at Morningstar’s web site (morningstar.com) on the fund’s page under the “Ratings and Risk” and “MPT Statistics” tabs.

The Active Expense Ratio

This over payment for an actively managed fund’s active contribution leads us to the third often overlooked key statistic for a mutual fund – the fund’s effective annual expense ratio, also known as the fund’s Active Expense Ratio (AER). The Active Expense Ratio metric was created by Professor Ross Miller as a means of measuring the extent to which investors are potentially overpaying for the limited contribution of an actively managed fund’s management team. Using an actively managed mutual fund’s R-Squared number and the incremental, or additional, cost of the actively managed fund’s expense ratio, Professor Miller found in many cases, actively managed funds are effectively charging their investors annual expense ratios significantly higher than the fund’s stated annual expense ratio, in most cases fees 3-4 times the fund’s stated rate, in some cases even higher.

The actively managed fund that I have using as an example has a stated annual expense ratio of 0.66 percent and a 5-year R-squared of 88.85. Once again, using the Vanguard Growth Index Investor fund as our benchmark, result in an AER of 1.91, approximately three times the fund’s stated annual expense ratio. Using the fund’s 10-year R-squared of 93.38 results in an AER of 2.57, approximately four times the fund’s stated annual expense ratio.

For more information about the Annual Expense Ratio and the calculation process, click here.

Conclusion

Costs obviously matter, as they reduce an investor’s end return. Each additional 1 percent in a fund’s fees and expenses reduces an investor’s end return. Over twenty years, each additional 1 percent in fees and expenses reduces an investor’s end return by approximately 17 percent. A fund’s R-squared number and its AER can provide valuable information to help investors and investment fiduciaries improve the performance of their portfolios by avoiding unnecessary expenses to create and maintain cost efficient investment portfolios.

An actively managed mutual fund’s load adjusted annualized return its R-squared and the three pieces of data required to calculate the fund’s Active Expense Ratio are all freely available online. Those willing to invest a little time in gathering such information and making the evaluations should be rewarded with greater financial security and the peace of mind that brings, as well as the ability to spot the bogus “top” and “best” investment lists.

 

Posted in Absolute Returns, Asset Protection, Closet Index Funds, Common Sense, Consumer Protection, ERISA, Fiduciary, Investment Advice, Investment Advisors, Investment Fraud, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Wealth Accumulation, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , ,