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 , , , , , , , , , , , , , , , , ,

Four Things Every Investor and Fiduciary Should Remember-2016

The abundance of investment products and investment information available today can be intimidating and confusing to many investors, both novice and professional. Without question, the most common questions I get from people are how to properly manage their investment portfolios and/or how to evaluate financial advisers.

Over my twenty-plus years as an attorney and investment adviser, I have tried to help others focus on some of the critical information in order to avoid unnecessary investment losses, to help level the playing field against some of the ne’er-do-well that continue to defraud the public and plague the financial services industry.

I started thinking about some of the “inside” information I have shared with my clients that produced the most reaction and appreciation.  In hindsight, I think four core facts/numbers/principles have stood out the most to me and my clients.

1. “75″ – The number “75″ is actually important for two reasons.  First, a study by Schwab Institutional found that approximately 75% of investor portfolios were poorly structured and unsuitable for their investors given the investors’ financial needs and goals.  I believe that this is primarily a result of the fact that (1) stockbrokers are not required to act in a client’s best interests, and (2) investors are often mislead by portfolios that appear to be diversified because they hold a number of different types of investments, but such portfolios are often not truly, effectively diversified.

The second reason that the number “75″ is important is because research and history have shown that approximately three out of four , or 75%, of stocks follow the general trend of the market.  So, bottom line, it is hard not to make in a bull market. This simply supports the popular Wall Street adage, “[don’t] confuse brains with a bull market.”

2. “94″ – While there are many firms and individuals in the financial services industry calling themselves wealth managers, a study by CEG Worldwide, a well-respected financial services consulting firm, concluded that 94% of those calling themselves wealth managers or claiming to provide wealth management services failed to meet the criteria used to qualify as wealth managers.  The criteria that CEG used in their study to determine true wealth management was based primarily on advisers who practiced wealth management as a process as compared to those who simply used “wealth management” as a marketing ploy to push product.  This is the same criteria that investors and fiduciaries should use in choosing a financial advisor to work with.

Secondly, one expert has suggested that this number (OK, actually 93.6, which rounded off is 94), and the study that produced it may have caused more damage to investors than any other number/study.  The number comes from the famous 1986 Brinson, Hood and Beebower (BHB) study that stated that 93.6% of the variation of a portfolio’s returns could be explained by the portfolio’s asset allocation.

The study did not say that asset allocation explained 93.6% of the portfolio’s actual returns, but rather the variation of the portfolio’s returns.  Nevertheless, dishonest brokers and advisers misrepresented, and still do misrepresent,  the BHB study’s findings to convince investors to choose an asset allocation and rigidly adhere to it, despite the proven cyclical nature of the markets.  This is the mantra of the” buy and hold” approach to investing, an approach that some have suggested is better described as the “buy, hold and regret” approach to investing.  Just ask investors how well that worked during the 2000-2002 and 2008 bear markets.

3. Zero – This number represents the number of variable annuities (VA) and equity indexed annuities (EIA) an investor should own.  As a former compliance officer and a current securities attorney I have heard all the convoluted and conniving justifications for these atrocities.  I have written posts and articles warning investors about these products.  While there may be a few limited instances where they may make sense, such as wealth preservation for high net worth investors, the way they are marketed to the masses is extremely questionable.

One Wall Street Journal article reported that variable annuity salesmen were told to treat potential annuity clients as “blind twelve-year-old,” and to “put a pitchfork in their chests,” and provide questionable responses to potential client’s questions.  VA salesmen and VA advertisements often tout that by purchasing a VA the investor will never run out of money.

What is often not made clear that in order to guarantee that lifetime stream of money, you give up all rights to the money invested in the VA.  Once you annuitize your VA, the balance goes to the insurance company once you die, not to your heirs.  In most cases the insurance company offers various choices for payout, such as joint survivor and a guaranteed period, but these options generally result in lower periodic payouts and, in  some cases, additional fees.

One of the most onerous aspects of VAs is the excessive fees that most VAs charge, especially with regard to the so-called death benefit.  VAs typically guarantee that in the event the VA owner dies without having annuitized the VA, the owner’s heirs will receive either the accumulated value of the VA at the time of the owner’s death or the amount of the owner’s actual investment in the VA, whichever is greater.  So the VA issuer is only insuring the amount that the VA owner actually puts in the VA.

Meanwhile, the insurance company assesses the VA’s annual death benefit fee not on the basis of their actual legal obligation, which is the amount of the VA owner’s actual investment, but rather on the accumulated value of the VA.  One study estimated that the actual expense of the annual was approximately 0.10-0.12, but that the insurance companies often charged approximately 1.50%, or approximately fifteen times the estimated value, resulting in a nice windfall for the insurance company.  The additional fee also cost a VA investor by reducing this investment return.

EIAs are also problematic.  EIAs are generally sold with the pitch that investors can earn the same return that the stock market does, with the guarantee that even if the market is down, the EIA investor is guaranteed a minimum return.  What many investors are told is that the potential return is usually capped at a relatively low number, say 10%, and then  is reduced even more by a “participation rate,” usually an additional 2-3% reduction.  In short, the EIA investor is looking at annual rate of between 2-7%.  If the market is up 20% or more for the year, just who is getting the benefit of the excess over the investor’s return?

4. “Portfolio management is-and always should be-a defensive process.” – Charles Ellis

As people who follow me know, I am a devoted fan of Charles D. Ellis. In my opinion, his book, “Wining the Loser’s Game,” is the best book on investing and should be required reading for every investor.

Far too many investors and financial advisers spend their time chasing investment returns. As we discussed earlier, three out of four stocks follow the general trend of the market. So the market will take care of the upside. Investors, fiduciaries and investment professional should spend more time implementing strategies to that will provide downside when the inevitable market corrections and bear markets occur. Yet few do.

When I speak to groups of investors I always reinforce the value of defensive investing by ask pose the standard 50% loss/50% gain question to them – if my $10,000 portfolio loses 50% in year 1, followed by a 50% gain in year 2, what is the value of my portfolio at the end of year 2? Invariably, there will be those that say the value of the portfolio is zero (50-50). The correct is answer is obviously $7,500, since the 50% return in year 2 was only the $5,000 value as a result of the 50% loss in year 1. (Note: For those interested , the formula for calculating the amount of return needed to recover from a loss is [(1/1-percentage of loss)-1] times 100.)

Many stockbrokers and other financial advisers try to discount such losses by blaming the markets and claiming that everyone is also losing money, that simply is not, and should not be true, at least not to the same extent as those who failed to implement effective defensive strategies in constructing and managing their investment portfolios. Whether the chosen strategy is as simple as proper diversification and/or rebalancing, or a little more advanced strategy such as the use of protective puts and/or inverse index funds, there are effective wealth preservation strategies that can help provide the downside protection that all investors need to reduce potential investment losses.

Investment losses are not only costly in terms of the actual loss sustained, but they also constitute an opportunity cost since once the market does recover, the capital lost during the downturn in the market cannot fully participate in the new gains in the market since it must help recover from the previous loss. As I tell [people, “you’ll never get ahead if you have to spend all of your time catching up.”

In my practice, I believe that adopting a defensive approach to wealth management includes preventing losses due to unnecessary fees and costs since they also reduce an investor’s end return . By focusing on investments that are cost-efficient, an investor can attempt to maximize the benefits of compound returns on their portfolio.

I created the Active Management Value Ratio™ 2.0 (AMVR) to provide investors, attorneys, financial advisers and other financial professional with a simple means of evaluating the prudence of actively managed mutual funds. Despite their poor historical performance records against passively managed, or index, funds and the facts their fees and other costs are often 300-400 higher than index funds, approximately 80 percent of all money invested in U.S. mutual funds is invested in actively managed mutual funds.

The AMVR is based on studies by investment icons Charles Ellis and Burton Malkiel. As Ellis points out in “Winning the Loser’s Game,”

Index funds reliably produce a “commodity product” that reliably delivers the market rate of return with no more than market risk….When a commodity product is widely available, the real cost of any alternative is the incremental cost as a percentage of the incremental value. So, rational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index.1

[T]he incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fee for a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high – on average, over 100 percent incremental returns!2

That’s right: All the value added – plus more – goes to the manager, and there’s nothing left over for the investors who put up all the money and took all the risks.

In computing a fund’s incremental costs, the AMVR uses both a fund’s stated expense ratio and a calculation of the fund’s trading costs. While many investment formulas factor in a mutual fund’s expense ratio, I have never seen a formula that includes a fund’s trading costs in the evaluations process.

One of the reasons for this oversight may be the fact that mutual funds are not legally required to report their actual trading costs. However, trading costs are a legitimate issue, as they do reduce a fund’s bottom line and, consequently an investor’s end return. Furthermore, as noted by investment icon Burton Malkiel in his classic, “A Random Walk Down Wall Street,”

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting the future performance [of mutual funds] are expense ratios and turnover.

The process for calculating the AMVR for an actively managed mutual fund is straightforward and only requires the ability to add, subtract and divide.The data needed to perform the calculation is available online for free at such site as,,and

A fund’s AMVR score is calculated by dividing a fund’s incremental, or additional, costs by the fund’s incremental, or additional, returns. If a fund fails to provide any positive incremental returns above and beyond those of a less costly index fund, then the fund is obviously not a prudent investment option. Likewise, if a fund does provide a positive incremental return, but the fund’s incremental costs exceed such incremental return, then the fund is obviously not a prudent investment since an investor would actually lose money on the investment. A more detailed description of the AMVR and the calculation process is available here.

The AMVR also provides a means for investors to evaluate the quality of advice that they are receiving from their financial advisers. Investors should perform their own AMVR calculations on the investments being recommended to them or that are actually in their investment portfolios and immediately question any recommendations that fail to produce an acceptable AMVR score. Investors in 401(k), 403(b) or similar pension plans should calculate the AMVR score for each investment option in their plan and question any investment option with an unacceptable AMVR result.

So that’s my approach to successful wealth management in a nutshell. I do use some additional screens in analyzing investment portfolios, but the AMVR has proven to be very effective as a first step in eliminating imprudent investments. Investors and fiduciaries that use the AMVR and remember the principles and numbers discussed in this article should be in a better position to protect both their financial security and/or their clients’ financial  security.

© 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 Fiduciary, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, portfolio planning, Portfolio Planning, Retirement Planning, Variable Annuities, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , ,

James W. Watkins, III, quoted in new 401(k) article

I was recently quoted in an article addressing best practices of leading 401(k) plans. The article raises a number of relevant issues regarding providing a meaningful plan to help plan participants accomplish their financial goals.

The article, “Is your 401(k) helping or hurting your retirement savings,” is available at the MarketWatch web site:

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

The Coming Storm: Fundamental Retirement Fairness for Educators

In the world of pension investments, TIAA-CREF is generally acknowledged as the “600 pound gorilla,” at least with regard to universities and other higher education institutions. So I was somewhat surprised when a colleague sent me an article, written by university educators, raising questions about TIAA-CREF and asked me to read it.

if all TIAA-CREF participants were restricted to only TIAA-CREF over a forty-year time horizon, out estimate of the terminal wealth loss is between $700 billion and $4.2 trillion, depending on the mix of investor sophistication level.

access to a set of equity indexes in addition to the TIAA-CREF menu would have increased the value of terminal wealth by more than 100%.

Numbers like that obviously gets an ERISA attorney’s attention. My colleague asked me if I would perform a forensic fiduciary prudence analysis on the 403(b), 457(b) and Optional Retirement Plan (ORP) investment options for a major Southern university, focusing on three of the vendors in such plans: TIAA-CREF, Valic, and Fidelity Investments. The plight of educators with regard to pension options is well documented. Even so, the findings of my forensic fiduciary prudence analysis surprised me.

The ORP is an retirement savings option that has been gaining in popularity on universities and other higher education institutions. Unlike the traditional defined benefit retirement plan, the OPR is a defined contribution plan that theoretically gives educators and other plan participants the option to have greater control over their account, and, hopefully, the opportunity for greater returns.

I focused my forensic fiduciary prudence analysis on the core equity-based investment options for each of the three plans, a total of 86 mutual funds. I did not analyze any variable annuities offered by the three vendors, as the inequitable and high fees charged by such investments basically resulting in such investments being imprudent on their face.

While I performed a comprehensive forensic analysis of the 86 funds, I wanted to focus on one of my proprietary metrics, the Active Management Value Ratio 2.0™ (AMVR), a simple cost/benefit metric, due to its simple nature and easy to understand calculations. I calculated both a simple AMVR and an adjusted AMVR, which factored in a fund’s R-squared rating and the potential impact of a fund’s “closet index” status.

The forensic analysis showed that only 18 of the 86 funds would pass the simple AMVR screen, with only 2 of the 18 being able to pass the adjusted AMVR screen as well. Of the 18 passing the AMVR screen, 4 would have been subject to disqualification based on fiduciary issues such as 12b-1 fees and questionable share classes.

So why do I bother to mention these findings? Because plaintiffs’ attorneys are going to devoting even more attention to the area of pension plans, including 403(b) and 457(b) plans. In 2007 the IRS implemented new rules for 403(b) and 457(b) plans, arguably making more of such plans subjects to the fiduciary requirements of ERISA. Even if such plans are not subject to ERISA, the plans should be subject to potential liability for breach of fiduciary duties under both federal and state common law, particularly under principles of trust and common law.

The issues involving the fundamental fairness of educator-based retirement plans have been well documented. It was not until the LaRue decision in 2008 that the Supreme Court recognized the fundamental difference between defined benefit and defined contribution plans, thus allowing for better protection of employee’s retirement financial security.There is no justifiable reason for  not allowing educators, at all levels, to not have the same rights to protect their retirement financial security by recognizing a similar right to redress similar breaches of fiduciary duties by universities and the investment committees that chose the investment options available within 403(b), 457(b) and ORP plans.

Expect to see the plaintiffs’ bar actively seek to obtain these basic and fundamental investment rights for educators at all levels. Just since last week, when news of my study leaked out, I have received over a dozen request for additional forensic fiduciary prudence analyses on other universities and state university systems.

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