The “Secret” Morningstar

I love Morningstar. It is my primary research source. I enjoy the posts of their columnists. But unlike most investors who use Morningstar, I basically ignore their legendary “star” system. Morningstar itself has told investors that their star system is not intended to be used for predictions of future performance. Various studies  have examined the sustainability of a mutual fund’s “stars” rating and found an overall pattern of lack of sustainability.

No, I love the “secret” side of Morningstar, the wealth of valuable information that allows me to evaluate other aspects of a fund, factors that have been shown to provide a meaningful evaluation of a fund’s value. Financial publications like to publish “best of” or “top” list at the end of one year or the beginning of a new year. In most cases, the lists are based on a fund’s nominal, or simple/stated, returns.

The problem with nominal returns is they can often be misleading. For example, actively managed funds often impose a front-end load, or sales charge. The front-end load is immediately deducted every time an investor invests in the fund. The maximum front-end load currently allowed by law is 5.75 percent. That means if you purchase $100,000 of a fund, the amount you will have to invest will only be $94,250.

As a result, the investor who invests in a fund that charges a front-end load will always lag the performance of an investor who purchases a no-load fund, assuming similar performance between the two funds. The odds of similar returns is increasing as many actively managed funds are posting high R-squared, or correlation of returns, numbers.

Funds that essentially track comparable market indices and/or comparable index funds, are referred to as “closet index” funds or “index huggers.” The problem with closet indexing is that investors usually obtain the same, in many cases lower, returns that they could have obtained on a no-load fund, but at a significantly high cost. That is why funds are legally required to provide investors with their load adjusted returns. The impact of front-end loads reducing investor returns even worse over time due to the impact of annual compounding.

Investors should also compare funds’ risk-adjusted returns. A basic principle is that investment returns are a function of risk assumed. Funds are not legally required to publish their risk-adjusted returns, and there are many methods used to calculate risk-adjusted returns. Many investors are unaware that Morningstar publishes a statistic that incorporates both a fund’s risk-related return and tax-efficiency score. It is available under the “Tax” tab on a fund’s Morningstar main page.

“Secret” Morningstar also provides me with valuable information that I use in evaluating a fund’s cost-efficiency. While mutual funds proclaiming to be #1 in performance are common, how many investors have ever seen a mutual fund ad claiming to be #1 in cost-efficiency. Don’t expect to see one anytime soon, as studies have shown that very few actively managed funds are even close to being cost-efficient. In fact, studies consistently find that very few actively managed mutual funds even manage to cover their costs.

As a securities/ERISA attorney, I rely on the Restatement (Third) Trusts for the applicable standards to determine applicable legal compliance for investment fiduciaries, specifically Section 90, otherwise known as the Prudent Investor Rule (PIR). Three key provisions of the PIR are:

  • comment b, which states that fiduciaries must be cost conscious,
  • comment f, which states that fiduciaries must seek either the highest return for a given level of cost and risk, or conversely, the lowest level of cost and risk for a given level of return, and
  • comment h(2), which states that an actively managed mutual funds that is not cost-efficient is an imprudent investment.

Re-read the last bullet point. Now combine that with the previous note that studies have consistently shown that very few actively managed mutual funds are cost-efficient. Funds that are not cost-efficient means that investors effectively suffer a new investment loss. Now take that information and review those “best of” and “top” articles again.

Far too many investors lose money unnecessarily by only evaluating funds based on their nominal, or stated, returns. I refer to my law practice as focusing on wealth preservation. As well-known Scottish proverb states

make as much money as you can, and keep as much as you can. That’s the secret of getting rich.

That is why I created the Actively Managed Value Ratio™ (AMVR). The AMVR is free on various parts of this site and allows investors, investment fiduciaries and attorneys to quickly evaluate the cost-efficiency of an actively managed mutual fund using the same “secret” Morningstar data that I use in my law practice. In other words, the AMVR can help you maximize your investment returns and protect that wealth.

Gura math a theid leat! (“Good luck”)

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Posted in Active Management Value Ratio, AMVR, Asset Protection, Closet Index Funds, Common Sense, Consumer Protection, Fiduciary, Fiduciary Standard, Investment Advice, Investment Advisors, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , ,

Are Your 401(k) Plan’s Mutual Funds Legally Prudent?

“You get what you don’t pay for.” – John Bogle

Full Disclosure and Total Transparency: I am an attorney. More specifically, I am a wealth preservation attorney and a plaintiff’s securities/ERISA attorney. I primarily offer forensic litigation and consulting services to individuals, trial attorneys and entities such as trusts, estates and pension plans.

The goal of this post is to level the playing field, provide you with some information and a worksheet to help you better evaluate your investment choices, whether in a private investment account or a 401(k) plan or other form of pension plan. For some reason ERISA, the major legislation covering most private retirement plans, does not require that employers provide employees in their pension plans with meaningful investment education programs.

I recently did an interview with Robin Powell of the “The Evidence Based Investor.” Robin is a well-known and well-respected journalist in the U.K. who is leading the movement for evidence-based investing. In the article, I told the story of an American CEO who suggested to me that the reason pension plans do not voluntarily provide meaningful educational programs for workers is that then the workers would realize how bad most pensions plans are and would possibly sue their employers.

I believe that investors have a right to be treated fairly by being provided with a win-win situation, both in private investment accounts and pension plans. There is currently an ongoing debate about whether employees should be required to enroll in their company’s pension plans. In my opinion, that would be a significant, and costly, mistake for employers unless, and until, they ensure that their pension plan is compliant with ERISA and equitable to plan participants. Currently, I would argue that most are neither.

When I work with securities/ERISA attorneys, I explain my four-point investment fiduciary liability system:

  1. The Supreme Court has stated that the Restatement (Third) of Trusts (Restatement) is a valuable resource in resolving fiduciary issues, especially involving ERISA questions.
  2. Section 90 of ERISA (aka the Prudent Investor Rule), comment b, states that fiduciaries have a duty to be cost-conscious.
  3. Section 90 of ERISA, comment f, states that in selecting investments for pension plans and other accounts, fiduciaries have a duty to choose investment that provide the highest level of return for a given level of costs and risks or, conversely, the lowest level of costs and risks for a given level of return.
  4. Section 90 of ERISA, comment h(2). states that fiduciaries should not choose or recommend actively managed mutual funds unless it is “realistic” to assume that such funds will produce sufficient returns to cover the extra costs and risk commonly associated with such funds, i..e., such funds are cost-efficient.

And there is the rub, the investment industry’s “dirty little secret.” Investment ads and  mutual fund companies love to tout investment return numbers. However, even the numbers they tout are often “highly suspect.” Ads touting “we’re #1” or “we’re the best” are common, based on nominal return numbers. How many investment ads have you ever seen touting “we’re the most cost-efficient fund?” Care to guess for the reason for the absence of such ads? The overwhelming majority of actively-managed funds are simply not cost-efficient.

My focus on cost-efficiency is a direct result of the research of investment notables, including icons Charles D. Ellis and Burton G. Malkiel.

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of 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% of incremental returns.1

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.”2

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover.3

“there is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4

With that information in mind, I created a simple metric, the Active Management Value Ratio™ 3.0 (AMVR), that allows investors, investment fiduciaries and attorneys to determine whether an actively managed mutual fund is cost-efficient, and therefore compliant with the standards set out in the Prudent Investor Rule. It is usually about this time that stockbrokers point out that they are not required to adhere to fiduciary standards, to put a customer’s financial interest ahead of their own. That’s not always true though. And as I tell people, even if it is not currently legally required that stockbrokers only recommend and use prudent investments in your accounts to protect your financial security, you can still make that a requirement in order to handle your accounts in order to protect your financial security? Your money, your rules.

This is a snapshot of a AMVR analysis between the retail version of a leading actively managed large-cap growth fund, AGTHX, and a comparable Vanguard retail large-cap growth fund, VIGRX.


Incremental Return Analysis
The actively-managed fund actually outperforms the Vanguard fund based on nominal, or stated, return. However, the actively-managed fund imposes a front-end load/fee of 5.75 percent on purchases of retail shares, which is immediately deducted from an investor’s account. As a result, an investor will never receive the stated nominal fee since their account has less money to benefit from the fund’s future returns. In this case, an investor would have received a five-year annualized return of only 14.11 percent over the period from October 1, 2013 to September 29, 2018, not the stated nominal return of 15.47 percent over that same period. Note: All return numbers stated herein will cover the same period.) You get what you don’t pay for!

A common saying in the investment world is that returns are a function of risk. There-fore, in order to get a more accurate evaluation of a fund, the fund’s returns need to be adjusted for the level of risk the fund assumed in achieving the indicated returns. In my practice, I use Morningstar’s risk-adjusted return methodology.

Stockbrokers and mutual funds will often argue that “investors cannot eat risk-adjusted returns.” I find that argument interesting for two reasons. First, it is not unusual for actively-managed funds returns to improve on a risk-adjusted basis. Second, stockbrokers and mutual fund companies have no reluctance to tout a good “star” rating from Morningstar in their marketing programs. Perhaps they are unaware that Morningstar is on record as stating that their “star” system is based largely on a fund’s risk-adjusted returns.

However, here the actively-managed fund under-performs the Vanguard fund on both a load-adjusted and risk-adjusted basis. As a result, the actively managed fund is imprudent based on returns alone when compared to the Vanguard fund.

Incremental Return Analysis
When an actively-managed fund fails to provide a positive incremental return, there is obviously no reason to perform an incremental cost analysis. Investors invest to make money, not underperform another comparable fund.However, I want to do one for the sake of example.

Simple, straightforward math. “My, Dear, Aunt, Sally” from our elementary school math days._All of the information needed to complete an AMVR analysis is available for free online at sites such as morningstar.com, marketwatch.com, and yahoo.com. I like to add trading costs into the AMVR analysis based on Malkiel’s findings, However, an AMVR analysis is still valid without adding a fund’s trading costs.

In this example, the nominal incremental cost between the two funds is 67 basis points (0.67). (Note: A basis point is 1/100th (.01) of one percent.) That means that the actively-managed fund’s incremental, or excess, costs constitutes 71 percent of the fund’s total costs, with the investor receiving absolutely no positive return for such costs. Investors need to remember that each additional 1 percent in fees and costs reduces an investor’s end-return by approximately 17 percent over 20 years. That loss would also need to be adjusted on a percentage basis based on the investment’s overall percentage within the investor’s total portfolio.

Closet Indexing
Closet indexing is a serious problem in investment industries around the world. Closet indexing refers to situations where an actively-managed fund claims that it offers actively-managed funds and charges significantly higher fees based on the purported benefits of active management. However, more often than more, such funds simply track the performance of a comparable, less expensive index fund, wasting an investor’s money. Again, you get what you don’t pay for.

To evaluate the impact of possible closet indexing, I perform a second incremental cost analysis using Ross Miller’s Active Expense Ratio (AER). It is not necessary to perform an AER analysis to benefit from an AMVR analysis. I simply perform the extra analysis due to my clientele and to further protect against cost-efficiency.

A simple explanation of the AER is that the metric uses a fund’s R-squared number, or correlation of returns, to determine the extent to which an actively-managed fund tracks a comparable market index or index fund. The metric than adjusts a fund’s incremental cost number to reflect the effective cost of the fund in light of extent to which the fund’s performance is properly attributable to the active management of the fund, rather than a market index or comparable index fund.

In the immediate case, the fund’s high R-squared number, combined with the level of the fund’s incremental costs, results in an effective annual expense ratio of 5.40 percent, significantly higher than the Vanguard’s expense ratio of 0.17. The resulting incremental cost constitutes approximately 95 percent of the actively-managed fund’s AER-adjusted effective annual expense ratio. High fees with absolutely no positive incremental return.

Bottom line: An underperforming and overpriced fund is never prudent.

Retirement Share Analysis
Another class of mutual funds shares are retirement shares. Pensions plans should never contain mutual funds that impose any sort of front-end, back-end, or any other type of purchase load/fee. Never agree to pay such added fees, on either retail or retirement shares. There is simply no need, as there are excellent no-load mutual funds that do not impose such unnecessary fees.

A longstanding debate in the investment industry is which offers the best retirement shares-Vanguard or Dimensional Fund, more commonly known as DFA. Both are industry leaders that offer low-cost, primarily index-based funds. But I always recommend that investors perform an AMVR analysis in evaluating funds. Once you learn where to locate the limited amount of data needed, you will find that an AMVR takes less than a couple of minutes.

 

 

The retirement shares AMVR analysis compares an institutional DFA large-cap value fund, DFLVX, with a comparable institutional Vanguard large-cap growth fund, VIVIX. Comparing risk-adjusted returns, the DFA fund slightly under-performs the Vanguard fund, thus providing no positive incremental return.

Once again, high incremental costs with no positive incremental returns based on either DFLVX’s nominal, or stated, returns or AER-adjusted returns. An analysis of the fund’s incremental returns shows the fund’s stated expense ratio constitutes 85 percent of the fund’s stated total annual expense ratio and 95 percent of the fund’s AER-adjusted effective annual expense ratio.

Once again, the evidence clearly indicates that this particular fund is not cost-efficient and is thus imprudent relative to the Vanguard fund, in accordance with the standards established by the Restatement (Third) of Trusts and the Prudent Investor Rule.

Cost-efficiency and 401(k) Plans
Each year “Pensions and Investments” (P&I) puts out an informative report listing the top 50 mutual funds in domestic defined contribution plans, such as 401(k) plans. At the end of each calendar quarter, I do an AMVR analysis of the top 10 non-index funds on P&I’s list. Plan participants and plan sponsors might find it interesting to check to see if any of their plan’s investments are on the analysis and, if so, check their current AMVR rating. The most current quarterly analysis is available on Slideshare.

Conclusion
Investors, both individuals and pension plan participants, deserve to be able to have the investment information they need to adequately protect their financial security and “retirement readiness.” Plan sponsors deserve to have the investment information they need to help their plan participants work toward “retirement readiness,” as well as protect themselves against unnecessary and unwanted personal liability.

Funds that are not cost-efficient result in unnecessary investment losses. Unfortunately, most studies indicate that the majority of actively-managed funds do not cover their investment costs, and thus are neither cost-efficient nor prudent.

The Active Management Value Ratio™ provides a simple means of obtaining such information by determining the cost-efficiency of actively-managed mutual funds. The AMVR calculations require limited data, all of which is freely available at various online sites. In our analyses, we do provide one additional metric, our proprietary InvestSense Quotient, which analyses a fund’s efficiency, both in terms of cost and risk management, as well as a fund’s consistency of performance.

One of the key aspects of the AMVR is its simplicity, both in performing the necessary calculations and interpreting the results. Interpreting the AMVR’s results requires just two questions:

(1) Does the fund provide a positive incremental return?
(2) If so, does the fund’s positive incremental return exceed the fund’s incremental costs?

If the answer to either question is “yes,” then the fund is not cost-efficient, and is legally imprudent. It is as simple as that.

The AMVR is an opportunity for investors, attorneys, plan sponsors and other investment fiduciaries to prove the truth of our company’s motto-“the power of the informed investor.”

Notes
1. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e.
2. Ellis, Charles D., “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018, 10.
3.. Malkiel, Burton, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
4. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.

                      Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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 Active Management Value Ratio, AMVR, Closet Index Funds, Consumer Protection, Consumer Rights, ERISA, Fiduciary, Fiduciary Standard, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , ,

Variable Annuities: Estate Planning Saboteurs

As a wealth preservation attorney, my practice involves various areas of the law including investment portfolio analysis, asset protection, risk management and estate planning. Three primary wealth saboteurs are investment portfolio mismanagement, tax erosion, and personal liability exposure.

I recently read a story indicating that sales of variable annuities have significantly increased. As I wrote in an earlier post, a key question that every investor should always ask before making any investment is “why?”

That question certainly applies with variable annuities. Variable annuities usually involve two of the three risk saboteurs-portfolio mismanagement and tax erosion. Variable annuities can completely destroy an investor’s estate plan.

Variable Annuities and Tax-Deferred Growth
People usually say that they invested in a variable annuity for opportunity for tax-deferred growth. What they fail to realize is that there are other less destructive means of obtaining tax-deferred growth.

Individual retirement accounts (IRAs) are one source of tax-deferred growth without the excessive costs and restrictions associated with variable annuities. IRAs also allow investors to choose their own cost-efficient investment options, allowing investors to avoid the overpriced and poorly performing investment options usually selected for variable annuities.

With most variable annuities typically have a minimum combined cost of 3 percent or more annually, investors should remember that each additional 1 percent of annual fees and costs of an investment reduces an investor’s end-return by approximately 17 percent over twenty years. That could result in an investor losing more than half of their end-return due to a variable annuity’s fees and costs alone, especially if the annuity owner invests in one of the so-called “living benefit” riders often pitched to prospective variable annuity purchasers.

Variable Annuities and Tax-Erosion
Investors often fail to recognize the difference between tax-deferred and tax-free. Tax-deferred means that at some point, somebody is going to be required to pay taxes on an investment. Tax-free means just that, no tax will ever be required to be paid.

When taxes are paid on gains in a variable annuity, those gain are generally taxed as ordinary income. Tax rates on ordinary income gains are always higher that tax rates on so-called “capital gains.” Explaining capital gains is beyond the scope of this article. Capital gains are generally based on the nature of the investment and/or the length of time an investment has been held by an investor. The takeaway here-capital gains are generally preferred over ordinary income due to lower tax rates.

Two mistakes I constantly see are people putting investments that are already tax-advantaged into tax-advantaged accounts. 401(k)/403(b) accounts and IRAs already provide tax-deferral to investors. So why would anyone buy a variable annuity and put the annuity inside a 401(k)/403(b or IRA account?

The same goes for investing in investments that may qualify for capital gains treatment or pay out capital gains income, e.g., stock and equity mutual funds, inside a variable annuity. All that does is convert capital gains into ordinary income for tax purposes, resulting in higher taxes. A general rule of thumb is to place tax-inefficient investments, into tax-deferred account, thereby deferring taxation of otherwise immediately taxable income.

Another general rule of thumb is to place tax-efficient investment in regular investment accounts to take advantage of any favorable tax options, i.e., capital gains and qualify for a stepped-up basis once the investment owner dies. Variable annuities do not generally qualify for a stepped-up basis once the owner of the annuity dies. This is why variable annuities can effectively destroy an estate plan.

Variable Annuities and Loss of Life Savings
Variable annuities are often pitched with the line that investor will never lose their original investment. Furthermore, a variable annuity owner will never run out of money because they can always annuitize their variable annuity and receive payments based on their original investment and the method they chose when they bought the annuity.

What annuity ads do not mention is that if you annuitize a variable annuity, you lose total control over the value of the annuity. Upon the death of the variable annuity owner or designated annuitant, the balance remaining in the variable annuity goes to the company that issued the variable annuity, typically an insurance company not to the variable annuity owner’s family of other designated beneficiaries.

I doubt very few people would say that they worked all their life just so they can benefit an insurance company. But that’s essentially what variable annuity are, a bet by variable annuity issuer that the annuity owner will annuitize and die before depleting the value within the variable annuity, the sooner the better so they receive greater value.

The Beloved Death Benefit Scam
Anyone being pitched a variable annuity will undoubtedly hear that variable annuities offer a death benefit which ensures that when they die, assuming that they have not annuitized the variable annuity, their designated beneficiaries will receive no less that their invested principle.

Moshe Milevsky, a well-respected expert on variable annuities, exposed the death benefit scam by disclosing that variable annuity issuers were generally charging variable annuity owners an annual expense fee that was ten times the actual inherent value of the annuity’s death benefit. While fees naturally vary between variable annuities, the excessive overcharge issue remains. Google “Moshe Milevsky The Titanic Option” to read the article online.

Due to the historic patterns of the stock market, it is extremely unlikely that a variable annuity owner would ever need to available themselves of the death benefit, leading one of colleagues to utter the best analysis of the death benefit in variable annuities:

A variable annuity owner needs the death benefit like a duck needs a canoe paddle.

Selah.

Conclusion
Two takeaways that anyone considering purchasing a variable annuity should remember. The first is a well-known saying in the investment industry-“annuities are sold, not purchased.” The second comes from an article I recently reading read at a web site entitled “The Balance” (thebalance.com)-

Annuities are a form of insurance, and insurance is a risk management tool—not an investment… For investing purposes, index funds are often a better choice than a variable annuity. For the purpose of a guaranteed outcome, other types of annuities are better. That doesn’t leave many situations where a variable annuity is a smart choice.

Variable annuities can easily destroy a well-done estate plan. As the referenced quote points out, there are other viable and more sensible options for achieving the same goals without destroying one’s estate plan and possibly providing nothing for one’s family and heirs.

For those interested in an analysis of the sales pitches variable annuity salesmen often use, click here.

Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

Posted in Estate Planning, Fiduciary, Integrated Estate Planning, Investment Advice, Investor Protection, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Variable Annuities, Variable Annuity Abuse, Wealth Preservation | Tagged , , , , , , , , , , ,

Setting the Record Straight on Asset Allocation

One of the “dirty little secrets” of the investment industry is to deliberately misrepresent the findings of a study on the importance of asset allocation. The study, commonly referred to as the BHB study after the three gentleman who conducted the study, found that asset allocation explained 93.6% of the variation in an investment portfolio’s returns. The study made no representations about the determinants of an a portfolio’s returns, only the variations in a portfolio’s returns.

The study examined three general types of investments – stocks, bonds and cash. Stocks are generally acknowledged as riskier than bonds, and bonds are generally acknowledged as being riskier than cash. So the BHB study should not come as a surprise to anyone. higher allocations to stocks, as compared to bonds and  cash, can be expected to increase a portfolio’s overall volatility, or variation in returns.

Investors who understand the true findings of the BHB study and that fact that it made no representations as to the determinants of a portfolio’s actual returns and better protect their financial security by detecting misrepresentations regard the value of investment recommendations.

For an excellent analysis of the true meaning of the BHB study, click here.

Posted in Absolute Returns, Asset Protection, Consumer Protection, Fiduciary, Fiduciary Standard, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , ,

InvestSense’s Comments on SEC “Best Interest” Proposal

The Securities and Exchange Commission is currently seeking public comments on its “Best Interest” (BI) proposal. The proposal would reportedly provide a standard of conduct for anyone providing financial services to the public.  The standard would supposedly protect investors from the abusive marketing practices of the investment industry that led to the Department of Labor’s fiduciary standard in the first place.

While I appreciate the fact that the SEC recognizes the need to address the fiduciary issue, I have concerns about whether the SEC is sincere about adopting a meaningful fiduciary standard that will provide the protection that investors need, or just putting on a show that will result in a watered down version of FINRA’s “suitability” standard.

The SEC’s mission statement clearly indicates that protection of investors is a primary purpose. Judicial decisions involving the agency have clearly stated that it is the SEC’s duty to protect investors, not the investment industry.

In Norris & Hirshberg v. SEC (177 F.2d 228), the court rejected the defendant’s suggestion that the securities laws were intended to protect the investment industry, stating that

“[t]o accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protection of the broker-dealer rather than for the protection of the public. On the contrary, it has long been recognized by the federal courts that the investing and usually naive public need special protection in this specialized field.” (at 233)

In Archer v. SEC (133 F.2d 795), the court echoed those same concerns, stating that

“[t]he business of trading in securities is one in which opportunities for dishonesty are of constant recurrence and ever present….The Congress has seen fit to regulate this business.”

Any suggestion that a “suitability,” or “just OK,” standard provides the same protection that a true fiduciary, or “best interest at all times,” standard is disingenuous and a blatant violation of the agency’s mission statement and the very purpose for which the agency was formed.

The need for a meaningful fiduciary standard for anyone financial services to the public can also be seen in the investment firms retreating from being held to any fiduciary duties in connection with 401(k) plans, arguably in order to engage in the same abusive marketing strategies that led to the DOL’s fiduciary standard in the first place.

In FINRA Regulatory Notice 12-25, FINRA stated that the suitability standard and the best interest standard are “inextricably intertwined.” If one accepts that as true, then the SEC should have no objection to clearly defining the legal duty owed to investors as a “fiduciary” duty and defining the duty using the term fiduciary and the terms set out in the ’40 Act, since the best interest standard requires a higher standard of conduct(fiduciary)than the suitability standard just OK).

he late General Norman Schwarzkopf once stated that “the truth is, we all know the right thing to do. The hard part is doing it.” For the sake of American investors, follow the court’s admonition in Norris & Hirshberg and do the right thing and properly protect American investors, instead of the investment industry. by adopting a meaningful fiduciary standard.

The public comment period is open until August 1, 2018. Comments can be submitted at https://www.sec.gov/comments/s7-07-18/s70718.htm

Posted in Best Interest Proposal, Best Interests, Consumer Protection, Consumer Rights, Fiduciary, Fiduciary Standard, Investment Advice, Investor Protection | Tagged , , , , , , , , , ,

1+1=33%, or the Myth of the 1% Annual Investment Fee

This post is going to be short and sweet, as I keep getting calls and emails from people who wonder why their portfolios are not performing as well as they think they should. In most cases, their portfolios are the victims of what I call the “It’s Only 1 Percent” curse.

Many financial and investment advisers “only” charge an annual management fee of 1 percent of the amount of your account. Same for most actively managed mutual funds. What most investors do not understand is the impact of compounding on the “only 1 percent” annual fee.

As an attorney, I put a lot of emphasis on verifiable evidence. Some simple calculations will help explain how over time a seemingly low 1 percent fee can sabotage your investment portfolio.

First, let’s look at the impact of a 1 percent over 10 years. We’ll use a starting account of $100,000, but the impact is the same regardless of the numbers you use.

10% over 10 years=$259,374
9% over 10 years =$236,736

The difference is $22,638, or a loss of 8.72 percent

Over a 20 year period, the numbers would be:

10% over 20 years=$672,750
9% over 20 years =$560441

The difference is $112,309, or a loss of 16.69 percent.

For those of you who want to confirm the numbers, the Excel formula for 10% for 20 years is simply “=1.10^20.” You then take that number and multiple it by your base/starting amount. Here, it would be “=6.72750*100,000”, resulting in $672,750.

According to the Morningstar Research Center, as of July 6, 2018, the average stated annual expense ratio of domestic large cap growth mutual funds is 1.10 percent. Once an investor factors in a fund’s R-squared number to avoid cost-inefficient “closet index” funds, an actively managed mutual fund’s effective annual expense is often 4-5 times higher than the fund’s stated expense ratio.

The next step is to factor in an actively managed fund’s trading costs. Since fund’s are not required to disclose their actual trading costs, InvestSense uses a metric created by Vanguard founder John Bogle as a proxy for a fund’s actual costs. Bogle’s metric is simple – double a fund’s turnover ratio and multiply that number by 0.60. According to Morningstar, as of July 6, 2018, the average turnover ratio for domestic large cap growth funds is 56 percent, resulting in a trading cost of .67 basis points. (a basis point is .01 percent of 1)

The final step is to simply combine a fund’s stated annual expense ratio and its Bogle trading costs number, and multiply that number by the conversion number from your earlier calculations, e.g., 16.69 % or 8.72%. Here, using the Morningstar data, the numbers would project a 29.54 percent reduction in their end-return over a twenty year period. Variable annuities generally have costs of 2.5-3.0 annually. Using our Morningstar data, over a 20 year period, a VA owner could see a reduction of 50 percent or more in their twenty year end-returns.

Conclusion

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of 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% of incremental returns. – Charles D. Ellis

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

The next time you see a stated investment fee of 1 percent, know that that representation may not properly reflect the true impact of annual expense fees and other costs on your investment return. I highly recommend that investors and investment fiduciaries do a more comprehensive cost-efficiency analysis using InvestSense’s proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR). For more information about the AMVR and the simple calculation process, click here.

Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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 Active Management Value Ratio, AMVR, Asset Protection, Closet Index Funds, Fiduciary, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Retirement, Retirement Plan Participants, Retirement Planning, Uncategorized, Variable Annuities, Variable Annuity Abuse, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , ,

The Active Management Value Ratio™ 3.0: Investment Returns and Wealth Preservation for Investors and Fiduciaries

Studies have consistently shown that people are more likely to understand and retain information that is conveyed visually rather than verbally or in print. I regularly receive requests for copies of the Powerpoint slides. So for those of you that have never seen one of my presentations on the value of InvestSense’s proprietary metric, the Active Management Value Metric (AMVR) 3.0, here is a simple explanation of how the AMVR can help you detect cost-inefficient actively managed mutual funds in your personal portfolios and 401(k) plan accounts and better protect your financial security.

The Active Management Value Metric (AMVR) 3.0
Active Management Value Metric (AMVR) 3.0 is based on combining the findings of two prominent investment experts, Charles Ellis and Burton Malkiel, with the prudent investment standards set out in the Restatement (Third) Trusts’ “Prudent Investor Rule.”

[R]ational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index.” – Charles Ellis

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

Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs,…If the extra costs and risks of an investment program are substantial, those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;… – Restatement (Third) Trusts [Section 90 cmt h(2)]

The following slides are based on the returns and risk data, 2017of a popular actively managed mutual fund over the five-year period January 1, 2013 to December 31, 2017, compared to the returns and risk data of a comparable Vanguard index fund. The fund charges a front-end load, or purchase fee, of 5.75 percent. The Vanguard index fund does not charge a front-end load.

Nominal Returns
Mutual funds ads and brokerage accounts often provide a fund’s returns in terms of its nominal, or unadjusted returns. In our example, the actively managed fund’s incremental, or extra, costs exceed the fund’s incremental returns. This would result in a net loss for an investor, making the fund cost-inefficient and a poor investment choice. Furthermore, 67 percent of the actively managed fund’s fee is only producing 1 percent of the actively managed fund’s overall return. Yet another way of looking at the analysis – would you rather pay $31 for 15.92% return or $94 for an additional 0.16% of return?

Load-Adjusted Returns
However, Investors who invest in funds that charge a front-end load do not receive a fund’s nominal return since funds immediately deduct the cost of the front-end load at the time of an investor’s purchase of the fund. Since there is less money in the account to start with, an investor naturally receives less cumulative growth in their account when compared to a no-load fund with the same returns. This lag in cumulative growth will continue for as long as they own the mutual fund.

The calculation of a fund’s load-adjusted returns can be somewhat confusing. Several online sites provide load-adjusted return data, including marketwatch.com and the fidelity.com site.

In our example, once the impact of the front-end load is factored into the fund’s returns, the investor not only charges higher fees, but also suffers an opportunity cost, as the fund underperforms the benchmark, the comparable Vanguard index fund. This double loss clearly makes the fund cost-inefficient and a poor investment choice.

Risk-Adjusted Returns
A final factor that should be considered is the risk-adjusted return of a fund. When comparing funds, it is obviously important to know if a fund incurred a higher level of risk to achieve its returns relative to another fund since investors may not be comfortable with such risk. As the quote from the Restatement points out, at the very least, investors would expect a higher return that would compensate them for a higher level of risk.

In our example, the actively managed fund assumed slightly less risk than the Vanguard index fund. As a result, the actively managed fund’s returned improved slightly, but not enough to avoid the same double loss suffered in the load-adjusted scenario. Once again, this double loss clearly makes the fund cost-inefficient and a poor investment choice.


The investment industry will often downplay unfavorable risk-adjusted results, saying that “investors cannot eat risk-adjusted returns.” However, the combined impact of additional fees and under-performance should not be ignored by an investor. Each additional 1 percent in fees results in approximately a 17 percent loss in end return for an investor over a twenty-year period. Historical under=performance can be considered an additional cost in evaluating a fund’s cost-efficiency since investor’s invest to make positive returns and enjoy the benefits of compounding of returns.

Interestingly enough, funds that may criticize risk-adjusted performance numbers have no problem touting favorable “star” ratings from Morningstar, which bases its “star” rating on, you guessed it, a fund’s risk-adjusted returns. Risk-adjusted return data for a fund can be found on the “Taxes” tab, which factors load-adjusted returns into their calculation

In my legal and consulting practices, we add two additional screens. The first screen is designed to eliminate “closet index” funds. Closet index funds are actively managed mutual funds that essentially track a market index or comparable index fund, but charge fees significantly higher, often 300-400 percent or higher, than a comparable index fund. Conseqently, closet index funds are never cost-efficient.

The second screen InvestSense runs is a proprietary metric known as the InvestSense Fiduciary Rating (IFR). The IFR evaluates an actively managed mutual fund’s efficiency, both in terms of cost and risk management, and consistency of performance.

Conclusion
The Active Management Value Ratio™ 3.0 (AMVR) is a simple, yet very effective, tool that investors and investment fiduciaries can use to identify cost-inefficient actively managed mutual funds and thus better protect their financial security. All of the information needed to perform the AMVR calculations is freely available online at sites such as morningstar.com, fidelity.com, and marketwatch.com.

For those willing to take the time to do the research and the calculations, the rewards can be significant. For fiduciaries, the time spent can be especially helpful in avoiding unwanted personal liability, as plaintiff’s securities and ERISA attorneys are becoming increasingly aware of the forensic value AMVR analysis provides in quantifying fiduciary prudence and investment losses. As a result, more securities and ERISA attorneys are incorporating AMVR analysis into their practices.

Posted in Closet Index Funds, Consumer Protection, DOL fiduciary rule, ERISA, Fiduciary, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, pension plans, Portfolio Construction, portfolio planning, Retirement Plan Participants, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , | 1 Comment