Upon Further Review-Rethinking the Investment Decision-Making Process

In college, my minor was psychology. My thesis was on heuristics, cognitive biases, and the decision-making process. I have always been fascinated by the way the mind works.

Nobel Laureate Daniel Kahneman’s best seller, “Thinking Fast and Slow,” offers a valuable insight into how we make decisions. Click here to view a 2-minute analysis of Kahneman’s thoughts.

When I created the Active Management Value Ratio™ (AMVR) metric, it was based on these same principles. The goal was to provide a metric that could help investors, including plan participants, make meaningful investment decisions.

Based on my 30+ years in the investment industry, initially as a securities compliance director for both broker-dealers and registered investment advisers, and now as a securities and ERISA attorney and consultant, I believe that the two primary reasons some investors make poor investment decisions is a lack of information/education, and misplaced reliance on illusory investment returns and investment advice.

Psychology and Decision-Making
The reference to investment “illusion” refers to various misconceptions about investment returns and investment advice. In many cases, those misconceptions are the result of the influence of psychological heuristics and cognitive biases.

Heuristics are mental shortcuts that people take in making decisions. The bat/paddle and ball analogy in the Kahneman video is an excellent example of how we use heuristics to simplify the decision-making process, the intuitive or “fact thinking” process.

The problem that a decision-maker must consider is that heuristics can often result in errors due to the influence of cognitive biases that may influence a decision-maker’s judgment. Common cognitive biases that influence decisions include

  • Confirmation bias – the tendency to give greater weight to information that confirms our existing beliefs.
  • Anchoring bias – the tendency to put greater emphasis on and credibility to the first piece of information that we hear.
  • Authority bias – the tendency to blindly rely on any and all advice and recommendations provide by those appearing to have expertise on a topic.
  • “Halo effect” – the tendency for an initial impression of a person to influence the overall and ongoing opinion we have of them.

Based on my experience, these four cognitive biases often come into play in the investment decision-making process. In my opinion, the most damaging example of this problem is the authority bias. Far too often, investors blindly rely on investment advice and recommendations that they believe are objective and in their best interest, from a “trusted adviser,” someone they believe is far more experienced and knowledgeable in such matters. Unfortunately, in far too many cases, the reality in many cases is that the “trusted adviser” is simply someone simply trying to sell an investment product, or as one expert said, “someone whose job it is to make money on you, not for you.”

Psychology and the Active Management Value Ratio™
As I mentioned, heuristics and cognitive biases were a primary consideration when I created the AMVR metric. As the video points out, the influence of large numbers is a well-known cognitive bias.

What would be your initial reaction if I were to recommend this investment to you?

In many cases, the intuitive/fast thinking model would notice the 22.73 percent return with an expense ratio of “only” 78 basis points. 22.73 vs. 0.78. The initial intuitive reaction would most likely be very positive.

Now, what would be your reaction if you were presented with the following AMVR forensic analysis slide on the same investment?

Hopefully, an investor’s rational, “slow thinking” decision-making side would quickly convince them that the is not be the “bargain” it first appeared to be relative to a comparable index fund. This opinion is supported by the opportunity to consider the two investments based on a cost-efficiency comparison.

The actively managed fund not only failed to provide a positive benefit, or incremental return, but also had a significant incremental cost. Costs matter. A simple rule of thumb for investors to remember is that over a twenty-year period, each additional 1 percent in investment costs/fees reduces an investor’s end-return by approximately 17 percent.

The Illusion of Investment Returns
While the “illusion” of investment returns refers to the errors in judgment resulting from issues with heuristics and cognitive biases, it also refers to errors in evaluating investments due to the failure to properly assess the effective costs of actively managed mutual funds.

The chart above shows cost-efficiency in terms of a fundamental cost/benefit analysis, incremental costs relative to incremental returns. The actively managed fund failed to produce a positive incremental return. As a result, the prudence analysis was easy.

A common error in evaluation occurs when the actively managed fund does provide a positive incremental return. The AMVR analysis below shows such a situation.

The chart is significant in two ways. First, it shows that an investor could achieve approximately 99.5 percent of the actively managed fund’s return at a much lower cost, 5 basis points. A basis point equals .01 percent of 1 percent; 100 basis points equals 1 percent.

Second, that means that we are effectively paying 72 basis points, the incremental cost, for just 5 additional basis points of return, the incremental return. Paying a cost/fee fourteen times the benefit/return received is obviously an issue in terms of prudent investing.

Advanced Cost-Efficiency
At the end of each calendar quarter, I prepare an AMVR “cheat sheet” for my investment fiduciary consulting clients, such as pension plan sponsors and trustees. The “cheat sheet” for the first quarter of 2022, for six of the most popular investment options in U.S. defined contribution plans, e.g., 401(k) plans, is shown below.

I provide two sets of data, one based on the funds’ publicly stated, or nominal, information, the second based on incremental risk-adjusted returns and incremental correlation-adjusted costs. For more information about why I provide the adjusted returns and costs, click here.

Comparing the funds on a nominal cost/nominal return basis, five of the six funds failed to even outperform the comparable index fund, making them an imprudent investment choice. The fact that they paid additional costs for such underperformance only makes matters worse. One fund, Dodge & Cox Stock would have been cost-efficient, as its nominal incremental return (1.62) exceeded it nominal incremental cost (0.47).

Comparing the funds on an adjusted cost/adjusted return basis results in the similar scenario, with the same five funds still proving to be imprudent investment choices. However, using the adjusted numbers, Dodge & Cox Stock also proves to be an imprudent investment choice, as its incremental correlation-adjusted cost (8.77) significantly exceeds its incremental risk-adjusted return (0.34).

The Dodge & Cox Stock scenario provides a perfect example of why investors should consider risk-adjusted returns and correlation-adjusted costs in making investment decision. Dodge & Cox’ Stock’s relatively high expense ratio combined with its high r-squared, or correlation, number to drive up its effective expense ratio. Invest Sense calculates a fund’s incremental correlation-adjusted cost using Miller’s Active Expense Ratio.

Many online investment sites include a fund’s r-squared number. Investors considering actively managed mutual funds should always note a fund’s r-squared number for two reasons. First, it helps warn investors about potential “closet index” funds. Closet index funds are funds that tout the advantages of active management, but in reality provide end-returns similar to, in many cases worse, than the end-returns of comparable, but less costly, index funds.

Second, a fund’s r-squared number indicates the likelihood that an actively managed fund will be able to outperform a comparable index fund. Actively managed funds operate at an inherent disadvantage to index funds due to their higher fees and expenses, e.g., management fees and trading costs. A high r-squared number means that the actively managed fund closely mirrors the performance of a comparable index or index fund, making it unlikely that the actively managed fund will be able to make up for such higher expenses.

Going Forward
People often indicate that they are confused and intimidated by the investment process. That was another reason that I created the Active Management Value Ratio™ metric and made it as simple as possible. While many investors focus only on returns, returns without accompanying cost-efficiency are essentially meaningless, as it indicates that an investment’s incremental investment costs exceed its incremental investment returns. Cost exceeding returns is never a sound investment strategy.

The information needed to perform an AMVR analysis on a nominal basis is freely available online. The AMVR “cheat sheet” analysis showed that in many cases, an AMVR analysis based on a fund’s nominal costs and returns alone is enough to expose cost-inefficient mutual funds.

Investors willing to go online, find the cost and return information, and perform what one judge described as “third grade math” can easily calculate the cost-efficiency of their existing and prospective investments and hopefully improve their investment success and financial security.

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

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

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

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

The following slide is based on the returns and risk data of a popular actively managed mutual fund over a five-year period, compared to the returns and risk data of a comparable Vanguard index fund. When InvestSense does a forensic AMVR analysis, we examine both a five and a ten-year period to analyze consitency of performance. The actively managed fund charges a front-end load, or purchase fee, of 5.75 percent. The Vanguard index fund does not charge a front-end load.

Nominal Returns
Mutual funds ads and brokerage accounts often provide a fund’s returns in terms of its nominal, or unadjusted returns. In our example, the actively managed fund does even produce a positive incrremental return, resulting in an additional cost, an opportunity, cost for an investor. This is a common scenario due to additional costs and fees, e.g., higher expense ratio, higher trading costs, typically associated with actively managed mutual funds.

Had the actively managed fund actually produced a positive incremental return, the question would be whether the actively managed fund’s incremental costs exceeded the fund’s incremental returns. If so, this would result in a net loss for an investor, making the fund cost-inefficient and a poor investment choice.

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

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

In our example, once the impact of the front-end load is factored into the fund’s returns, the fund further underperforms the benchmark, the comparable Vanguard index fund. This double loss clearly makes the fund even noire cost-inefficient and a poor investment choice.

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

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

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

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

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

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

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

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

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1Q 2022 AMVR “Cheat Sheets”

On the 5-year cheat sheet, only one fund, Dodge & Cox Stock (DODGX), posted positive incremental returns on both nominal and risk-adjusted returns. While DODGX passed the AMVR screen on nominal returns, the fund failed to pass the AMVR screen on a risk-adjusted basis due the combination of a relatively high standard deviation (15.99) and a high r-squared/correlation number (97), resulting in an extremely high correlation -adjusted/Active Expense Ratio score (8.77).

InvestSense calculates AMVR using a fund’s correlation-adjusted incremental costs (using Ross Miller’s Active Expense Ratio metric) and risk-adjusted incremental returns (using Morningstar’s risk-adjusted return methodology), based upon the belief that such data provides a more accurate evaluation of a fund’s prudence.

The same results hold true on the 10-year AMVR cheat sheet. The results on both cheat sheets illustrate the importance of factoring in r-squared/correlation of returns. Using DODGX as an example, its r-squared of 97 suggests that a fiduciary could achieve 97 percent of DODGX’s return for the much lower cost of the benchmark index fund, in this case Vanguard’s Large Cap Growth Index Fund, Admiral shares. As a result, a fiduciary would be effectively paying a much higher expense ratio for the risk-adjusted incremental return, as shown in both charts.

The data shown covers the respective time periods, ending on 3/31/2022. The benchmarks used are the Admiral shares of the Vanguard funds comparable to the referenced funds’ Morningstar asset category: Vanguard Large Cap Growth Index Fund (VIGAX), Vanguard Large Cap Value Index Fund (VVIAX), and Vanguard Large Cap Blend Index Fund (VFIAX).

Posted in 401k, Active Management Value Ratio, cost efficient investing, cost-effficiency, ERISA, Fiduciary, fiduciary prudence, fiduciary responsibility, Fiduciary Standard, Portfolio Construction, portfolio planning, Portfolio Planning, Wealth Management, Wealth Preservation | Tagged , , , , , , | Leave a comment

4Q 2021 AMVR “Cheat Sheet”

At the end of each calendar quarter, InvestSense publishes the 5 and 10-year Active Management Value Ratio (AMVR) scores of the non-index funds in “Pensions & Investments” annual survey of the most used mutual funds in U.S. defined contribution plans. Currently there are six such funds.

One of the interesting things about the 2021 survey is the continued growth of investments in index funds. The P&I survey ranks funds based on amount of assets invested in each fund, not the actual performance of the fund. The #1 fund overall is the Fidelity S&P 500 Index Fund. The fund is far and away the leader, holding almost 80% more DC assets than the #2 ranked fund.

The AMVR calculates the cost-efficiency of an actively managed mutual fund relative to a comparable index fund. Section 90 of the Restatement (Third) of Trusts emphasizes the importance of cost-efficicency. In announcing the adoption of the Securities and Exchange Commission’s new Regulation Beast Interest, former SEC Chairman Jay Clayton noted the importance of cost-efficiency, stating that

A rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes expected utility.

The AMVR is essentially the basic cost/benefit analysis taught in economic classes, with a fund’s incremental costs and its incremental return as the input values (incremental costs/incremental returns). An AMVR score greater than 1.0 indicates that the actively managed fund is cost-inefficient, as its incremental costs exceed its incremental returns.

Since the six funds funds currently in=the “cheat sheets” are all large cap funds, we use three Vanguard index funds (VIGAX, VFIAX and VVIAX) for benchmarking. While some people use nominal costs and nominal returns, sucb data can often be misleading. For that reason, InvestSense calculates AMVR scores using an actively managed fund’s incremental correlation-adjusted costs (ICAC) and incremental risk-adjusted returns (IRAR).

The impact of a fund’s r-squared, or correlation, number is gaining greater recognition as issues such as “closet indexing” receive increased attention. InvestSense uses Miller’ Active Expense Ratio in computing a fund’s (ICAC). As Miller explained,

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.

So, with that background, the new 4Q 2021 AMVR cheat sheets are shown below:

This image has an empty alt attribute; its file name is 4q-2021-5y-amvr-cheat-sheet.jpg
This image has an empty alt attribute; its file name is 4q-2021-10y-amvr-cheat-sheet.jpg

Two key numbers to look for in using the AMVR is a fund’s r-squared/correlation number and its expense ratio. As you look at the two charts, you can see how dramatically the combination of a high r-squared number and a high expense impacts a fund’s overall cost-efficiency. This is the main reason InvestSense uses incremental correlation-adjusted costs instead of nominal costs, to get a truer evaluation of a fund’s cost-efficiency.

In analyzing the data, the two key questions are:

1. Did the actively-managed fund provide a positive incremental return?
2. If so, did the fund’s incremental return exceed the fund’s incremental costs?

If the answer to either of these questions is “no,” the actively-managed fund is not cost-efficient, and an imprudent investment choice, relative to the benchmark fund.

As to the 5-year AMVR chart, using the ICAC/AER and IRAR data, none of the six fund’s would be prudent relative to the benchmark.

As to the 10-year AMVR chart, using the ICAC/AER and IRAR data, only the Vanguard PRIMECAP Fund’s Admiral shares would be prudent relative to the benchmark, here the Admiral shares of Vanguard’s S&P 500 Fund.

Two funds deserve particular mention. The significant difference in Dodge& Cos Stock Fund’s return data is due to the fact that they had a relatively high standard deviation (19+). The T. Rowe Price Blue Chip Growth Fund usually produces relatively good returns, but the fund’s unusually high expense ratio negates such performance, especially when the fund’s r-squared number is considered.

Some people have told me that the concept of the AMVR and its calculation process are easier to understand by reviewing some of my PowerPoint presentations and the worksheet examples. Those are available at https://www.slideshare.net. Search under “Active Management Value Ratio” to view all of the available presentations.

© Copyright 2022 InvestSense, LLC. All rights reserved.

This article is for informational purposes only and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in Active Management Value Ratio, AMVR, Consumer Protection, cost efficient investing, cost-effficiency, DOL fiduciary rule, ERISA, Fiduciary, fiduciary prudence, fiduciary responsibility, Fiduciary Standard, financial planning, Portfolio Construction, portfolio planning, Retirement Planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , | Leave a comment

The Dangers of “Black Box” Financial Planning/Plans

Financial planning, when done properly, can be a valuable process to consumers. So say yes to the process of financial planning. However, when it comes to financial plans, avoid the inherent issues of “black box” financial planning and “canned” financial plans by performing a quality check using certain guidelines.

Various financial planning firms offer financial planning/retirement planning/asset allocation plans (hereinafter “financial plan(s)”). The price typically ranges from a couple of hundred dollars to thousands of dollars. What the public is not told and does not realize is that the quality of such plans may vary significantly. At best, such plans are a simple snapshot of a client’s situation at that particular time. At worst, they can mislead a client and cause serious financial.

Technically speaking, the quality of such plans depends on the accuracy of the assumptions and other data entered into the software program used to produce a plan. Most of such programs are highly unstable, where slight errors can produce significant errors. As William Jahnke has stated, “the instability of the return-generating process rips the theoretical guts out of the practice of static asset allocation.”1 Furthermore, many of these programs are based upon Microsoft Excel, which was never intended to handle the numerous interrelated calculations used by most financial planning softwar

When I am asked to review a financial plan, the first thing I do is review the data and assumptions that were used in preparing the plan. The second thing I do is to reverse engineer the complete plan to see where errors were made in the calculations and/or advice provided by he plan. After thirty years of dealing with financial planning quality of advice issues, most errors that clients would miss are readily apparent and easy to discern to me.

Financial plans assume a constant rate of growth for investments. This simply does not portray reality. Historically, the stock market suffers one down year for every two positive years. Losses suffered during bear markets such as the 2000-2002 and 2008 definitely one’s financial  situatio

Financial plans use either past performance or projected performance, or “guesstimates,” of investments to prepare the financial plan. The problem with past performance data is that, as the required disclosure for investments states, “past performance is no guarantee or future returns.”  The problem with projected performance, or “guesstimates,” is that they are just that, guesstimates, which can be easily manipulated to convince clients to make decisions that benefit the party that prepared the financial plan more than the best interests of the client.

An investor should always ask the planner who prepared the plan to provide the investor with all the data and assumptions that were used in preparing the plan. One common scenario we see is the choice of the assumptions to ensure that certain investment purchases are mad

One common example of this involves small cap investments. Most people have portfolios that are heavily invested in large cap, blue chip stocks. One reason for this scenario is that blue chip stocks are often stocks that people are familiar with (e.g., AT&T, Coke, McDonald’s). Since most financial planning software favors investments with certain characteristics (e.g., high returns and low risk/standard deviation), a planner can ensure that the plan recommends such products by using assumptions meeting such criteria.  So, if a planner wants to ensure that purchases of small cap products are recommended to produce commissions for the planner, they can manipulate the data to ensure such results without the investor suspecting anything.

Another common scenario I encounter is where the planner blindly relies purely on the financial planning software’s output and lacks the knowledge and or experience to identify software mistakes or poor advice. a situation commonly referred to as “black box” financial planning. As Harold Evensky, one of the nation’s most skilled and respected financial planners has opined,

One of the most frequent criticism of wealth manager optimization is the use of a complex computer program, frequently referred to as a black box. This pejorative description suggests that the wealth manager is implementing an asset allocation policy without understanding how the allocations were determined. The presumption is that the black box, not the wealth manager, is making the decision. Unfortunately, this is often a valid criticism.2

As usual, Mr. Evensky is right on point. Whenever I question planners about the quality of their plans and the advice provided, more often than not the first response is the “deer in the headlights” look, followed with an admission of simply following whatever the software produced and/or a meritless, legally insufficient explanation based on inaccurate interpretations of financial theories such as Modern Portfolio Theory. The quality of advice issues with regard to some financial plans is so bad that Nobel laureate Dr. William F. Sharpe has deemed the situation to be “financial planning in fantasyland.”3

What investors need to understand is that proper financial planning involves more than a financial plan. Proper financial planning is a process, an ongoing process, not a product. CFP® professionals are taught a specific process that includes

(1) determining your current financial situation
(2) developing financial goals
(3) identifying alternative courses of action
(4) evaluating alternatives
(5) creating and implementing a financial action plan, and
(6) reevaluating and revising the plan.

Given the limitations and issues inherent in “canned”, cookie-cutter, financial plans, more and more true financial planners are foregoing the formal financial plan in some cases and focusing more on an effective financial planning process using a modular financial planning process. Given the need to reevaluate and revise the plan as needed, this puts the focus on the client’s best interests and allows the planner and client to focus on building a meaningful and trusting relationship.

If you are a client who has already had a financial plan prepared, I issue the same challenge to you that I make in my wealth preservation challenges. Review the various spreadsheets and check the accuracy of the calculations of the first ten rows on the spreadsheet. Unfortunately, the other forms of deception used in connection with financial plans are often subtle and difficult for the public to detect without the help of someone experienced in such matters.

For what it’s worth, whenever I point out the calculation errors in a financial plan, the planner and his company often respond by saying that they were simply calculating future value, so the last line of the spreadsheet only needs to be correct. When I ask if the customer, who paid for the plan, was informed that the planner knew that most of the numbers were wrong and were simply to fool the customer into thinking a lot of work went into the plan, I usually get more blank stares.

Likewise, when I ask whether the customer was informed of whether past performance or “guesstimates” were used in making the asset allocation recommendations, as well as the inherent issues with either approach, I often get more blank stares or a defense that the plan disclaimed liability the contents of the plan. So the planner asked the customer to pay for the plan, then basically added a disclaimer to the effect that the planner and his company were not liable for the quality of advice provided within the plan . So much for developing a relationship of trust. Your honor, the prosecution rests

So, once again, financial planning, when done properly, can be a valuable process to consumers. As a CFP® professional for over 33 years, I am proud of our commitment to providing consumers with quality advice and our efforts to protect the public. Unfortunately, others holding themselves out as being “financial planners and/or providing “financial planning services” do not share that same commitment, with “financial planner” simply being seen as a marketing tool for selling questionable investment and/or insurance products.

So again, say yes to the lifelong, ongoing process of financial planning. However, when it comes to financial plans, understand the inherent issues and perform a quality check using the guidelines discussed herein.

Notes
1. Gary Marks, “Rocking Wall Street: Four Powerful Strategies That Will Shake Up The Way You Invest, Build Your Wealth, and Give You Your Life Back,” John Wiley & Sons, Hoboken, NJ (2007): 159-160
2. William Jahke, “Getting a Grip,” Journal of Financial Planning, April 2002, 28-30.
3. Harold Evensky, Stephen M. Horan, and Thomas R. Robinson, “The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets,” John Wiley and Sons, Hoboken, NJ (2011): 187
4. William F. Sharpe, “Financial Planning in Fantasyland,” available online at http://www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm

© 2021 InvestSense, LLC. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in financial planning, Wealth Management | Tagged | Leave a comment

3Q 2021 Top Ten 401(k) AMVR “Cheat Sheet”

Posted on October 3, 2021 by jwatkins

When InvestSense prepares a forensic analysis for a 401(k)/403(b) pension plan, a trust, an attorney, or an institutional client, we always do an analysis over five and ten-year time periods to analyze the consistency of performance. Since so many social media followers have asked this question, we are providing a forensic analysis for both time periods for our quarterly “cheat sheet” covering the third quarter of 2021.

At the end of each calendar quarter, we provide a forensic analysis of the top non-index mutual funds currently being used in U.S. 401(k) defined contribution plans. The list is derived from the annual survey conducted by “Pensions & Investments” and currently consists of six funds. Our forensic analysis is based on our proprietary metric, the Active Management Value Ratio™ 4.0 (AMVR).

The AMVR allows investors, fiduciaries and attorneys to determine the cost-efficiency of a fund relative to a comparable index fund. We typically use comparable Vanguard index funds for benchmarking purposes. People often ask why we do not use actual market indices like Morning star and actual funds. Actual market indices do not have costs, so they cannot be used to calculate a fund’s cost-efficiency.

In calculating a fund’s AMVR score, InvestSense compares a fund’s incremental risk-adjusted return to its incremental correlation adjusted costs. Five of the six funds do not qualify for an AMVR score, as they failed to provide a positive incremental return. While Dodge & Cost Stock did provide a positive incremental return, its, incremental correlation-adjusted costs exceeded its positive incremental risk-adjusted return. As a result, it would be deemed cost-inefficient under the AMVR.

Once again, five of the six funds do not qualify for an AMVR score, as they failed to provide a positive incremental return. While Dodge & Cost Stock did provide a positive incremental return, its, incremental correlation-adjusted costs exceeded its positive incremental risk-adjusted return. As a result, it would be deemed cost-inefficient under the AMVR.

People often ask about our uses of incremental risk-adjusted returns and incremental correlation-adjusted costs. As for our use of incremental returns, that is consistent with industry standards. While the financial services industry prefers to ignore risk-adjusted returns, “you can’t eat risk-adjusted returns,” it has no problem boasting about a good rating under Morningstar “star” system. I have to assume that the industry is not aware that Morningstar uses risk-adjusted returns in awarding its coveted stars.

The other justification for relying on risk-adjusted returns is that risk is generally thought to be a factor in return. As Section 90, comment h(2) 0f the Restatement (Third) of Trusts states, the use and/or recommendation of actively managed funds is imprudent unless it can be objectively determined that the active funds can be expected to provide investors with a commensurate return for the additional costs and risks associated with actively managed funds.

As for our use of correlation-adjusted costs, it allows us to use the AMVR to screen for “closet index” funds. Actively managed funds that have a high correlation to comparable, less-expensive are often referred to as “closet index” funds. Closet index funds are actively managed funds that tout the benefits of active management and charge higher fees than comparable index fund, but whose actual performance is actually similar to the comparable index funds. To be honest, “closet index” funds typically underperform comparable index funds.

Ross Miller created a metric, the Active Expense Ratio (AER), that allows investors and investment fiduciaries to determine the effective fee that they pay for actively managed mutual funds with high correlation, or R-squared, numbers. Miller explained the value of the AER:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funds engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.

Martijn Cremers, creator of the Active Share metric, commented further on the importance of correlation of returns between actively managed mutual funds and comparable index funds, saying that

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices…. Investors in a closet index fund are harmed by for fees for active management that they do not receive or receive only partially…. Such funds are not just poor investments; they promise investors a service that they fail to provide.

With those quotes in mind, it is interesting to note that all six of the actively managed funds on the 3Q cheat sheet all have R-squared/correlation numbers in the mid to high 90s.

Going Forward
Those that follow me on Twitter and/or LinkedIn know that I have posted a lot on those sites regarding the upcoming Supreme Court hearings in the Hughes v. Northwestern University 401(b) case. The oral arguments in the case are scheduled for December 6, 2021.

I will be posting more about the case as we get closer to the oral arguments. However, for now, I will just say that if the Court rules in favor of the plaintiff, it would essentially require plans to prove that the investment options they chose for a plan were prudent when they chose them.

Based on my experience with the AMVR and numerous forensic analyses for clients, I believe plans would be hard pressed to carry that burden. While the simplicity of the AMVR is often credited for its growing acceptance and use, the AMVR is still a powerful tool in 401(k)/403(b) litigation and pension plan risk management.

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Remembering David Swensen: “The Mutual Fund Merry-Go-Round”

The late David Swensen was the well-known Chief Investment Officer of Yale University. He was also an outspoken advocate for investor protection.

While performing some research for a brief, I ran across this op-ed, “The Mutual Fund Merry-Go-Round,” that David wrote for the New York Times. Time has diminished neither its accuracy, relevance or importance.

Posted in Active Management Value Ratio, Consumer Protection, Investment Advice, Investor Protection, portfolio planning, Wealth Management, Wealth Preservation | Tagged , , , , , , | Leave a comment

Recent AMVR Twitter and LinkedIn post

While the DOL (“fiduciary”) and the SEC (“best interest”) debate their applicable standards, I suggest that cost-efficiency should be a key factor in whatever they decide. Even former SEC chairman Jay Clayton discussed the importance of cost-efficiency re “best interest.”

In my practice, when I meet with a HNW investor or an investment fiduciary such as a plan sponsor, I show them an AMVR analysis of two well- known actively managed mutual funds. They regularly appear in personal accounts and 401(k)/403(b) plans. I then ask them if they would consider the fund to be prudent and/or in their “best interest.”

Then I explain how to use the AMVR using two simple questions:

(1) Does the actively managed fund provide a positive incremental return?

(2)If so, does that positive return exceed the fund’s incremental costs?

If the answer to either question is “no,” then the active fund is not cost-efficient relative to the passive benchmark fund. Can anyone honestly argue that a cost-inefficient mutual fund is either prudent or in an investor’s “best interest?”

Simple and straightforward, John Bogle’s “Humble Arithmetic .”

“Simple is the new sophistication.” – Steve Jobs

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New InvestSense video: “The Active Management Value Ratio 4.0: What Investors and Investment Fiduciaries REALLY Need to Know About Wealth Accumulation and Preservation”

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“‘Why’ – Investor Protection Made Simple”

=One of the most rewarding aspects of writing this blog and my books is when someone contacts you and thanks you for the information and advice that you provide. I recently had someone write and tell me that they have enjoyed my metric, the Active Management Value RatioTM 3.0, so much so that is has become a hobby to do AMVR analyses for their friends. The most commonly used word in emails and conversations has been a feeling of “empowerment..

I enjoy working with both investors, financial advisers and investment fiduciaries, such as plan sponsors. Many people ask me how I can work with groups that have inherent conflicts of interests. My answer is simple. In my practice, I always try to identify and address quality of advice issues and then provide suggestions and solutions that promote a common goal, a win-win situation for all parties.

For over thirty years, I have been involved in quality of financial/investment advice issues in some form or another. I have been a compliance director for both general securities and Registered Investment Adviser divisions, director of financial planning quality assurance for a major international insurance company, and the initial director of the peer review department at the CFP Board of Standards. And now I offer quality of advice services in the form of fiduciary audits for pension plans, trusts and other investment fiduciaries, as well as ERISA litigation support services.

So, I feel qualified to offer advice on my two blogs, this blog and my blog oriented toward ERISA professionals and investment fiduciaries, “The Prudent Investment Fiduciary Rules” (iainsight.wordpress.com). I truly believe in this blog’s byline – “The Power of the Informed Investor.” As Thomas Jefferson once said, “knowledge is power, knowledge is protection, knowledge is happiness.”

I am a firm believer that the best investor protection strategies are proactive and simple. As Steve Jobs once said, “simple is the new sophisticated.”

Once of my favorite examples of the power of “why” involves a widow who dared to question an asset allocation prepared by a financial adviser. The widow’s husband had carefully created a portfolio that would provide his wife with a portfolio that provided her with the upside potential of capital gains, while at the same time providing her with the incom she would need when he was gone.

When the adviser started to explain the pretty multi-color asset allocation pie charts and calculations, the widow cut the adviser off and simply asked “why.” Unsatisfied with the adviser’s explanation, the widow thanked the adviser for their time and left. The widow left her husband’s work intact and enjoyed a comfortable life thereafter.

In this blog, I want to address three wealth management/asset allocation quality of advice situations that I commonly encounter:

  • quality of advice issues regarding asset allocation recommendations due to the instability of the asset allocation software itself;
  • quality of advice issues due to inconsistency between a financial plan’s recommendations and actual implementation of the advice, what I call recommendation-implementation gaps; and lastly,
  • quality of advice issues due to the recommendation of cost-inefficent investments during implementation of the asset allocation recommendations..

My goal is to help the reader understand and recognize the issues so that they can hopefully avoid the risk management and financial issues involved in each scenario.

Asset Allocation Software Issues
Various financial planning firms offer asset allocation recommendations to the public. The price typically ranges from a couple of hundred dollars to thousands of dollars. What the public is not told and does not realize is that such recommendations may have serious flaws, rendering them virtually worthless.

Many of these asset allocation recommendations are created by asset allocation software programs. Most of such programs are, unfortunately, highly unstable. Like any computer program, the data generated is subject to the the quality of such results depends on the accuracy of the assumptions and other data entered into the software program, the “garbage in, garbage out” syndrome.. Slight errors in the input data can produce significant errors in the recommendations generated.

Asset allocation programs typically suffer from two common problems. First, most of these programs are based upon programs are based upon Microsoft Excel, which, according to software engineers I have worked with, was never intended to handle the numerous interrelated calculations used by most financial planning software.

Secondly, most asset allocation software programs are based on a concept known as “means-variance optimization (MVO). MVO favors investments with high returns relative to volatility/standard deviation. This bias, and the quality of advice issues it creates, has led one expert to characterize MVO-based programs as “estimization-error maximizers.”1

When I am asked to review asset allocation recommendations , the first thing I do is review the data and assumptions that were used in preparing the plan. Any software program is always vulnerable to the “garbage in, garbage out” syndrome. The second thing I do is to reverse engineer the recommendations to see where errors may have been made in the calculations and/or advice provided by the recommendations. After thirty years of dealing with financial/investment quality of advice issues, most errors that investors would miss are readily apparent and easy for me to spot.

Asset allocation recommendations typically assume a constant rate of growth for investments. This simply does not portray reality. Historically, the stock market suffers one down year for every two positive years. Losses suffered during bear markets such as the 2000-2002 and 2008 definitely one’s financial  situation. Financial/asset allocation recommendations typically use either past performance or projected performance, or “guesstimates,” of investments to prepare the financial plan.

The problem with past performance data is that, as the required disclosure for investments states, “past performance is no guarantee or future returns.”  The problem with projected performance, or “guesstimates,” is that they are just that, guesstimates, which can be easily manipulated to convince investors to make decisions that benefit the party that prepared the financial plan.

An investor should always ask the adviser who prepared the asset allocation recommendations to provide the investor with all the data and assumptions that were used in preparing the plan. One common scenario we see is manipulation of the assumptions to ensure that certain investment product are recommended..

One common example of this involves small cap investments. Most people have portfolios that are heavily invested in large cap, blue chip stocks. One reason for this scenario is that blue chip stocks are often stocks that people are familiar with (e.g., AT&T, Coke, McDonald’s). Since most financial planning software favors investments with certain characteristics (e.g., high returns and low risk/standard deviation), a planner can ensure that the plan recommends such products by using assumptions meeting such criteria.  So, if a planner wants to ensure that purchases of small cap products are recommended to produce commissions for the planner, they can manipulate the data to ensure such results without the investor suspecting anything.

Another common scenario I encounter is where the adviser blindly relies purely on the asset allocation software’s output and lacks the knowledge and or experience to identify software mistakes or poor advice, a situation commonly referred to as “black box” advising. As Harold Evensky, one of the nation’s most skilled and respected financial planners has opined,

One of the most frequent criticism of wealth manager optimization is the use of a complex computer program, frequently referred to as a black box. This pejorative description suggests that the wealth manager is implementing an asset allocation policy without understanding how the allocations were determined. The presumption is that the black box, not the wealth manager, is making the decision. Unfortunately, this is often a valid criticism.2

As usual, Mr. Evensky is right on point. Whenever I question advisers about the quality of their recommendations and the advice provided, more often than not the first response is the “deer in the headlights” look, followed with an admission of simply following whatever the software produced and/or a meritless, legally insufficient explanation based on inaccurate interpretations of financial theories such as Modern Portfolio Theory. The quality of advice issues with regard to investment recommendations is so bad that Nobel laureate Dr. William F. Sharpe has deemed the situation to be “fantasyland.”3

If you are an investor who has already had a financial plan prepared, I issue the same challenge to you that I make in my wealth preservation challenges. Review the various spreadsheets and check the accuracy of the calculations of the first ten rows on the spreadsheet. Unfortunately, the other forms of deception used in connection with financial plans are often subtle and difficult for the public to detect without the help of someone experienced in such matters.

For what it’s worth, whenever I point out the calculation errors in a financial plan, the planner and his company often respond by saying that they were simply calculating future value, so the last line of the spreadsheet only needs to be correct. When I ask if the customer, who paid for the plan, was informed that the planner knew that most of the numbers were wrong and were simply to fool the customer into thinking a lot of work went into the plan, I usually get more blank stares

Likewise, when I ask whether the customer was informed of whether past performance or “guesstimates” were used in making the asset allocation recommendations, as well as the inherent issues with either approach, I often get more blank stares or a defense that the asset allocation document disclaimed liability for the asset allocation recommendations. So the adviser asked the customer to pay for the asset allocation recommendations, then basically added a disclaimer to the effect that the adviser and/or his firm were not liable if the recommendations were worthless. So much for developing a relationship of trust.

Recommendation-Implementation Gaps
A serious flaw in asset allocation software is the fact that most asset allocation software is only designed to produce recommendations based on broad, generic asset, not the actual investments eventually chosen during the implementation of the asset allocation recommendations. The performance data and cost data between the generic asset categories and actual investment products is usually very significant, essentially invalidating both the asset allocation program’s input data and the recommendations themselves, “garbage in, garbage out.” This concern is rarely disclosed or discusses with investors.

That is another reason why investors should always ask the adviser for a list of the assumptions used in preparing the asset allocation recommendations. The investor can then use one of the various asset allocation programs online to verify the adviser’s work. Some of the online asset allocation programs may even allow you to perform a limited number of asset allocation calculations based on actual investment products.

Advisers usually have access to advanced asset allocation software programs that allow them to go back and perform an revised asset allocation analysis based on the actual investments recommended during implementation. I know I can. I can even call Vanguard and they will do the analysis for me. Yet, for some reason, advisers do not offer to perform this valuable value-added service for clients. Have to wonder why.

Implementation Cost Concerns
While the recommendation-implementation gaps issue looks at general consistency issues in the transition from recommendations to implementation, an investor should always look at the cost-efficiency of the specific investment products recommended by an adviser. A cost-efficiency analysis is simply a cost-benefit analysis comparing the costs and returns of an actively managed mutual funds to those of a comparable low-cost index funds.

I have written extensively on a simple metric that I created, the Active Management Value RatioTM (AMVR) The AMVR is based on the research and concepts of investment icons such as Charles D. Ellis, Dr. William Sharpe and Burton L. Malkiel. Since studies show that people are more visually oriented, I simply created a visual version of their work.

The AMVR slide below shows how profound the impact of cost-inefficient investments can be on an investor’s end-return. The slide represents the retail class shares of a popular actively managed fund.

A couple of things immediately stand out. First, the impact of a fund’s charging a front-end load to purchase their mutual fund. Most actively managed fund’s charge a front-end load; index funds do not. Secondly, the actively managed fund failed to provide a positive incremental return, or outperform the index fund. And finally, the actively managed fund is clearly cost-inefficient, as its incremental costs (0.47) exceeded it incremental return (-1.12).

So, if an adviser were to this fund during the implementation of their asset allocation recommendations, a prudent investor should immediately ask the adviser to perform an AMVR analysis, or do one themselves. Once the analysis shows results such as those shown above, the investor should immediately ask…”Why?” For more information about the AMVR and the calculation process., click here.

Going Forward
Unfortunately, investors cannot, and should not, blindly accept investment advice from anyone. Yet, the evidence shows that most people do because someone is a “broker” or an “adviser,” a professional trained in such matters. Consider the following:

  • A study by CEG Worldwide concluded trhat 94 percent of those holding themselves out as “wealth managers” were actually nothing more than product salesmen.4
  • A study by Schwab Institutional reported that 75 percent of the transferred investor portfolios inspected were unsuitable given the customer’s financial situation or goals.5

President Ronald Reagan might have expressed it best – “Trust, but verify.” Use the “CommonSense InvestSense” blog and other online resources to educate yourself on common investment concerns, strategies and techniques. Always practice proactive InvestSense and never be afraid to ask “why.”

Notes
1. Richard O. Michaud, Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation (Boston, MA: Harvard Business School Press, 1998), 36.
2. Harold Evensky, Stephen M. Horan, and Thomas R. Robinson, “The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets,” John Wiley and Sons, (Hoboken, NJ: John Wiley and Sons, 2011),187.
3. William F. Sharpe, “Financial Planning in Fantasyland,” available online at http://www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm.
4.Brooke Southall, “Wirehouse accounts don’t match client goals,” InvestmentNews, March 12, 2007, 12.
5. Charles Paikert, “Poll: Few advisers are ‘real’ wealth managers,” https://www.investmentnews.com/article/20071029/FREE/710290324?template=printart; the John Bowen post upon which the article is based is available at http://www.cegworldwide.com/resource/expert-team/003-bp-john-bowen.

© 2021 InvestSense, LLC. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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