“Humble Arithmetic,” Prudence, and Successful Investing – 2019

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

In 2005, the late John Bogle, of Vanguard fame, spoke at the 60th anniversary conference of the Financial Analysts Journal. Mr. Bogle’s presentation, entitled “The Relentless Rules of Humble Arithmetic,” suggested that the argument over the EMH, the efficient market hypothesis, was essentially meaningless and that time would be better spent examining the CMH, the Cost Matters Hypothesis.(1)

In support of the CMH, Bogle referenced a quote from Louis Brandeis, one of America’s great legal jurists. Brandeis, in addressing issues within the investment industry and the rampant investment speculation at that time, commented on the “relentless rules of humble arithmetic.”(2) Bogle noted that “the relentless rules of humble arithmetic” devastate the long-term returns of investors.”(3)

In addressing “the relentless rules of humble arithmetic,” Bogle stated that

No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur. It is the central fact of investing.(4)

Costs matter, period. Far too many investors see a 1 percent annual fee for a mutual fund and dismiss it as only 1 percent. Throw in an additional 1 percent advisory fee and now the investor is looking at a cumulative fee of 2 percent.  If the investment is a variable annuity, throw in an additional 1-1.5 percent, for a cumulative 3-3.5 cumulative fee.

Some investors will still believe that it is only 3 percent without calculating the actual dollars and costs involved. If we assume no taxes and a tax-deferred account, a starting principal of $50,000, an annual return of 7 percent, and an investment period of twenty years, our end wealth would be approximately $193,484.22. Increasing the fees by 1 percent (reducing the annual return to 6 percent) would reduce the investor’s end wealth to $160,356.77, or a reduction of 17.1 percent.

Add another 1 percent of fees (reducing the annual return to 5 percent) and the investor’s end return is reduced to $132,664.89, or a reduction of 31.4 percent. And finally, add yet another 1 percent of fees (reducing the annual return to 4 percent) and the investor’s end return is reduced to $109,556.16, or a reduction of 43.4 percent.

Costs matter.

Charles Ellis, noted industry leader, has recently suggested that the value of active management should be evaluated based upon the investment’s fees as a percentage of incremental return rather than as fees as a percentage of assets under management.(5)

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns.

When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!(6)

Ellis correctly points out that investors already own the assets in their accounts, so such assets should not be evaluated in terms of an advisor’s services or in computing advisory fees.

Ellis also suggests that evaluating fees based on the incremental return investors receive from an advisor’s services can also prevent misleading representations. As an example, Ellis points out that a stated fee of 1 percent,based on assets under management, can actually be considered as an effective fee of 12.5 percent if the incremental return to the client is only 8 percent, since the real contribution of active management would only be the incremental return.

The investment industry often counters with the argument that the additional fees allow for professional money management and improved returns for investors. And yet, the evidence on historical performance seems to indicate otherwise. Standard and Poor’s publishes various reports comparing the performance of indices and actively managed funds. The reports, known as the SPIVA reports, have consistently shown that the majority of actively managed funds do not outperform their relative indices.

The SPIVA end-year 2018 reports found that the performance of 64.49% of large-cap funds and 68.45% of small cap funds lagged behind their benchmark indices. The only category that was able to post an underperformance record below 50% was midcap funds, where only 45.84% percent of the funds underperformed their benchmark.(7)

The performance figures are equally unfavorable for active funds when viewed over three, five, ten and fifteen-year horizons, with underperformance for all categories at or over 80 percent over all these time periods.

Other studies have produced similar reports of the underperformance of actively managed mutual funds.  One of the most detailed studies ever conducted reported analyzed the twenty year period ending in 1998. The study found that

  • Over the twenty year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 2.1 percent a year;
  • Over a fifteen year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 4.2 percent a year; and
  • Over a ten year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 3.5 percent a year.(8)

Now go back and look at the previous data on the impact of lower returns. Is paying higher fees for less return than a simple index fund prudent?

The same study examined the pre-tax performance of actively managed mutual funds and found that

  • Over the twenty year period, investors had a 14 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.9 percent and an average loss of 3.9 percent.
  • Over the fifteen year period, investors had a 5 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.1 percent and an average loss of 3.8 percent.
  • Over the ten year period, investors had a 2 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.4 percent and an average loss of 2.6 percent.(9)

Do those numbers present evidence of prudent investment choices? Critics will argue that the study is over twenty years old. And yet, the recent SPIVA statistics, and the various court decisions and settlements, suggest that the results have not improved.

Costs matter, whether such costs are in terms of fees or the opportunity costs that result from a fund’s underperformance. One study estimated that between 1996 and 2002, the underperformance of broker-sold actively managed mutual funds cost investors approximately $9 billion dollars a year, with such funds producing an annual return of 2.9 percent over the time period, as compared to an annual return of 6.6 percent for directly purchased index funds.(10) Another study estimated that for the period 1980-2005, actively managed mutual funds produced an annual return of 7.3 percent, compared to an annual return of 12.3 percent for index funds.(11)

The last example of the value of humble arithmetic is my own proprietary metric, the Active Management Value Ratio (AMVR).  Given the evidence that suggests that even when actively managed equity-based mutual funds do outperform similar index funds they only do so by a slim margin, a logical question is whether the actively managed funds are cost efficient for investors.

Rather than go through the entire calculation process again, I will direct readers to my posts and white papers on this blog.  Using simple subtraction and division, an investor can evaluate the cost efficiency of an actively managed mutual fund in approximately one minute. And yet, this humble arithmetic process can result in significant savings for investors.

In one analysis, I used the AMVR to evaluate the performance of twenty-three of the most common  actively managed mutual funds used within pension plans. I calculated the AMVR score for the funds for both a 5-year and 10-year period, setting an AMVR score of 1.5 or lower as the acceptable standard for cost efficiency. An AMVR score of 1.5 or less would indicate that the active portion of a fund’s annual fee was less than 50 percent greater than the portion of the fund’s return attributable to active management

The 5-year AMVR analysis resulted in only nine of the funds qualifying for an AMVR score at all, and only four of the twenty-three funds having an AMVR score of 1.5 or less.  The 10-year AMVR analysis resulted in twelve funds qualifying for an AMVR score, and only four of the twenty-three funds achieving an AMVR score of 1.5 or less.

Costs matter with regard to cost efficiency.

Those who promote actively managed mutual funds will offer various arguments against the evidence presented in this post.  I suggest that investors perform the easy calculations required by the AMVR. Perhaps Upton Sinclair summed up the active management opposition best when he noted that “it is difficult to get a man to understand something when his salary depends on his not understanding it.”

So it is easy to understand the motive behind proponents of actively managed funds promoting such funds. However, in light of the evidence presented herein, what is not so easily understood is the fact that according to the 2013 Investment Company Factbook, 82.6 percent of the money invested in equity-based mutual funds was invested in actively managed mutual funds!

Whether this fact is due to salesmanship skills or lack of information, the disparity between investments in index funds and actively managed fund suggests that investors may be suffering millions of unnecessary financial losses annually due to both the high costs usually associated with actively managed funds and the underperformance often shown by actively managed mutual funds. As David Swensen, the highly respected chief investment officer of Yale University, has pointed out

at the end of 2007, index funds accounted for only slightly more than 5 percent of mutual fund assets, leaving almost 95 percent of assets in the hands of wealth-destroying active managers. In a rational world, the percentages would be reversed.(12)

While the 2019 Investment Company Institute reports that disparity has improved to 36 percent of investors’ assets invested in index funds,(13) the statistic indicate that investors are still acting irrationally and fiduciaries using actively managed mutual funds may be violating their fiduciary duty of prudence. 

The First Circuit Court of Appeals (First Circuit) recently handed down its decision in Brotherston v. Putnam Investments, LLC. The First Circuit vacated the lower court’s decision in which the court had dismissed the plaintiff’s ERISA excessive fees/breach of fiduciary duty action. In a brilliantly written opinion, the Court offered some valuable advice to not only pension plan sponsors, but, in light of the SEC’s new Regulation BI, arguably the investment industry as a whole, stating that

More importantly, the Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits.

Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry ‘wolf.'(14)

The First Circuit’s words were reminiscent of a similar warning 40 years earlier by law professor John Langbein, who served as the Reporter for the committee that drafted the Restatement (Third) Trust:

When market [aka index] funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.(15)

Going Forward
What I have provided in this post is essentially the same prudence/due diligence strategy that I use in litigating or providing expert witness services in ERISA and breach of fiduciary duty cases.  While the nature of such cases often requires extensive use of statistics, the beauty and strength of the strategy is its simplicity and easy verification using “humble arithmetic.” With an increasing number of actively managed mutual funds having high R-squared numbers and, in essence, acting as “closet index” funds, it is becoming more common to see situations where the active component of the fund’s annual expenses greatly exceeds the benefit derived from such active management, in many cases by 300-400 percent, or more.

Winston Churchill once said “men occasionally stumble over the truth, but most of them pick themselves up and hurry of as if nothing ever happened.” Hopefully, this post will help some investors and investment fiduciaries realize the “truths” discussed herein and the need for a closer evaluation of mutual funds in terms of cost and its impact on returns, opportunity cost, and cost efficiency, by using the resources referenced herein. For those who value their financial security and/or the avoidance of unlimited personal liability, the relatively small time required for such analysis will prove to be time well spent.

© 2013, 2019 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.

Notes

1. John Bogle speech, “The Relentless Rules of Humble Arithmetic,” available online at https://personal.vanguard.com/bogle_site/sp20060101.htm.
2. Louis D. Brandeis, Other People’s Money, New York:F. A. Stokes (1914).
3. Bogle Speech.
4. Bogle Speech
5. Charles D. Ellis, “Investment Management Fees Are (Much) Higher Than You Think,” Financial Analysts Journal, May/June 2012, Vol. 68, No. 3:4-6
6. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”               available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c

7. https://www.spglobal.com/_assets/documents/corporate/us-spiva-report-11-march-2019.pdf
8. Robert Arnott, Andrew Berkin and Jia Ye, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Journal of Portfolio Management, Summer 2000, Vol 26, No.4.
9. Arnott, Berkin and Ye.
10. John Bogle, The Little Book of Common Sense Investing:The Only Way to Guarantee Your Fair Share of Stock Market Returns,” New York:John Wiley and Sons (2007), 103
11. Bogle, “Common Sense Investing,” 51, 103.
12. Ibid.
13.fhttps://www.ici.org/pdf/2019_factbook.pdf, 39
14. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018)
15. John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law(1976). (Faculty Scholarship Series: Paper 498) available online at http://digitalcommons.law.yale.edu/fss_papers/498

Posted in Investment Portfolios, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , ,

Full Disclosure: The Art of Reading and Interpreting Mutual Fund Ads

One of the most frequent questions I receive is how to effectively read and interpret mutual fund advertisements. I receive this question not only from individual investors, but from professional investment fiduciaries, such as pension plan sponsors, and securities/ERISA attorneys.

One of the first principles I was taught in law school was in my contracts class-“the large print giveth, and the small print taketh away.” Nowhere is that truer than with regard to investment advertising.

Another rule with regard to investment advertising is that it is as much about what is not said as it is about what is said. Current securities laws do not require that mutual fund companies disclose certain information that is crucial in properly evaluating a mutual fund.

As readers of this blog know, I am a staunch advocate of evaluating mutual funds in terms of their cost-efficiency. My position is based in large part on the fiduciary principles established by the Restatement (Third) of Trust (Restatement), especially Section 90, more commonly known as the “Prudent Investor Rule” (PIR).

Section 90 of the Restatement sets out several relevant standards in determining whether a fiduciary has fulfilled its fiduciary duty of prudence, including

  • A fiduciary has a duty to be cost-conscious.1
  • In selecting investments, a fiduciary has a duty to seek either the highest level of a return for a given level of cost and risk or, inversely, the lowest level of cost and risk for a given level of return.2
  • Due to the impact of costs on returns, fiduciaries must carefully compare funds’ costs, especially between similar products.3
  • Due to the higher costs and risks typically associated with actively managed mutual funds, a fiduciary’s selection of such funds is imprudent unless it can be shown that the fund is cost-efficient.4

Even if you are not a fiduciary, these standards are excellent guidelines to follow in selecting high-quality mutual funds. Many “professionals” will counter that there is more to evaluating a mutual fund that just its fees and expenses.

My response is that cost-efficiency considers both costs and return, more specifically, returns relative to costs. The importance of cost-efficiency in evaluating actively managed mutual funds is a result of comment h(2) of the PIR-as well as the results of numerous studies that have consistently concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient, with findings such as

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.5

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.6

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.7

[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.8

Load Fees
Before we address the issue of cost-efficiency overall, we should look at the impact of loads since most actively managed funds impose either a front-end load/fee or a back-end load/ fee, also known as a “contingency” load/fee, since they are usually only imposed if an investor tries to redeem the shares before a certain period of time has elapsed.

Front-end loads are imposed at the time an investor initially purchases the shares of a mutual fund. The practical result is that load fees reduce the amount of an investor’s initial investment, which in turn effectively reduces an investor’s return compared to a comparable fund that does not impose a load fee.

The maximum front-end load fee currently allowed by law is 5.75 percent. So how much impact does that have on an investor’s end-return? American Funds is one of the most well-known mutual fund groups in the United States. Their funds often appear in mutual fund lists, most notably their Growth Fund of America fund (GFOA). Since they do charge a 5.75 percent load on most of their retail shares, I will use one of their well-known marketing pieces for purposes of analysis in this post. The piece is available online at

https://www.capitalgroup.com/individual/insights/the-capital-advantage/five-american-funds-that-beat-the-first-index-funds-lifetime-results.html

The basic message of the “large print” is to claim that investors would have achieved greater returns over the period 1976-2018 had they invested in the American funds listed in the advertisement rather than an S&P 500-based index fund. But what does the small print say, taketh away?

The first thing I do is look for the “magic disclosure words” that typically appear in actively managed fund advertisements. The disclosure simply states that the returns do not reflect the subtraction of any loads or other expenses, which would have reduced the fund’s returns as stated in the advertisement. Funds are required to disclose a fund’s load-adjusted returns in the fund’s prospectus. In this advertisement, American Funds does state that the results shown do reflect the deduction of any sales loads.

However, two things immediately stand out. First, the ad does not provide any actual numbers that would allow an investor to verify the performance claims made in the advertisement. Several online sites consistently state that GFOA’s quarterly performance record, as of the five-year period ending September 30, 2019, was 10.62, with a load-adjusted return of 9.63 over that same time period. So GFOA’s load reduced an investor’s end-return by approximately 100 basis points. (A basis point is equal to .01 percent, and 100 basis points equals 1 percent.)

Secondly, the piece claims that the results are based on the performance of the funds from 1976 to 2018, and the deduction of the “maximum” 5.75 percent front-end load. However the piece notes that “[t]he maximum initial sales charge was 8.50% prior to July 1, 1988.” Therefore, the failure to subtract the maximum sales charge that existed prior to July 1, 1988, 8.50 percent, instead of the post-1988 5.75 percent, raises obvious questions about the validity of the return numbers cited in the advertisement and the advertisement’s overall claims as well, since the higher sales load would presumably result in lower returns for that period.

These are things lawyers look for, as should investors and investment fiduciaries as well. The claims in the advertisement may very well be legitimate, even after the appropriate sales load is deducted. However, without the numbers to independently verify the returns, we can only note the discrepancy regarding the sales-load deduction. As President Reagan said, “trust, but verify.”

Bottom line: Take the time to read the entire ad, remembering that “the large print giveth, and the small print taketh away.” Also take the time to go beyond the stated numbers and examine other factors related to performance.

“What Have You Done For Me Lately?”
Whenever I see mutual funds touting their long-term performance, I immediately look to see how the fund has performed more recently. The American Funds advertisement is a perfect example of why I include that step.

As we see in the chart provided, over the 1, 5, and 10 year period, with the exception of the AMCAP fund’s 10-year return, the listed American Funds have actually underperformed the S&P 500 Index. As an attorney or an investor, I would want to examine this further to try to determine what might have contributed to the underperformance other than general market conditions, e.g., factors such as poor management, a change in management, and/or excessive or increased fees.

Bottom line: The recent performance of the American Funds funds listed in the advertisement is not a ringing endorsement for investing in them at this time compared to the returns provided by comparable index funds

Cost-Efficiency Analysis
Given the knowledge that the listed American Funds funds have recently underperformed the S&P 500 index, we have a pretty good idea that none of those funds are cost-efficient relative to a comparable index fund benchmark. However, Morningstar categorizes the S&P 500 Index fund as a large cap blend fund, and not all of the listed American Funds funds are large cap blend funds.

For instance, GFOA is categorized as a large cap growth fund. Therefore, in assessing cost-efficiency, GFOA should be compared to an appropriate benchmark, a comparable large cap growth index fund.

I typically use Vanguard’s index funds for benchmarking purposes. There are those that claim it is not appropriate to use Vanguard’s index funds for benchmarking purposes due to significant difference in their business platforms, that that would be unfairly comparing “apples to oranges.”

As they like to say on South Georgia quail preserves, “that dog don’t hunt.” Whether we are talking about ERISA plans/accounts or non-ERISA accounts, if we accept the proposition that the goal is the protection and financial betterment of the plan participant and/or retail client, a fund’s business platform is totally irrelevant. The First Circuit Court of Appeals’ recent decision in Brotherston v. Putnam Investments, LLC totally, and brilliantly, rejected that argument.9 (Note: Putnam has filed for a writ of certiorari, asking the Supreme Court to hear the case. As of yet, the Court has not decided whether to hear the case.)

The Active Management Value Ratio™
Based upon the Restatement and the studies of investment icons such as Nobel laureate Dr. William F. Sharpe and Charles D. Ellis, I created a simple metric, the Active Management Value Ratio™ (AMVR), that allows investors, investment fiduciaries and attorneys to quickly determine the cost-efficiency of an actively managed mutual fund.

In analyzing an investment option, Nobel laureate William F. Sharpe has noted that

[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative. 10

Building on Sharpe’s theory, investment icon Charles D. Ellis has provided further advice on the process used in evaluating the cost-efficiency of an actively managed mutual fund.

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns.

When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!11

While I normally adjust a fund’s return for any loads, when applicable, and for risk, that is not necessary in the case of GFOA’s nominal returns AMVR analysis. In the case of GFOA, the basic AMVR analysis quickly reveals the cost-inefficiency of the retail version of the fund.

Since GFOA underperforms the benchmark, Vanguard’s Growth Index (VIGRX), the extra incremental cost is essentially money just thrown away, the antithesis of prudent wealth management. As the introduction to Section 7 of the Uniform Prudent Investor Act states, “wasting beneficiaries’ money is imprudent.”

From a cost-efficiency standpoint, it should also be noted that 74 percent of GFOA’s total expense ratio (48/65) produced no positive incremental return above the return of the benchmark. Again, wasted money.

Note: The process used for performing an AMVR analysis on an actively managed mutual fund’s retirement shares is exactly as described above. The only difference is that retirement shares do not impose load fee…or least a plans sponsor or other investment fiduciary had better not select such funds.l

AMVR Plus
The AMVR metric provides extremely useful information regarding the cost-efficiency of an actively managed mutual fund. However , an investor’s analysis should not end there if they want a truly accurate cost-efficiency analysis of an actively managed mutual fund. There is a direct, negative relationship between a fund’s R-squared correlation number, a fund’s incremental costs, and the fund’s cost-efficiency. Morningstar states that R-squared reflects the percentage of a fund’s movements that are explained by movements in its benchmark index, [rather than any contribution by the fund’s management team.]

Professor Ross Miller of the State University of New York/Albany did a study on the impact of closet indexing, focusing primarily on the relationship between an actively managed mutual fund’s R-squared number, “closet index” status, and the resulting overall financial impact of the two. “Closet index” funds are actively managed funds whose returns are essentially the same as a comparable index fund, but who charge much higher fees than the index fund. The higher an actively managed fund’s R-squared number, the greater the likelihood that the actively managed fund can be classified as a closet index fund.

An R-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s returns could be attributed to an index fund rather than the active fund’s management team. If an investor is paying an annual expense fee of 1% for an actively managed mutual fund that only contributes 2 percent of the fund’s total return, and a comparable index fund is producing 98% of the fund’s return, while charging an annual expense fee of just 0.20% percent, the effective annual expense ratio for the actively managed fund is significantly higher than the stated 1%.

There is no universally agreed upon level of R-squared that designates an actively managed mutual fund as a closet index fund. I use an R-squared correlation number of 90 as my threshold indicator for closet index status.

Miller’s findings were extremely interesting, namely that

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds 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.12

As a result of his study, Ross Miller, created the Active Expense Ratio (AER) metric. A fund’s AER number is based on a fund’s R-squared number.

Since many investors are unfamiliar with the AER metric, a frequent question I receive is why even calculate an AER-adjusted AMVR. One of the benefits of calculating an actively managed  fund’s AER number is that the calculation process results in calculating the actual percentage of active management provided by the actively managed fund in question. Miller refers to this measurement as a fund’s “active weight.”

Deriving a fund’s “active weight” number provides valuable insight into the amount of active management actually provided by a fund purporting to provide active management, especially since such funds ‘ higher fees are based on the purported benefits of active management. However, Miller claims the primary benefit of calculating a fund’s AER number is that the AER provides investors with a quantitative analysis of the implicit cost of the fund’s active management component. The AER accomplishes this by simply dividing an actively managed fund’s incremental cost by the fund’s active weight number.

In many cases, once a fund’s R-squared correlation number is factored in, the fund’s AER is significantly higher than the fund’s stated expense, often as much as 400-500 percent higher. Investors and investment fiduciaries should remember John Bogle’s advice on investment costs, “you get what you don’t pay for, as well as the fact that simple mathematics proves that each one percent in fees and expenses reduces an investor’s or fiduciary’s end-return by approximately seventeen percent over a twenty-year time period.

Adjusting our AMVR analysis to incorporate GFOA’s AER number results in the following AMVR chart:

Factoring in GFOA’s AER and the fund’s increased implicit costs as a result of GFOA’s high r-squared number (98) relative to a comparable large cap growth benchmark (VIGRX), and its GFOA’s Active Weight number (0.1250), simply emphasizes the cost-inefficiency and overall imprudence of GFOA’s retail shares relative to the comparable, less expensive Vanguard Growth Index Fund (VIGRX).

I have always used Vanguard’s index funds, as they traditionally have had the lowest expense ratios and highest cost-efficiency rating. As more funds adjust their fees and expenses, it may become prudent to calculate AMVR numbers using multiple comparable benchmarks.

For instance, Fidelity has recently significantly reduced the fees and expenses on a number of new or existing index funds. Substituting Fidelity Large Cap Growth Index fund, FSPGX, as our benchmark fund, the AMVR chart using the AGTHX’s and FSPGX’s three-year nominal, or stated, numbers, would have resulted in an even more dramatic analysis of AGTHX’s cost-efficiency.

Adjusting AGTHX’s three-year nominal numbers for applicable front-end loads/fees and AER would have resulted in the following AMVR chart.

The  only reservation I have regarding the use of the new lower-cost Fidelity funds at this point is their short track record. The numbers in the referenced chart only cover the most recent three-year period, as the fund began operations in 2016. Although I fully expect the new low-cost Fidelity funds to perform comparably to other index funds, I prefer to a use funds with at least a five-year performance record, as that usually includes at least one down performance, which provides a better overall example of how a fund may perform in such situations.

Some people avoid the whole closet index debate and simply calculate a mutual fund’s cost-efficiency using the basic AMVR calculation and then answering two simple questions:

(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?

(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?

If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and unsuitable/imprudent according the the Restatement’s prudence standards and should be avoided. The goal for an actively managed fund is an AMVR number greater than “0” (indicating that the fund did provide a positive incremental return), but equal or less than “1” (indicating that the fund’s incremental costs did not exceed the fund’s incremental return).

At the end of the day, common sense tells us that prudent investors do not knowingly waste money by investing in cost-inefficient investments. It may require a little more work, but by using the AMVR metric, alone or in combination with Miller’s AER metric, investors can better protect their financial security and investment fiduciaries can hopefully avoid unnecessary personal liability exposure.

Going Forward

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

The simple numbers and numerous studies consistently establish that the overwhelming majority of actively managed mutual funds simply are not cost-efficient. As a result, such funds are imprudent under the Restatement (Third) of Trusts. Therefore, legally, a  recommendation or use of such funds would constitute a violate a breach of one’s fiduciary duties. A strong argument could also be made that a stockbroker’s and/or adviser’s recommendation or use of a cost-inefficient actively managed mutual fund would constitute a violation of both the SEC’s new “best interest” rule and FINRA’s suitability and “fair dealing” requirements.

I have written previously about the importance of the ultimate decision in Putnam Investments, LLC v. Brotherston. Putnam has appealed the First Circuit’s decision, which held that a pension plan, not the plan participants, has the burden of proof regarding causation of damages sustained by the plan participants. If  the Supreme Court upholds the First Circuit’s decision, either expressly or by simply refusing to hear the case, I believe it will cause a significant change in the landscape of the entire 401(k)/4043(b) industry.

My opinion is based on the examples we have examined herein, examples that show that plans, as well as plan advisers, will be hard-pressed in most cases to meet such a burden of proof, to prove that the funds that they selected for the plan participants were cost-efficient. I believe that this would result in more potential liability exposure and multi-million dollar judgements and settlements in favor of plan participants, unless and until 401(k) and 403(b) plans make the necessary adjustments, namely choosing only cost-efficient investment options for their plans.

Notes
1. Restatement (Third) Trusts, Section 90, cmt. b (American Law Institute).
2. Restatement (Third) Trusts, Section 90, cmt. f (American Law Institute).
3. Restatement (Third) Trusts, Section 90, cmt. m (American Law Institute).
4. Restatement (Third) Trusts, Section 90, cmt. h(2) (American Law Institute).
5. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
6. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e.
7. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
8. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
9. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018).
10. Willam F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
11. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”               available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
12. 1. Ross M. Miller, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol. 5, No. 1, First Quarter 2007. Available at SSRN: https://ssrn.com/abstract=972173

© Copyright 2019 The Watkins Law Firm. 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, Asset Protection, Best Interest Proposal, Best Interests, Consumer Protection, ERISA, Fiduciary, Investment Advice, Investment Advisors, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , , ,

Investor, Protect Thyself: The InvestSense Investor Self-Defense Strategy

During his term as Chairman of the Securities and Exchange Commission (SEC).(1993-2001), Arthur Levitt focused more on investor protection than perhaps any other recent SEC Chairman. His advice from a1999 speech, “Financial Self-Defense: Tips From and SEC Insider,” is still relevant and valuable to investors today.

There are more ways to invest than ever before. But there also seem to be more ways to be confused – or to be misled.

America’s marketplace is generally honest – but there are some crooks out there. And, there’s only so much that law enforcement and regulatory watchdog agencies, like the SEC, can do.

You’ve got to do your part, too….You also need to be on guard when dealing with investment professionals. The vast majority of people selling securities are honest. But we do have people who walk a fine line between good sales practices and poor sales practice….

An informed investor looks beyond the packaging of a product and also sees what’s inside.1

Sadly, recently the SEC has seemingly focused more on protecting the interests of Wall Street rather than on the protection of investors, one of the stated purposes and goals of the commission. As a result, Chairman Levitt’s admonition to assume greater responsibility for self-protection when dealing with the investment and/or the pension/retirement industries is equally applicable today.

Active versus Passive-Costs Matter
The late John Bogle, founder of the Vanguard Group, was fond of reminding investors that “costs matter.” In the ongoing debate over actively managed funds compared to passively managed index funds, one issue that is undeniable is that actively managed mutual funds, by their very nature, will have higher costs than index funds, specifically trading and management costs.

Advocates of actively managed funds argue that that the higher costs are justified by the fact that actively managed funds produce higher returns for investors. Evidence would suggest otherwise. So the questions are (1) how much higher costs does an actively managed fund have compared to a comparable benchmark index fund, and (2) what impact do the higher costs have on a fund’s performance?

As for a fund’s management fees, those are reflected in a fund’s annual expense ratio/fee. Whether those fees are justified or not are reflected in the fund’s performance relative to a comparable benchmark index fund, as well as the actual amount of active management actually provided by a fund.

As for trading costs, mutual funds are not currently required to provide their actual trading costs to investors. Instead, funds are allowed to group actual trading costs into a generic category of “operating costs,” which are then deducted from a fund’s gross return in reporting a fund’s performance.

Allowing an actively managed fund to “hide” such important information as trading costs prevents investors from being able to compare such costs to make a meaningful evaluation of a fund’s efficiency in managing the fund. As the SEC and other government agencies have noted, such costs do have a significant impact on an investor’s return. Each additional 1 percent in fees and costs reduces an investor’s end return by approximately 17-18 percent over a twenty year period.

Fortunately, Bogle recognized the importance of trading costs. He created a simple metric that allows investors to create a proxy for such cost and compare such costs between funds. Bogle’s metric simply doubles a fund’s reported annual turnover ratio and multiples that number by 0.60. So, if a fund has an annual turnover ratio of 50 percent, Bogle’s metric would result in an estimated trading cost of .0.60 for comparison purposes.

Bogle himself acknowledged that his metric probably understates a fund’s actual trading costs. However, the metric is still valuable in that it provides investors, fiduciaries and attorneys with a means of comparing such costs. As studies and simple mathematics show, the potential impact of such costs is simply too important to ignore.

Investor Self-Defense and the Active Management Value Ratio™
Unfortunately, the sheer number of investment options and the complexity of same make it extremely difficult for investors to independently evaluate the available investment options. Inexplicably, despite the acknowledged importance of pension/retirement plans, such as 401(k) and 403(b) plans, and “retirement readiness,” there is no express requirement that employers provide employees with any type of investment education.

Fortunately, there are simple and extremely effective tools and strategies that investors and pension plan participants can use to independently evaluate investment options. One such tool is a metric I created, the Active Management Value Ratio™ (AMVR). The AMVR allows investors and others to follow Chairman Levitt’s advice and look “beyond the packaging of a product and also sees what’s inside.” The AMVR allows investors, plan participants, fiduciaries and attorneys to evaluate the cost-efficiency of an actively managed mutual fund.

The Supreme Court has stated that the Restatement of Trusts (Restatement) is a key resource in interpreting fiduciary law and resolving questions regarding prudent investing. Fiduciary law requires that a fiduciary always act in the best interests of the beneficiaries and/or other parties whose interests they represent. Even when a fiduciary is not actually involved, the investment standards established by the Restatement ensure that an investor’s best interests are being served.

The AMVR incorporates the Restatement’s prudent investment standards and is simply the basic cost-benefit equation that every economics student learns in their Econ 101 class. The only difference is that the AMVR compares the incremental costs and incremental returns between an actively managed mutual fund and a comparable index fund. Applying simple common sense, actively managed funds whose incremental costs exceed the fund’s incremental returns are deemed to be cost-inefficient, and thus an imprudent investment.

A simple worksheet would be as follows:

In the worksheet above, assume that we are comparing an actively managed mutual fund and a comparable index fund with the following cost and return data:

Active Fund: Annual Expense Ratio 1.00%/5-Year Annualized Return 10.50%

Index Fund: Annual Expense Ratio .0.10%/5-Year Annualized Return 10.00%

As a result, the actively managed fund would have incremental costs of 90 basis points and incremental returns of only 50 basis points. (A basis point is equal to .01 percent.) A fund’s AMVR score is simply its incremental costs divided by the fund’s incremental returns.

Here, the actively managed fund’s AMVR score would be 1.80 (.90/.50). An AMVR score greater than 1.00 indicates that a fund’s incremental costs are greater than its incremental returns, indicating that the fund is not cost-efficient. An AMVR less than zero indicates that the actively managed fund underperformed its benchmark, providing no positive return for an investor.

In interpreting the AMVR, an investor or other user only needs to answer two questions:

  1. Did the fund being evaluated 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 fund does not qualify as a prudent investment under the prudent investment standards established by the Restatement.

The AMVR calculation process provides another important piece of information regarding the cost-efficiency of an actively managed fund. In the example above, the numbers show that 90 percent of the actively managed fund’s total fee is only producing approximately 5 percent of the fund’s return. This is yet another example of the fund’s cost-inefficiency and further proof that it would not be a prudent investment choice.

Investor Protection Plus
While the AMVR example provided demonstrates the importance of evaluating the cost-efficiency of actively managed mutual funds, the nominal, or reported, numbers may not properly factor in the actual contribution of active management  in the fund’s performance, and thus may understate the implicit efficiencyof the fund’s fees and costs..Investors can avoid this oversight by simply considering an actively managed fund’s R-squared correlation number.

Morningstar states that

R-squared measures the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 10.

If you want a portfolio that moves like the benchmark, you’d want a portfolio with a high R-squared. If you want a portfolio that doesn’t move at all like the benchmark, you’d want a low R-squared.

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

So, by reviewing an actively managed fund’s R-squared number, an investor can get an estimate of exactly how much of an actively managed fund’s performance can be attributable to the fund’s management team, as opposed to the performance of an underlying market index. In our example, the actively managed fund’s R-squared number of 95 would indicate that 95 percent of the fund’s performance can actually be attributable to the performance of the benchmark, with only 5 percent of the fund’s return being attributable to the fund’s management team. In short, a fund’s R-squared score gives investors a totally new perspective on an actively managed fund’s fees and costs, specifically the fund’s annual expense ratio/fee.

Ross Miller created a metric, the Active Expense Ratio (AER). Miller has stated that the AER measures the implicit cost of an actively managed fund’s annual expense ratio/fee by factoring in the fund’s R-squared number. The higher an actively managed fund’s R-squared correlation number, the lower the actual contribution of active management to the fund’s performance and the higher the fund’s AER score.

Using our earlier example and assuming an R-squared correlation number of 95 percent for the actively managed fund, the cost-inefficiency of the actively managed fund becomes even more apparent.

The combination of high incremental costs (90) and a high R-squared correlation number (95) result in an AER of 5.35, over 400 percent higher than the fund’s stated annual expense ratio. This further supports the argument that investors, fiduciaries and attorneys should always factor in an actively managed fund’s R-squared number.

Morningstar provides an R-squared correlation number for each of the funds it analyzes under the “Risks” tab. The only issue with Morningstar’s R-squared number is that they often use the S&P 500 index as the benchmark for all equity funds. Since Morningstar classifies S&P 500 Index funds as large-cap blend funds, the use of the index for other categories of funds is subject to questioning. At InvestSense, we calculate our own R-squared correlation numbers using comparable Vanguard index funds from the same Morningstar style box as the actively managed fund being analyzed.

While advocates of actively managed funds would argue that the results can be manipulated by assigning a high R-squared number to a fund, a simple review of data from the Morningstar Data Research Center will show that a significant percentage  of U.S. domestic equity funds currently have a R-squared number of 90 or above. And yet, inexplicably, the majority of investment holdings in personal investment accounts and pension plans are still in actively managed mutual funds.

Lessons Learned

When people ask me what I do for a living, I tell them that I am a wealth preservation attorney. When they follow-up by asking me what that means, I tell them that I combine my 20+ years legal experience as a securities/RIA compliance director and estate planner with my 30+ years experience as a financial planner to help clients develop a REAL wealth management/preservation program that focuses on the accumulation, protection, and distribution of wealth.

“Get what you can, and keep what you have. That’s the way to get rich.” That Scottish adage essentially sums up my philosophy about wealth management and preservation. I have written various articles on the three aspects of REAL wealth management and preservation, all of which are available on this blog. However, as Chairman Levitt pointed out, investors need to have a better understanding of investing in order to protect their financial security.

In my practices, we provide various comprehensive forensic analyses that calculate the efficiency of an actively managed fund, in terms of both risk management and cost efficiency, as well as a fund’s consistency of performance. However, the AMVR itself provides public investors, fiduciaries and others with a simple, yet effective, means of avoiding unnecessary investment losses due to cost-inefficient actively managed mutual funds.

The issue of cost-efficient investing is gaining increased attention in both the legal and wealth management communities. Studies have consistently concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient, resulting in statements such as

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.2
  • 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.3
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.5

Financial plans often recommend that a customer spend less money than they earn. The AMVR just stands for the proposition of avoiding actively managed funds that are not cost-efficient, funds whose incremental costs exceed their incremental returns.

Advocates of active management will often claim that active management allows mutual funds to cover the higher costs associated with actively managed mutual funds, namely higher annual expense ratios/fees and higher trading costs. The above-referenced studies prove otherwise. Furthermore, given the high R-squared correlation numbers of many U.S. domestic equity-based funds, it can be argued that such funds are “closet index,” or “mirror” funds, further reducing any chance that the fund’s active management can cover their extra costs

Very few investors and investment fiduciaries even consider a fund’s R-squared correlation numbers. Stockbrokers and other investment professionals try to avoid the issue due to the overwhelmingly negative evidence on the performance on the commission-based actively managed funds they sell,

Nevertheless, in addition to the two AMVR questions we previously mentioned, we suggest that all investors and investment fiduciaries doing business with stockbrokers and/or other financial salesmen always include the following two questions as part of their self-defense strategy:

  1. Will you be acting as a fiduciary in advising me/managing my account, with full disclosure of material facts and putting my best interests first?
  2. Will all of the investments you recommend be cost-efficient, with incremental returns exceeding the investment’s incremental cost relative to an appropriate benchmark?

And finally, if the stockbroker or financial adviser answers “yes“ to both questions, ask them if they are willing to put those assurances in writing. One of the first things every law student learns in their first-year contracts class is that a verbal promise is only as good as the paper it is written on.

Notes
1. https://www.sec.gov/news/speech/speecharchive/1999/spch305.htm
2. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
3. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
4. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
5. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).

© Copyright 2019 The Watkins Law Firm/InvestSense. 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 Absolute Returns, Active Management Value Ratio, AMVR, Closet Index Funds, Consumer Protection, Consumer Rights, ERISA, Estate Planning, Fiduciary, Fiduciary Standard, Integrated Estate Planning, Investment Advice, Investment Advisors, Investment Fraud, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Retirement, Retirement Distribution Planning, Retirement Plan Participants, Retirement Planning, Uncategorized, Wealth Accumulation, Wealth Distribution, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , ,

Investopedia Top 100 Most Influential Financial Advisor Honor

Honored to be named by Investopedia as one of the Top 100 Financial Advisors for 2019. Unlike a lot of other “top” lists, Investopedia bases its selection largely on criteria such as contributions to online media to educate investors on timely topics such as wealth preservation, wealth preservation and investor self-protection strategies.

Additional information on the Investopedia Top 100 is available at https://bit.ly/31GZrzi.

Posted in Active Management Value Ratio, AMVR, Consumer Protection, Consumer Rights, Fiduciary, Investor Protection, Life Advice, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Retirement Planning, Wealth Accumulation, Wealth Distribution, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , ,

One Step to Building More Effective, and Safer, Investment Portfolios

What is the first factor an investor or investment fiduciary, such as a pension plan sponsor, should consider in evaluating an actively managed mutual? Most people’s answer would probably be a fund’s returns or the number of Morningstar “stars” given to a fund, despite the fact that Morningstar has warned investors that their “star” system was never intended to be used for predicting future returns.

Most investors and attorneys are surprised when they learn that the first piece of data I look at in evaluating an actively managed mutual fund is the fund’s R-squared correlation number. My reasoning is that a fund’ R-squared number provides meaningful context to the rest of a fund’s numbers.

The R-squared number I look at is the correlation of returns between an actively managed fund and a comparable index fund. I use a comparable index fund so that I can factor in incremental returns and incremental costs to calculate the actively managed fund’s cost-efficiency, or lack thereof.

[R-squared] is simply a measure of the correlation of the [investment’s] returns to the benchmark’s returns. An R-squared of 100 indicates that all movements of a [investment] can be explained by movements in the benchmark. An R-squared measure of 35, for example, means that only 35% of the [investment’s] movements can be explained by movements in the benchmark index.

The benchmarks I use most often are Vanguard index funds (VIGRX/VIGAX, VIVAX/VVIAX and VFINX/VFIAX). However, other low-cost index funds may also be appropriate.

Morningstar provides an R-squared number for the funds it covers. However, Morningstar tends to use the S&P 500 index in calculating the R-squared number for U.S. equity funds, even when the fund is question is not a large cap blend stock, which is how the S&P 500 Index is categorized. As an attorney, I would obviously object to any cost-efficiency comparisons using a different asset category other than the one for the fund in question.

R-squared gives me a quick signal of a potential “closet index” situation. Closet indexing is a world-wide problem that is receiving greater attention due to its impact on investors. Closet indexing is generally defined as a fund holding itself out as an actively managed fund, and charging higher fees based on such active management, but whose performance closely tracks the performance of a comparable, less expensive, index or index fund.

A recent check on the Morningstar Investment Research Center indicated that the average annual expense ratio on domestic equity-based funds was 1.06 percent (106 basis points). The average turnover ratio on such funds was 61 percent, which equates to 73 basis points for trading costs using Bogle’s turnover/trading costs metric.

Using such data, the average U.S, domestic equity mutual fund starts out almost 180 basis points in the hole. The only way to cover such a deficit is by producing annual returns higher than comparable index funds. However, when actively managed mutual funds typically report R-squared correlation numbers of 90 and above, the chances of an actively managed fund covering its costs are unlikely.

Result – the investor is stuck with a cost-inefficient investment that actually costs them money and returns. Examples of the findings of some studies include

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.
  • 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.
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.

John Bogle was known for his famous “humble arithmetic” speech in which he announced his Cost Matter Hypothesis, stating that

Gross return in the financial markets, minus the costs of financial intermediation, equals the net return actually delivered to investors….Whether markets are efficient or inefficient, investors as a group must fall short of the market return by precisely the amount of the aggregate costs they incur.  It is the central fact of investing.

Costs and the impact of such costs on performance, and therefore investors’ end returns, are at the heart of the ongoing debate over the merits of actively managed funds versus passive/index funds.

There are some, myself included, that have argued that “humble arithmetic” is equally valuable in evaluating actively managed mutual funds in terms of their cost-efficiency relatively to comparable index funds. Bogle was fond of saying that investors “get to keep what they don’t pay for.” Financial advisers and investment managers often try to minimize the cost of their services or their investment with the “it’s only 1 percent” argument.

However costs, like returns, compound over time, greatly increasing both. Each additional 1percent in fees/costs reduces an investor’s end-return by approximately 8 percent over a 10 year period and 17 percent over a twenty year period.

The impact of a fund’s fees and expenses can increase dramatically once a fund’s R-squared number is considered. Professor Ross Miller created a metric called the Active Expense Ratio (AER). Miller has said that the value of the AER is that it “enables one to compute the implicit cost of active management.”

The driving force behind the AER is the actively managed fund’s correlation of returns to a comparable index fund. Miller’s research has shown that actively managed funds often have a high R-squared, or correlation, number and charge significantly higher fees than comparable index funds. As a result, the AER often indicates that many actively managed have implicit annual expense ratios that are significantly higher than their stated rates, in many cases 500-600 percent higher, without an equally commensurate return to cover such fees.

Actively managed mutual funds routinely attempt to justify their higher fees based on the alleged benefits that their actively managed funds provide relative to comparable index funds. However, with many actively managed funds showing high R-squared correlation numbers of 90 and above, the contribution, if any, of active management to a fund’s overall performance is greatly reduced, especially from a cost-efficiency perspective.

There are those who argue that funds holding themselves out as providing active management and the purported benefits of same, whose high-R-squared correlation numbers indicate otherwise, are in violation of federal securities laws. Whether or not that is true, the fact remains that in evaluating an actively managed fund, the fund’s fees should be adjusted to reflect the fund’s reduced active management component and the resulting change in the implicit costs of such high R-squared actively managed mutual funds.

Whether you want to frame the question in terms of “best interest,” “prudence,” “suitability, or “fair dealing,” actively managed mutual funds with high R-squared correlation numbers and significant incremental costs compared to equivalent index funds are never in an investor’s best interest. How many of your current 401(k) and personal investments have a five-year R-squared number of 90 or above? A quick check on morningstar.com (under the “Risk” tab) might prove insightful.

As my colleague, Fred Reish, one of America’s leading ERISA attorneys, likes to say, forewarned is forearmed.

© Copyright 2019 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 Closet Index Funds, ERISA, Fiduciary, pension plans, portfolio planning, Portfolio Planning, Retirement, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , ,

CommonSense InvestSense About…Returns

As an attorney that specializes in wealth management/preservation and asset protection, I often see investors who have suffered unnecessary financial losses due to poorly designed and/or poorly managed investment portfolios. This is especially troubling, for as legendary investment expert Benjamin Graham once noted in his classic, “The Intelligent Investor,”

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

Three key concepts can help investors avoid unnecessary financial losses and help maximize an investor’s returns:

  1. Front-end loads dramatically reduce an investor’s end returns.
    Most stockbrokers and financial advisers recommend actively managed mutual funds for the commissions such products pay them. Commissions on actively managed mutual funds are commonly known as “front-end loads.” Under current law, the maximum front-end load that funds can charge is 5.75 percent of the total purchase price of the mutual fund.

Front-end load charges are automatically deducted at the time of the purchase of the fund, reducing the actual amount of a customer’s actual investment. So, on a $100,000 purchase of a mutual fund that charges a 5.75 percent front-end load, only $94,250 would actually go into a customer’s account.

Many investors are unaware of the cumulative impact of a front-end load. In our example, if we assume an annual return of 10 percent over ten years, the reduced initial investment due to the front-end load reduces an investor’s annualized return to 9.35 percent and a reduced actual dollar amount of almost $15,000 due to the impact of compounding.

Mutual funds are required by law to provide their return information net of fees, including any the impact of a front-end load. That information must appear in any ads published by a fund, as well as in a fund’s prospectus. The problem is that evidence shows that few investors actually look at a fund’s prospectus, and the load-adjusted return information is often buried in an ad’s small print.

2. Expense ratios and so-called “invisible” costs further reduce an investor’s returns. The impact of front-end loads is not the only factor that investors need to consider when selecting mutual funds. Studies have shown that most actively managed mutual funds are not cost-efficient, consistently underperforming comparable no-load index mutual funds due to the impact of the extra costs associated with active management, e.g, higher annual expense ratios and trading costs. Samples of the findings of such studies include the following:

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.
  • 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.
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.

As a result, index funds are usually the better choice for investors. Since mutual funds are not legally required to disclose their actual trading costs, these added costs are often referred to as “invisible” costs that investors forget to factor into their investment decision.

3. The actual contribution of an actively managed mutual fund’s management team is often negligible and, in some cases, actually cost investors. While many investors select mutual funds based on Morningstar’s famous “star” system, the most valuable information provided by Morningstar may actually be an actively managed fund’s R-squared correlation number.

Morningstar defines R-squared as

the relationship between a portfolio and its benchmark…. R-squared is not a measure of the performance of a portfolio….It is simply a measure of the correlation of the portfolio’s returns to the benchmark’s returns…. An R-squared measure of 35, for example, means that only 35% of the portfolio’s movements can be explained by movements in the benchmark index.

While actively managed funds like to tout the presumed advantages of the active management their fund allegedly provides, the evidence suggests that many funds’ returns are due more to the movement of the stock market than an actively managed fund’s management team. Evidence of this fact is supported by the percentage of actively managed funds with R-squared correlation numbers of 90 or above.

As index funds have consistently outperformed their more expensive actively managed counterparts, many actively managed funds have seemingly adopted a “if you cannot beat them, join them” approach to investing in hopes of minimizing both the extent of any potential underperformance relative to index funds and the potential loss of customers from such differences in performance.

© Copyright 2019 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 Closet Index Funds, Consumer Protection, Investment Advice, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , ,

Sound Investment Advice from Jack Bogle…Again

Why write anything? Mr. Bogle says it all.

https://www.yahoo.com/finance/news/vanguard-founder-jack-bogle-apos-194408395.html

Posted in Investment Advice, Investment Portfolios, Portfolio Construction, portfolio planning, Wealth Management | Tagged , , , ,