The Active Management Value Ratio™- Revealing the Undisclosed Cost of Actively Managed Mutual Funds

Despite overwhelming evidence that actively managed mutual funds generally underperform passively managed index funds, the evidence indicates that most investors continue to purchase and hold actively managed funds.  Even when an actively managed fund does outperform its relevant index, the margin is usually slim, often measuring less than 1 percent.  That 1 percent advantage may disappear entirely when the actively managed fund’s annual fees are factored in.

In analyzing the prudence of actively managed mutual funds, I use a proprietary formula, the Active Management Value Ratio™ (AMVR), to determine the cost effectiveness of an actively managed mutual fund. In short, most actively managed mutual funds simply are not cost efficient.

Most investors only think of mutual fund fees in terms of the annual expense fee quoted in ads and prospectuses.  What most investors do not realize is that in breaking down an actively managed mutual fund’s annual fee into its active and passive components, the active component usually exceeds the passive component by a wide margin.

Most investors expect to see a reasonable relationship between the fees they pay and the returns they receive. However, that is usually not the case when it comes to actively managed mutual funds, where it is not unusual to see the portion of the annual fee allocatable to active management, often 60-70 percent of the fund’s annual return, providing only 25-30 percent of the fund’s annual return.

When we apply the AMVR, we often find that the fund’s active fee component either significantly reduces or totally removes the active management component’s contribution to the fund’s overall return. In some cases, the active management component of the fund may actually end up costing an investor money.

To understand the AMVR, let’s start with a simple cost-benefit analysis.  Let’s assume that we have two mutual funds.  Fund A is an index fund that tracks the S&P 500 Index.  Fund A does not impose a load, or upfront fee, to purchase the fund and has an annual expense fee of 0.15 percent.  Fund B is a load fund that charges a purchase fee, or load, of 3.5 percent and an annual expense fee of 1.50 percent. Fund B’s purchase fee is immediately deducted from an investor’s initial investment, meaning the investor starts off at a loss.

Fund B has an R-squared rating of 90, meaning that ninety percent of the fund’s performance can be attributed to the performance of the underlying index, in this case the S&P 500 Index, rather than the contributions of the fund’s management.  So an investor could have received ninety percent of Fund B’s performance for essentially ten percent of Fund B’s annual fee.  In other words, an investor is paying ninety percent of the amount of Fund B’s fees for whatever returns Fund B earns in excess of the S&P 500’s return.  If Fund B does not outperform the S&P 500 Index, the investor receives nothing for the excess annual fees they paid for Fund B.

The AMVR provides an even more useful analysis.  For our analysis we will compare two popular actively-managed, domestic equity mutual funds, two funds that are often included in 401(k) plans.  Popularity aside, when we perform an AMVR analysis on these two funds, we get drastically different findings.

Fund #1   
• Fund’s Five-Year Annualized Return – 4.88%
• Fund Expense Ratio – 0.69%
• Index Fund’s Five-Year Annualized Return – 2.29%
• Index Fund’s Expense Ratio – 0.17%

The first step in computing the AMVR is to compute the difference between the funds’ expense ratios and the difference between the funds’ five-year annualized returns.

• Actively-Managed Fund’s Expense Ratio – Index Fund’s Expense Ratio = Active Cost
• Actively-Managed Fund’s Five-Year Annualized Return – Index Fund’s Five-Year Annualized Return =   Active Contribution

In our example, the Active Cost would be 0.52 (0.69 – 0.17) and the Active Contribution would be 2.59 (4.88 – 2.29)

The next step in calculating the AMVR is to compute both the Active Cost and the Active Contribution as a percentage of the actively-managed fund’s expense ratio and five-year annualized return, respectively.

• Active Cost/Actively-Managed Fund’s Expense Ratio = Relative Active Cost
• Active Contribution/Actively-Managed Fund’s Five-Year Annualized Return = Relative Active Contribution

In our example, the Relative Active Cost would be approximately 0.75, or 75% (0.52/0.69), and the Relative Active Contribution would be approximately 0.53, or 53% (2.59/4.88), resulting in an AMVR of 1.41 (.75/.53)

Fund #2 
• Fund’s Five-Year Annualized Return – (3.30%)
• Fund Expense Ratio – 0.52%
• Index Fund’s Five-Year Annualized Return – 3.69%
• Index Fund’s Expense Ratio – 0.17%

Performing the same steps as before for Fund #2 produces a Relative Active Cost of 0.67, or 67 percent (0.35/0.52). Since Fund #2’s annual return is less than the index fund’s return, the actively-managed fund has a negative Relative Active Contribution and, therefore, no AMVR rating.

For our purposes, we have found that it works best to calculate active cost as a percentage of active return, with an AMVR score of 0.75 or lower as a goal. An AMVR score of 1.00 or higher would indicate that an investor did not receive a commensurate return on the additional expense fees incurred on the actively-managed mutual fund.

In our example, Fund #1’s AMVR score of 1.41, indicates that our investor paid 75 percent more in fees than the index mutual fund’s total fee in order to receive the actively-managed portion of the fund, yet only received 53 percent more in returns.  This disparity raises potential questions regarding the prudence of investing in the fund.

These imbalances are also reflected in measurements such as a fund’s active expense ratio (AER).  The AER was developed by Professor Ross Miller of the State University of New York.  Dr. Miller’s study found that due to the fee issues associated with actively managed mutual funds, the effective annual expense ratio for such funds was often significantly higher, often 5-6 times greater, than the fund’s stated annual expense ratio.

Investors often see a stated fee of 1 percent and just dismiss it as being only 1 percent. What investors fail to see is the cumulative impact of fees.  According to a study done by the General Accounting Office, over a twenty year period, each 1 percent of investment fees reduces an investor’s ending return by approximately 17 percent.  So, if you are paying an investment adviser an annual management fee of 1 percent and paying annual 401(k) fees of 1 percent, goodbye 34 percent of your end-return.

This is why variable annuities are such a bad investment decision. If your investment adviser recommends that you purchase a variable annuity (generally imposing an annual fee of 2 percent) and recommends that you retain him to manage the variable annuity for you for an annual fee of 1 percent, goodbye 51 percent of your end-return. Add to that the fact that variable annuity issuers base their annual fee on the accumulated value of the annuity rather than on their actual legal obligation to you, an investor’s best course of action is to just say “no” to variable annuities.  (Please see our white paper under “Variable Annuities” for a more detailed analysis on variable annuities and the questionable and often misleading marketing tricks used to sell them.)

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