CommonSense InvestSense: Accumulating and Preserving Wealth

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

Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits and our salespersons’ compensation may vary by product and over time.

This was a disclosure proposed by the Securities and Exchange Commission (SEC) a part of the so-called “Merrill Lynch Rule” that would have allowed brokerage firms to be exempt from registering under the Investment Advisers’ Act of 1940, and thus avoiding the fiduciary duty of always putting a customer’s interests first. Fortunately, the Financial Planning Association FPA sued the SEC to prevent the SEC from implementing the Rule and the U.S. District Court of Appeals for the District of Columbia overturned the rule in 2007, thereby requiring brokerages to register as investment advisers in connection with certain types of accounts.

Unfortunately, overturning the Rule also meant that stockbrokers are not required to provide customers with the referenced disclosure. Be honest, how many of you knew the information contained in the disclosure? How many of you believe that requiring such a disclosure would be helpful to investors?

In 2006, the SEC sponsored a study by the Rand Corporation to assess the public’s understanding of the investment industry. That study found that most investors mistakenly believed that stockbrokers, rather than investment advisers, had a fiduciary duty to always put their customers’ interests first.

The fact that there are two different standards for those providing investment advice to the public is currently being discussed in Congress. The issue is whether there should be a universal fiduciary standard requiring that anyone providing investment advice to the public should always be required to put the customer’s interest first.

Seems simple enough, yet the debate has become quite heated and, in some cases, dirty. Proponents of a universal fiduciary standard argue that it is only fair and is need to protect investors against some of the wrong-doings of Wall Street. Opponents of a universal standard argue that requiring them to always put the customer’s interests first will result in some people having access to investment advice and will result in higher compliance costs for brokerage firms, costs that they will have to pass on to customers.

Yes, you read that right. The investment industry is essentially arguing that if they have to put a customer’s interests first, ahead of their own financial interest, their business model cannot function properly. Let that admission sink in.

Each week I receive requests from individual investors, trusts, pensions plans and other groups asking me to do a forensic analysis of their investments. My metric, the Active Management Value Ratio (AMVR), allows anyone to evaluate the cost effectiveness of their investments. In performing a forensic analysis, I actually calculate four metrics, including the AMVR, to provide a thorough analysis.

Confucius once said that “life is really simple, but we insist on making it complicated.” I submit that the same holds true for investing. Famous investor George Soros has been quoted as saying that “good investing is boring.” Famous economist Paul Samuelson echoes that point, saying that “investing should be more like watching paint dry or watching grass grow.”

As a wealth preservation attorney, I stress to clients the three primary reasons for loss of wealth – bad investments and/or investment management, taxes, and events resulting in liability losses. In working with clients and speaking to groups, I like to review my short three-step investor protection program.

Step 1 – Ask your financial advisor whether they will be acting as a fiduciary in connection with your account. If they answer yes, ask them if they are will to put their representation in writing and have the document and approved by their broker-dealer’s compliance department. Seems like a lot of trouble? Trust me, it can save you a lot of time and trouble if the stockbroker fails to honor their representation. Getting compliance’s approval prevent s them from coming back and attempting to deny liability by claiming that the stockbroker did not have the authority to make such promises. Trust me, common tactic.

Step 2 – My experience has been that too many investors fail to perform a cost-benefit analysis on proposed investment and therefore fail to realize the true impact of an investment’s fees and other costs. Step 2 actually involves three separate screens.

First, check Morningstar or another online resource to determine if the mutual fund that  you are considering has outperformed an appropriate benchmark such as an appropriate market index or market index fund. I recommend that investors compare three, five and ten-year returns to evaluate the consistency of a fund’s performance. Morningstar provides a simple-to-use format that easily allows such comparisons.

This screen will eliminate a lot of funds. Studies have consistently shown that the majority of actively managed mutual funds fail to outperform similarly based index mutual funds. Standard & Poors produces the SPIVA reports which compare the performance of actively managed mutual funds to the performance of index funds. These reports are free online.(1)

The 2012 year-end SPIVA report once again documented the under-performance of actively managed mutual funds. For calendar year 2012, 66.08 percent of all domestic equity funds underperformed their respective indices. More specifically, 63.25 percent of large-cap equity funds, 80.45 percent of mid-cap equity funds, and 66.50 percent of small-cap equity funds underperformed their respective indices.

The results were equally disappointing when reviewing three and five-year periods. For the three-year period 2010-2012, 74.35 percent of all domestic equity funds underperformed their respective indices. More specifically, 86.49 percent of large-cap equity funds, 90.22 percent of mid-cap equity funds, and 83.05 percent of small-cap equity funds underperformed their respective indices.

For the five-year period 2008-2012, 75.37 percent of all domestic equity funds underperformed their respective indices. More specifically, 90.03 percent of large-cap equity funds, 82.76 percent of mid-cap equity funds, and 79.16 percent of small-cap equity funds underperformed their respective indices.

Even when actively managed mutual funds do manage to outperform their relative benchmark, the risk-reward benefit is disappointing. A famous study analyzing the performance of actively managed mutual fund over two decades, ending on December 31, 1998. (2) The study concluded that actively managed mutual fund investors faced poor odds of winning the investment battle.

Over a ten-year period, the study concluded that the odds of outperforming a similar index fund was only 14 percent, with the average margin of victory approximately 1.9 percent and the average margin of defeat 3.9 percent. Over a fifteen year period, the study concluded that the odds of outperforming a similar index fund was only 5 percent, with the average margin of victory approximately 1.1 percent and the average margin of defeat 3.8. Over a twenty year period, the study concluded that the odds of outperforming a similar index fund was only 22 percent, with the average margin of victory approximately 1.4 percent and the average margin of defeat 2.6 percent percent

And yet, despite such information, the 2013 Investment Company Institute Factbook reports that 82.6 percent of all amounts invested in equity-based mutual funds is invested in actively managed mutual funds instead of  less expensive, better performing equity-based index funds. Common sense tells you that those those numbers should be reversed. Further evidence of the need for improved education and information for investors, trusts and pension plan participants.

Second, check the R-squared ratings for the funds you are considering. Many actively managed mutual funds have high R-squared ratings, suggesting that their performance is more the result of the performance of an underlying market index rather than the skills of the fund’s management team. Funds with high R-squared ratings are referred to as “close index” funds due to the extent that their performance tracks the performance of less expensive index mutual funds. There is no “official” R-squared rating number that designates a “closet index” fund. For my purposes, I use a rating of 90, although others use even lower numbers. Why pay a fee 4-5 times for basically the same results?

Which brings us to the AMVR. The AMVR basically allows individual investors and investment fiduciaries to perform a simple cost-benefit analysis on actively managed mutual funds. The AMVR only requires the ability to perform simple subtraction and division using data easily obtainable online from Morningstar, Lipper, Yahoo!Finance or similar source. Rather than go through the calculation process again, I will refer you to the post that details the calculation process. ( With a little practice, the entire calculation process for a fund should take only 1-2 minutes.

Based upon my experience, the AMVR often indicates that the incremental cost of an actively managed mutual fund far exceed the incremental benefit, if any, derived from such fund. In fact, it is not unusual to the incremental costs of such funds exceed the incremental benefit by 300-400 percent, or more. Hardly in an investor’s best interests and the reasons you do not see stockbroker’s or other “financial advisors” offering to calculate the AMVR on the actively managed mutual funds they recommend.

Step 3 – Just say “no” to variable annuities! I provide an in-depth analysis of variable annuities in my variable annuities white paper at my blog, In short, the pricing system used by most variable annuity companies produces an unmerited windfall for the variable annuity company at the variable annuity owner’s expense. Studies have shown that it may take as long as thirty years or more, perhaps never, for a variable annuity to break even on their investment. Furthermore, in order to receive the unlimited lifetime income payments spiel used to market variable annuities, the variable annuity owner has to give up ownership and control of the variable annuity, resulting in the annuity company, not the variable annuity’s heirs, receiving any balance in the annuity upon the  owner’s death.


I go back to the quote from Confucius – “life is really simple, but we insist on making it complicated” – and my assertion that the same can, and should apply to investing. In my opinion, the problem lies with an inherent battle of the best interests, with stockbrokers and other financial advisors not wanting investors to have the benefit of certain useful and important information that would expose the trust about some of their practices, and investors needing such information to make informed and appropriate investment decisions.

As the fiduciary debate continues in Washington and special interests push their anti-consumer agenda, investors should consider contacting their U.S. senators and representatives to let them know that they want to be treated fairly, that they want anyone providing investment advice to the public to be required to always put the customer’s financial interests first, ahead of those of the financial advisor. Enough is enough.

© 2013 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.


2. 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.

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