A 2007 study by Schwab Institutional estimated that approximately 75 percent of investor accounts they studied were unsuitable as being inconsistent with either an investor’s financial goals or financial needs.  While one might expect widespread denial of the study’s findings, an  Investment News article reported one professional’s response – “we’ve always known it.”(1)

Based on my personal experience, I think the 75 percent number is actually low if one considers factors such as cost-effectiveness and the excessive effective fees charged by “closet index” funds. Once such factors and other similar factors are considered, I believe that the number of unsuitable investment portfolios, including both imprudent investments and investment recommendations, would come closer to 90 percent.

In many cases investors lack the experience and knowledge to properly address the quality of their investments and the investment advice they receive. The purpose of this post is to address three screens that investors can use to evaluate their actual investments and/or investment advice they receive in hopes of better protecting their financial security.

“Relative” vs. “Absolute” Returns
A common marketing ploy is to boast about their actual, or absolute, returns when the stock market is enjoying favorable market conditions. When the stock market is suffering through down periods, mutual fund companies and other investment companies resort to using advertisements comparing their performance to the performance of their competitors, so-called relative performance ads, e.g., “we’re #1 in our category.”

The problem with relative returns is that they potentially allow mutual funds and other investment companies to hide periods of poor performance, poor absolute returns. Even if a fund has a year when it suffers a 20-30 percent loss, it can still run its “we’re #1” ads as long it beat the performance of it competitors.

The simplest way to avoid potentially misleading “relative performance ads” is to make sure to check a mutual fund’s actual performance by researching a fund at one of the free online sites, such as morningstar.com, yahoo.finance.com and marketwatch.com.

“Closet Index” Funds
Closet index funds, aka market index huggers,are one of the investment industry’s best kept secrets. In addressing the issue of closet index funds, Morningstar stated that

‘Closet indexing’ is the common term used to describe funds that claim to be actively managed but in fact are not sufficiently differentiated from the benchmark to support that claim. There are a few ways to spot funds that mimic their benchmark. Tools such R-squared and tracking error describe a portfolio’s deviation from the benchmark index in statistical terms based on its past returns.(2)

Closet index funds often underperform a comparable true index fund due to the facts that closet index funds often charge annual fees that are 300-400 higher than comparable true index funds. Therefore, from an investor’s perspective, closet indexing is often viewed negatively due to the fact that investors can generally achieve similar, in many cases better returns, simply by choosing an index fund with significantly lower fees.

As the Morningstar quote indicates, one of the most commonly used tools for detecting closet index funds is a fund’s R-squared rating. Morningstar.com provides a fund’s R-squared ratings on the fund’s Morningstar report page. (“Funds” tab>”Risks and Ratings”>”MPT Statistics”)

Morningstar defines R-squared as a metric that

measures the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 100….It is simply a measure of the correlation of the portfolio’s returns to the benchmark’s returns.

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.

While there is no universally accepted R-squared rating that officially designates a mutual fund as a closet index fund, Morningstar’s position is that a R-squared rating of 100-70 indicates a high correlation of returns between a fund and its applicable market index. From a legal perspective, a R-squared rating of 95-90 is commonly used in classifying a fund as a closet index fund.

To emphasize the negative impact of closet index funds, Professor Ross M. Miller created the Active Expense Ratio. Using a fund’s R-squared rating, Professor Miller found that in most cases the combination  of the higher annual expense ratio of closet index funds, combined with their high R-squared rating, often resulted in an effective annual expense ratio 6-8 times greater than its advertised annual expense ratio. Definitely not in the best interests of investors.

Cost Effectiveness Analysis Using Incremental Costs/Returns
The final screen involves a metric I personally created, the Active Management Value Ratio™ 2.0 (AMVR). The AMVR is actually based on the simple cost/benefit analysis most economics major learn in first-year Econ 101, with a mutual fund’s incremental costs and incremental return being used as the input data.

The AMVR is based on the studies of investment icons Charles D. Ellis and Burton L. Malkiel. Ellis introduced the concept of analyzing mutual funds based on their incremental costs and incremental returns. His argument is that index mutual funds have become, in essence, commodities,  and that the proper way to evaluate any commodity is in terms of their incremental, or added, costs and returns. Malkiel’s contribution to the AMVR is his research finding that the two most reliable indicators of a mutual fund’s future performance are the fund’s annual expense ratio and its trading costs.

By focusing on a fund’s incremental cost and incremental returns, investors can get a better idea of the true value, if any, added by an actively managed mutual fund’s management team. What many investors find is that active management often adds very little, if any, positive returns over and above the returns of a comparable, yet less expensive, passively managed index fund. Furthermore, even when an actively managed mutual fund does provide a positive incremental return, that return is negated by the fact that the actively managed fund’s incremental costs exceed the fund’s positive incremental return.

Calculating an actively managed mutual fund’s incremental returns only requires that the annualized return of a benchmark/index fund is subtracted from the annualized return of the actively managed mutual fund. I prefer to use the funds’ five year annualized returns in order to get at least one period of down or negative returns and, thus,  a better picture of the funds performance patterns. In some cases I will also analyze rolling five-year returns to verify the funds’ historical trends.

In calculating the funds’ incremental returns, I rely on Malkiel’s findings and combine a fund’s stated annual expense ratio with its trading costs. Since mutual funds are not required to disclose their actual trading costs, I use a proxy developed by John Bogle, former chairman of the Vanguard family of funds. Bogle simply doubles a fund’s stated turnover ratio and then multiples that number by 0.60 based on historical data re trading costs. While the trading cost number may not exactly match a fund’s actual trading costs, the application of a uniform factor to get a proxy number is acceptable and helpful in getting a better picture of a fund, as trading costs for an actively managed mutual fund are often higher than a fund’s annual expense ratio and both reduce an investor’s end return.

The calculation process only require a couple of pieces of data, all of which are freely available online at sites such as morningstar.com and yahoo.finance.com. As an investor, fiduciary or attorney becomes more familiar with the calculation process, the entire calculation process takes two minutes or less per fund.

As I mentioned earlier, the simplicity of interpreting a fund’s AMVR score in terms of prudence and “best interests” is one of the metric’s strengths. An example will help demonstrate this fact.

Fidelity Contrafund is a well-known actively managed fund whose K shares appear in many 401(k), 457(b) and 403(b) plans . In fact, the fund was the number one fund in the “Pensions and Investments” article. Will Danoff, the fund’s manager has a stellar performance record and is often mentioned as one of the mutual fund industry’s best all-time managers. But does it currently pass the fiduciary prudence and “best interests” test?

Morningstar classifies Fidelity Contrafund K (FCNKX) as a large cap growth fund. For comparative purposes, we will use one of Vanguard’s leading large cap growth funds, the Growth Index fund. Using the same process as before, the analysis shows Contrafund has incremental costs of 86 basis points . Based on the funds’ stated annualized five-year returns, Contrafund does not produce any positive incremental returns (12.80 percent vs. Growth Index’s 13.14 percent) or other benefits to an investor above and beyond those provided by the comparable, and less expensive, index fund.

Contrafund also demonstrates why a fund performance should be evaluated on both its nominal and risk-adjusted returns. Ellis originally suggested that in calculating incremental returns, the risk adjusted returns of funds should be used. If we substitute the two funds’ risk adjusted returns in the calculation process, Contrafund actually produces a positive incremental return of 0.69 percent, or 69 basis points (12.85 percent versus Growth Index’s 12.16 percent). However this would still not allow Contrafund to pass the prudence or “best interests” test since an investor would lose money by investing in the fund since Contrafund’s incremental costs exceed it’s risk-adjusted incremental returns.

A third way of interpreting the cost effectiveness of a fund’s AMVR score is by comparing the percentage of returns produced by a fund to the fund’s incremental costs as a percentage of the fund’s total costs. In the immediate example, the incremental. or added costs, of the actively managed fund equal 87.5 percent of the fund’s cost (1.40/1.60), yet such costs are only adding an additional 1 percent of return. Again, hard to argue that such results indicate a prudent investment that is in the client’s “best interests,” especially given the other findings that indicate that the comparable index fund is a better investment choice.

For further information about the AMVR, click here.

Conclusion
Far too often investors get stuck holding unsuitable investment and investment portfolios simply because they lack the experience and knowledge to detect imprudent investment advice from a stockbroker or other financial adviser. Incredibly enough, the law allows such “professionals” to put their own financial best interests ahead of their customers’ best interests.

In this post we discussed three simple, yet effective screens that investors can use to evaluate the quality of their investments and the investment advice they receive. By incorporating all three screens, investors can better protect their financial security by avoiding unnecessary investment risk and excessive investments fees.

Notes
1. Brooke Southall, “Wirehouse accounts don’t match client goals,” InvestmentNews, March 12, 2007, 12.

2. “Watch Out For Closet Index Funds,” available online at http://www.morningstar.co.uk/uk/news/147931/watch-out-for-closet-index-funds.aspx

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This article is for informational purposes only, and is not designed or 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.