Controlling the Controllable: Factoring Investment Costs Into the Prudence/Suitability Equation

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

In an earlier post, I discussed the benefits of controlling the controllable aspects of investing. Investors cannot control the performance of the markets. Investment fiduciaries are not held liable for the eventual performance of the markets. However, investors and investment fiduciaries can control certain elements of investing that play a significant role in determining an investor’s and/or pension plan participant’s success.

Costs associated with an investment are a key factor in determining whether an investment is a prudent and/or suitable choice. The Securities and Exchange Commission has consistently warned investors about the need to look beyond a mutual fund’s past performance numbers and to factor in a fund’s costs when selecting mutual  funds.1 A mutual fund’s annual expense ratio is an obvious cost that an investor should consider. However other less discussed, or “hidden,” costs are equally important and should always be considered in selecting investments.

American Funds’ Growth Fund of America and Fidelity Investments’ Contrafund are two popular mutual funds, both in terms of retail shares and retirement shares. Both funds are classified by Morningstar as large cap growth funds. Vanguard’s Growth Index Investors (retail)/Institutional (retirement) funds will serve as the benchmark fund in this analysis since it is also classified as a large cap growth fund.

Two cost-related metrics that allow investors and investment fiduciaries, such as 401(k) plan sponsors, to evaluate the cost efficiency of mutual funds are the Active Management Value Ratio (AMVR) and Professor Ross Miller’s Active Ratio (AER).

The AMVR is a metric created by InvestSense, LLC.  The AMVR is essentially the same simple cost/benefit metric that students learn in every Econ 101 class. The AMVR compares an actively managed mutual fund to a comparable passively managed/index fund. The AMVR then uses the actively managed fund’s incremental cost and incremental return, if any, as the variables in the calculation process.

In interpreting a fund’s AMVR score, the Optimum Wealth Zone is between zero and one. An AMVR score less than zero would indicate that the actively managed fund underperformed its relative benchmark, and thus provided no positive incremental return for an investor. An AMVR score greater than one would indicate that while the actively managed fund in question did provide a positive incremental return, the fund’s incremental costs exceeded such return, resulting in a loss for an investor or plan participant.

Retail Share Analysis
Analyzing the retail shares of the three mutual funds, based on the five-year annualized performance and cost data as of 12-31-2016, neither Growth Fund of America (AGTHX) nor Contrafund (FCNTX) provided any positive incremental return. Growth Fund of America’s nominal return would have provided an incremental return of +1.13 over Vanguard Growth Index Investor. However, since Growth Fund of America charges investors a front-end load of 5.75%, which is immediately deducted from an investor’s investment, the proper performance number to use in evaluating the fund is its load-adjusted return. Growth Fund of America’s load adjusted return underperformed the benchmark. Since both funds underperformed the relevant benchmark, neither fund would be considered a prudent or a suitable investment since an investor would have lost money.

Retirement Share Analysis
Analyzing the retirement shares of the three mutual funds, based on the five-year annualized performance and cost data as of 12-31-2016, Growth Fund of America’s R-6 shares (RGAGX, the least expensive of the fund’s six R share classes) produced a positive incremental return of +1.52. However, Contrafund’s K shares (FCNKX) failed to provide any positive incremental return. It should be noted that mutual fund companies do not charge front-end loads on retirement shares, as it would create violations of ERISA’s rules and regulations.

Since Growth Fund of America’s R-6 shares did produce a positive incremental return, the next step in the AMVR analysis is to compare the costs of the fund to the costs of the benchmark fund. Based on the studies of well-respected experts such as Burton Malkiel and Mark Carhart2, the AMVR combines a fund’s annual expense ratio and John Bogle’s trading cost metric3 in calculating a fund’s total costs. The total costs on Growth Fund of America’s R-6 shares was 1.03 basis points (a basis point equals .01 percent), while the benchmarks total costs were only 31 basis points. Since Growth Fund of America’s total costs exceeded those of the benchmark. Growth Fund would not be a prudent or a suitable investment since an investor would have lost money.

“Closet index”, or “index hugger,” funds are mutual funds that hold themselves out as actively managed funds, but are funds, in truth, that provide similar returns as passively managed index funds, albeit at significantly higher annual fees/costs. Using an actively managed fund’s R-squared rating, Professor Ross Miller of SUNY-Albany created a metric that allows investors and investment fiduciaries to calculate the effective annual expense ratio investors pay given the reduced contribution of active management. A fund’s R-squared number estimates the correlation of performance between a fund and a relative market index.

Calculating the AER scores for both the retail and retirement share previously mentioned, again based on the five-year annualized performance and cost data as of 12-31-2016, resulted in an AER fee of 2.98 for the Growth Fund of America shares and an AER fee of 2.90 for Contrafund.

AER Adjusted AMVR Analysis
In performing my forensic analyses, I then go back and recalculate a fund’s AMVR score using the fund’s effective AER fee as an actively managed fund’s incremental costs. I add this extra step to address the ongoing “closet index” issue. Contrafund can be eliminated based solely on its failure to produce any positive incremental return for an investor. However, both funds would be considered imprudent and unsuitable investments using their AER numbers, since the AER numbers for both funds exceeds the incremental returns numbers both funds.

In assessing the prudence of a fiduciary’s investment decisions, the courts often turn to the Restatement (Third) Trusts. The Restatement and the Securities and Exchange commission have both cautioned investors and investment fiduciaries that evaluating investment based solely on the investment’s past performance is not enough, that factors such as an investment’s associated costs should be considered in determining whether the investment is a prudent investment option.4

The AMVR and the AER are two simple, yet effective, metrics that allow investors and investment fiduciaries to determine the cost efficiency of actively managed mutual funds. By identifying and avoiding mutual funds that are not cost efficient, an investor and/or investment fiduciary can better protect their financial security and avoid potential personal liability issues.


1. Securities and Exchange Commission, “Mutual Fund Investing: Look at More Than a Fund’s Past Performance,”(SEC Report), available online at
2. Burton Malkiel, “A Random Walk Down Wall Street,” 11th ed. (W.W Norton & Co., 2016) 460; Mark M. Carhart, “On Persistence in Mutual Fund Performance,” The Journal of Finance, Vol. 52, Issue No. 1 (March 1997), 57-82.
3. John Bogle’s metric for calculating an estimate of a fund’s trading costs is [2 x fund’s stated annual turnover] x 0.60.
4. SEC Report; Restatement (Third) Trusts, Section 90 cmt h(2) and cmt m.

Appendix A
The following performance and cost information was used in performing the calculations referenced herein

Growth Fund Of America:
Five-Year Annualized Return: Retail-13.68 (load-adjusted); Retirement-15.42
Costs: Retail-Expense Ratio-0.66; Turnover-31%
Costs: Retirement-Expense Ratio-.33; Turnover-31%
Five-Year R-squared rating-88 (for both retail and retirement shares)

Five-Year Annualized Return: Retail-13.46; Retirement-13.58
Costs: Retail-Expense Ratio-0.68; Turnover-41%
Costs: Retirement-Expense Ratio-.58; Turnover-41%
Five-Year R-squared rating-85 (for both retail and retirement shares)

Growth Index Investors (retail)/Institutional (retirement) Fund:
Five-Year Annualized Return: Retail-13.90; Retirement-14.06
Costs: Retail-Expense Ratio-0.18; Turnover-11%
Costs: Retirement-Expense Ratio-.07; Turnover-11%

© 2017 InvestSense, LLC. All rights reserved.

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

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