Are Your 401(k) Plan’s Mutual Funds Legally Prudent?

“You get what you don’t pay for.” – John Bogle

Full Disclosure and Total Transparency: I am an attorney. More specifically, I am a wealth preservation attorney and a plaintiff’s securities/ERISA attorney. I primarily offer forensic litigation and consulting services to individuals, trial attorneys and entities such as trusts, estates and pension plans.

The goal of this post is to level the playing field, provide you with some information and a worksheet to help you better evaluate your investment choices, whether in a private investment account or a 401(k) plan or other form of pension plan. For some reason ERISA, the major legislation covering most private retirement plans, does not require that employers provide employees in their pension plans with meaningful investment education programs.

I recently did an interview with Robin Powell of the “The Evidence Based Investor.” Robin is a well-known and well-respected journalist in the U.K. who is leading the movement for evidence-based investing. In the article, I told the story of an American CEO who suggested to me that the reason pension plans do not voluntarily provide meaningful educational programs for workers is that then the workers would realize how bad most pensions plans are and would possibly sue their employers.

I believe that investors have a right to be treated fairly by being provided with a win-win situation, both in private investment accounts and pension plans. There is currently an ongoing debate about whether employees should be required to enroll in their company’s pension plans. In my opinion, that would be a significant, and costly, mistake for employers unless, and until, they ensure that their pension plan is compliant with ERISA and equitable to plan participants. Currently, I would argue that most are neither.

When I work with securities/ERISA attorneys, I explain my four-point investment fiduciary liability system:

  1. The Supreme Court has stated that the Restatement (Third) of Trusts (Restatement) is a valuable resource in resolving fiduciary issues, especially involving ERISA questions.
  2. Section 90 of ERISA (aka the Prudent Investor Rule), comment b, states that fiduciaries have a duty to be cost-conscious.
  3. Section 90 of ERISA, comment f, states that in selecting investments for pension plans and other accounts, fiduciaries have a duty to choose investment that provide the highest level of return for a given level of costs and risks or, conversely, the lowest level of costs and risks for a given level of return.
  4. Section 90 of ERISA, comment h(2). states that fiduciaries should not choose or recommend actively managed mutual funds unless it is “realistic” to assume that such funds will produce sufficient returns to cover the extra costs and risk commonly associated with such funds, i..e., such funds are cost-efficient.

And there is the rub, the investment industry’s “dirty little secret.” Investment ads and  mutual fund companies love to tout investment return numbers. However, even the numbers they tout are often “highly suspect.” Ads touting “we’re #1” or “we’re the best” are common, based on nominal return numbers. How many investment ads have you ever seen touting “we’re the most cost-efficient fund?” Care to guess for the reason for the absence of such ads? The overwhelming majority of actively-managed funds are simply not cost-efficient.

My focus on cost-efficiency is a direct result of the research of investment notables, including icons Charles D. Ellis and Burton G. Malkiel.

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.1

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.”2

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover.3

“there is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4

With that information in mind, I created a simple metric, the Active Management Value Ratio™ 3.0 (AMVR), that allows investors, investment fiduciaries and attorneys to determine whether an actively managed mutual fund is cost-efficient, and therefore compliant with the standards set out in the Prudent Investor Rule. It is usually about this time that stockbrokers point out that they are not required to adhere to fiduciary standards, to put a customer’s financial interest ahead of their own. That’s not always true though. And as I tell people, even if it is not currently legally required that stockbrokers only recommend and use prudent investments in your accounts to protect your financial security, you can still make that a requirement in order to handle your accounts in order to protect your financial security? Your money, your rules.

This is a snapshot of a AMVR analysis between the retail version of a leading actively managed large-cap growth fund, AGTHX, and a comparable Vanguard retail large-cap growth fund, VIGRX.

Incremental Return Analysis
The actively-managed fund actually outperforms the Vanguard fund based on nominal, or stated, return. However, the actively-managed fund imposes a front-end load/fee of 5.75 percent on purchases of retail shares, which is immediately deducted from an investor’s account. As a result, an investor will never receive the stated nominal fee since their account has less money to benefit from the fund’s future returns. In this case, an investor would have received a five-year annualized return of only 14.11 percent over the period from October 1, 2013 to September 29, 2018, not the stated nominal return of 15.47 percent over that same period. Note: All return numbers stated herein will cover the same period.) You get what you don’t pay for!

A common saying in the investment world is that returns are a function of risk. There-fore, in order to get a more accurate evaluation of a fund, the fund’s returns need to be adjusted for the level of risk the fund assumed in achieving the indicated returns. In my practice, I use Morningstar’s risk-adjusted return methodology.

Stockbrokers and mutual funds will often argue that “investors cannot eat risk-adjusted returns.” I find that argument interesting for two reasons. First, it is not unusual for actively-managed funds returns to improve on a risk-adjusted basis. Second, stockbrokers and mutual fund companies have no reluctance to tout a good “star” rating from Morningstar in their marketing programs. Perhaps they are unaware that Morningstar is on record as stating that their “star” system is based largely on a fund’s risk-adjusted returns.

However, here the actively-managed fund under-performs the Vanguard fund on both a load-adjusted and risk-adjusted basis. As a result, the actively managed fund is imprudent based on returns alone when compared to the Vanguard fund.

Incremental Return Analysis
When an actively-managed fund fails to provide a positive incremental return, there is obviously no reason to perform an incremental cost analysis. Investors invest to make money, not underperform another comparable fund.However, I want to do one for the sake of example.

Simple, straightforward math. “My, Dear, Aunt, Sally” from our elementary school math days._All of the information needed to complete an AMVR analysis is available for free online at sites such as,, and I like to add trading costs into the AMVR analysis based on Malkiel’s findings, However, an AMVR analysis is still valid without adding a fund’s trading costs.

In this example, the nominal incremental cost between the two funds is 67 basis points (0.67). (Note: A basis point is 1/100th (.01) of one percent.) That means that the actively-managed fund’s incremental, or excess, costs constitutes 71 percent of the fund’s total costs, with the investor receiving absolutely no positive return for such costs. Investors need to remember that each additional 1 percent in fees and costs reduces an investor’s end-return by approximately 17 percent over 20 years. That loss would also need to be adjusted on a percentage basis based on the investment’s overall percentage within the investor’s total portfolio.

Closet Indexing
Closet indexing is a serious problem in investment industries around the world. Closet indexing refers to situations where an actively-managed fund claims that it offers actively-managed funds and charges significantly higher fees based on the purported benefits of active management. However, more often than more, such funds simply track the performance of a comparable, less expensive index fund, wasting an investor’s money. Again, you get what you don’t pay for.

To evaluate the impact of possible closet indexing, I perform a second incremental cost analysis using Ross Miller’s Active Expense Ratio (AER). It is not necessary to perform an AER analysis to benefit from an AMVR analysis. I simply perform the extra analysis due to my clientele and to further protect against cost-efficiency.

A simple explanation of the AER is that the metric uses a fund’s R-squared number, or correlation of returns, to determine the extent to which an actively-managed fund tracks a comparable market index or index fund. The metric than adjusts a fund’s incremental cost number to reflect the effective cost of the fund in light of extent to which the fund’s performance is properly attributable to the active management of the fund, rather than a market index or comparable index fund.

In the immediate case, the fund’s high R-squared number, combined with the level of the fund’s incremental costs, results in an effective annual expense ratio of 5.40 percent, significantly higher than the Vanguard’s expense ratio of 0.17. The resulting incremental cost constitutes approximately 95 percent of the actively-managed fund’s AER-adjusted effective annual expense ratio. High fees with absolutely no positive incremental return.

Bottom line: An underperforming and overpriced fund is never prudent.

Retirement Share Analysis
Another class of mutual funds shares are retirement shares. Pensions plans should never contain mutual funds that impose any sort of front-end, back-end, or any other type of purchase load/fee. Never agree to pay such added fees, on either retail or retirement shares. There is simply no need, as there are excellent no-load mutual funds that do not impose such unnecessary fees.

A longstanding debate in the investment industry is which offers the best retirement shares-Vanguard or Dimensional Fund, more commonly known as DFA. Both are industry leaders that offer low-cost, primarily index-based funds. But I always recommend that investors perform an AMVR analysis in evaluating funds. Once you learn where to locate the limited amount of data needed, you will find that an AMVR takes less than a couple of minutes.



The retirement shares AMVR analysis compares an institutional DFA large-cap value fund, DFLVX, with a comparable institutional Vanguard large-cap growth fund, VIVIX. Comparing risk-adjusted returns, the DFA fund slightly under-performs the Vanguard fund, thus providing no positive incremental return.

Once again, high incremental costs with no positive incremental returns based on either DFLVX’s nominal, or stated, returns or AER-adjusted returns. An analysis of the fund’s incremental returns shows the fund’s stated expense ratio constitutes 85 percent of the fund’s stated total annual expense ratio and 95 percent of the fund’s AER-adjusted effective annual expense ratio.

Once again, the evidence clearly indicates that this particular fund is not cost-efficient and is thus imprudent relative to the Vanguard fund, in accordance with the standards established by the Restatement (Third) of Trusts and the Prudent Investor Rule.

Cost-efficiency and 401(k) Plans
Each year “Pensions and Investments” (P&I) puts out an informative report listing the top 50 mutual funds in domestic defined contribution plans, such as 401(k) plans. At the end of each calendar quarter, I do an AMVR analysis of the top 10 non-index funds on P&I’s list. Plan participants and plan sponsors might find it interesting to check to see if any of their plan’s investments are on the analysis and, if so, check their current AMVR rating. The most current quarterly analysis is available on Slideshare.

Investors, both individuals and pension plan participants, deserve to be able to have the investment information they need to adequately protect their financial security and “retirement readiness.” Plan sponsors deserve to have the investment information they need to help their plan participants work toward “retirement readiness,” as well as protect themselves against unnecessary and unwanted personal liability.

Funds that are not cost-efficient result in unnecessary investment losses. Unfortunately, most studies indicate that the majority of actively-managed funds do not cover their investment costs, and thus are neither cost-efficient nor prudent.

The Active Management Value Ratio™ provides a simple means of obtaining such information by determining the cost-efficiency of actively-managed mutual funds. The AMVR calculations require limited data, all of which is freely available at various online sites. In our analyses, we do provide one additional metric, our proprietary InvestSense Quotient, which analyses a fund’s efficiency, both in terms of cost and risk management, as well as a fund’s consistency of performance.

One of the key aspects of the AMVR is its simplicity, both in performing the necessary calculations and interpreting the results. Interpreting the AMVR’s results requires just two questions:

(1) Does the fund provide a positive incremental return?
(2) If so, does the fund’s positive incremental return exceed the fund’s incremental costs?

If the answer to either question is “yes,” then the fund is not cost-efficient, and is legally imprudent. It is as simple as that.

The AMVR is an opportunity for investors, attorneys, plan sponsors and other investment fiduciaries to prove the truth of our company’s motto-“the power of the informed investor.”

1. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
2. Ellis, Charles D., “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018, 10.
3.. Malkiel, Burton, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
4. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.

                      Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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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