How to REALLY Evaluate a Mutual Fund

Get what you can and keep what you have – that’s the way to get rich. – Scottish adage

I am a securities/ERISA attorney. I am also a wealth preservation attorney. As a wealth preservation attorney, I help people design and implement strategies to help them accumulate, protect and preserve their wealth. As a familiar Wall Street adage says, “don’t tell me how much money you made, tell how much money you kept.”

I am of Scotch-Irish heritage, so I am especially fond of the opening quote. Simple, pure common sense approach to wealth preservation. As the late Steve Jobs used to say, “simple is the new sophistication.”

And yet, I continually see people who have chosen to invest in imprudent investments that are actually costing them money in terms of consistent underperformance and/or excessive fees and other costs. Sometimes the poor investment choices are simply due to a lack of investment education. Unfortunately, poor investment choices are the result of poor and misleading investment advice from “investment professionals.

I have written several articles on the REAL wealth management investment process that I recommend to clients: accumulation, protection, preservation.  Simple, proven, common sense techniques that work.

Mutual funds have become the primary investment for most Americans. Chosen wisely, they provide investors with a simple and effective way to accumulate wealth and manage investment risk.

Wisely is the operative term. “Investment professionals” sometimes do not disclose all of the  information an investors needs to make investment choices, as it would reveal information that would convince an invest not to purchase the “adviser’s” investment products. This inherent conflict of interest has been and continues to be the subject of an intense debate, a legal battle of the best interests. Unfortunately, it appears that the federal regulators have chosen to protect Wall Street  instead of investors with the full protection they need.

Several years ago I created a metric, the Active Management Value Ratio™ (AMVR) to help protect investors and pension plan plan sponsors. The AMVR is simple and straightforward. I talked my way out of calculus in both high school and college (“I’m going to be an attorney. I don’t need no stinkin’ calculus.”). Therefore, the AMVR requires nothing more than the simple “My Dear Aunt Sally” math skills we learned in elementary school. All of the information needed is freely available online at sites such as, yahoo! and

AMVR 101

There are a number of articles that discuss the AMVR and the calculation process. I want to discuss in this post is some basic mistakes that I see investors make that cost-investors dearly.

  • Returns – Investors see mutual funds ads that tout a mutual fund’s performance. However, those returns are known as nominal, or stated, returns, and they can be very misleading.For instance, let’s say a mutual fund is claiming an annual return of 20% for the year. Most actively managed mutual funds charge what is called a front-end load, a fancy term for a commission, when an investor purchases shares in their fund. The maximum front-end load that a mutual fund can legally charge is currently 4.50%.Mutual funds immediately deduct a fund’s front-end load at the time of purchase. This reduces the amount of money you have in the fund, and thus the amount of return an investor will receive.For example, on initial purchase of $100,000 of a fund that charges a 4.50% front end load, an investor will actually only have $95,500 invested in the fund. A 10% return on the original investment of $100,000 would provide a return of $10,000. A 10% return on $95,500 only provides a return of $$9,550, a difference of $450.Over time, that difference grows significantly. Aristotle called compound interest the “eighth wonder of the world. Investment returns obviously vary over time. However, to show the impact that front-end load can have on returns, over a 10-year period, that difference would grow to approximately $11,672. The difference would grow to approximately $30,273 over a 20-year period. So, investors always need to adjust a mutual fund’s stated return for any front-end loads charged by a fund. If a fund does not charge a front-end load, then go straight to risk-adjusted return.The next step is to adjust a fund’s load-adjusted return for the amount of risk a fund incurred in producing its returns. A common saying is that return is a function of risk. The most commonly used factor in adjusting investment returns for risk is a fund’s standard deviation. InvestSense uses the standard deviation available at, as it provides standard deviation over several time periods.
  • Costs – The late John Bogle of Vanguard fame was known for saying “costs matter.” And they do.Most investors are familiar with the concept of a fund’s annual expense ratio (ER). ERs include a fund’s management fee and a few other expenses. However, ERs do not include a fund’s trading costs.It is assumed that an actively managed fund will engage in trading the investments in the fund. Therefore, actively managed fund should incur higher trading costs than a passive/index fund. However, a fund’s trading costs are often referred to a “hidden” cost sine they are only reported collectively with other “operational costs.”Investors always want to select mutual funds that are cost-efficient, funds whose incremental, or extra returns, are greater than its incremental costs. Since trading costs are not separately reported by fund’s, InvestSense uses a metric created by John Bogle to create a proxy for a fund’s trading costs.That simple metric is to double a fund’s reported turnover rate, and then multiply that number by 0.60. For a fund with a turnover ratio of 25%, an investor would use 30%, or 0.30, for the fund’s trading costs. An investor then combines the fund’s stated ER with the trading costs number to get a fund’s total costs number to use in comparing mutual funds for cost-efficiency purposes.
  •  Cost “Secrets” – Two things that many “investment professionals” do not like to discuss, and therefore rarely discuss with customers, are cost-efficiency and “closet indexing.” If customers knew bout cost-efficiency and “closet indexing, they would never invest in actively managed mutual funds. With regard to cost-efficiency, the experts have made it very clear:

    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.

    [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.

    [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.

If a fund is not cost-efficient, it effectively means that an investor is suffering a net loss. As one expert likes to say, “costs are negative returns.

“Closet indexing” refers to a situation where a funds holds itself as providing active management to customers, but provides essentially the same, or poorer, returns than a comparable index fund, albeit at a substantially higher costs. As noted investment legend Rex Sinquefield summed up active management and “closet indexing” perfectly

We all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it.

Going Forward
Each additional 1% in fees and costs reduces an investor’s end return by approximately 8% over 10 years and approximately 17% over twenty years. Investors should apply those same concerns to a fund’s underperformance relative to a comparable index fund. Investors should always look for funds that provide them with an opportunity for upside potential as well as downside protection.

Get what you can and keep what you have – that’s the way to get rich

Copyright © 2019 InvestSense, LLC. All rights reserved.

This article is for informational purposes only. It 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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