What is the first factor an investor or investment fiduciary, such as a pension plan sponsor, should consider in evaluating an actively managed mutual? Most people’s answer would probably be a fund’s returns or the number of Morningstar “stars” given to a fund, despite the fact that Morningstar has warned investors that their “star” system was never intended to be used for predicting future returns.

Most investors and attorneys are surprised when they learn that the first piece of data I look at in evaluating an actively managed mutual fund is the fund’s R-squared correlation number. My reasoning is that a fund’ R-squared number provides meaningful context to the rest of a fund’s numbers.

The R-squared number I look at is the correlation of returns between an actively managed fund and a comparable index fund. I use a comparable index fund so that I can factor in incremental returns and incremental costs to calculate the actively managed fund’s cost-efficiency, or lack thereof.

[R-squared] is simply a measure of the correlation of the [investment’s] returns to the benchmark’s returns. An R-squared of 100 indicates that all movements of a [investment] can be explained by movements in the benchmark. An R-squared measure of 35, for example, means that only 35% of the [investment’s] movements can be explained by movements in the benchmark index.

The benchmarks I use most often are Vanguard index funds (VIGRX/VIGAX, VIVAX/VVIAX and VFINX/VFIAX). However, other low-cost index funds may also be appropriate.

Morningstar provides an R-squared number for the funds it covers. However, Morningstar tends to use the S&P 500 index in calculating the R-squared number for U.S. equity funds, even when the fund is question is not a large cap blend stock, which is how the S&P 500 Index is categorized. As an attorney, I would obviously object to any cost-efficiency comparisons using a different asset category other than the one for the fund in question.

R-squared gives me a quick signal of a potential “closet index” situation. Closet indexing is a world-wide problem that is receiving greater attention due to its impact on investors. Closet indexing is generally defined as a fund holding itself out as an actively managed fund, and charging higher fees based on such active management, but whose performance closely tracks the performance of a comparable, less expensive, index or index fund.

A recent check on the Morningstar Investment Research Center indicated that the average annual expense ratio on domestic equity-based funds was 1.06 percent (106 basis points). The average turnover ratio on such funds was 61 percent, which equates to 73 basis points for trading costs using Bogle’s turnover/trading costs metric.

Using such data, the average U.S, domestic equity mutual fund starts out almost 180 basis points in the hole. The only way to cover such a deficit is by producing annual returns higher than comparable index funds. However, when actively managed mutual funds typically report R-squared correlation numbers of 90 and above, the chances of an actively managed fund covering its costs are unlikely.

Result – the investor is stuck with a cost-inefficient investment that actually costs them money and returns. Examples of the findings of some studies include

• 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.
• 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.

John Bogle was known for his famous “humble arithmetic” speech in which he announced his Cost Matter Hypothesis, stating that

Gross return in the financial markets, minus the costs of financial intermediation, equals the net return actually delivered to investors….Whether markets are efficient or inefficient, investors as a group must fall short of the market return by precisely the amount of the aggregate costs they incur.  It is the central fact of investing.

Costs and the impact of such costs on performance, and therefore investors’ end returns, are at the heart of the ongoing debate over the merits of actively managed funds versus passive/index funds.

There are some, myself included, that have argued that “humble arithmetic” is equally valuable in evaluating actively managed mutual funds in terms of their cost-efficiency relatively to comparable index funds. Bogle was fond of saying that investors “get to keep what they don’t pay for.” Financial advisers and investment managers often try to minimize the cost of their services or their investment with the “it’s only 1 percent” argument.

However costs, like returns, compound over time, greatly increasing both. Each additional 1percent in fees/costs reduces an investor’s end-return by approximately 8 percent over a 10 year period and 17 percent over a twenty year period.

The impact of a fund’s fees and expenses can increase dramatically once a fund’s R-squared number is considered. Professor Ross Miller created a metric called the Active Expense Ratio (AER). Miller has said that the value of the AER is that it “enables one to compute the implicit cost of active management.”

The driving force behind the AER is the actively managed fund’s correlation of returns to a comparable index fund. Miller’s research has shown that actively managed funds often have a high R-squared, or correlation, number and charge significantly higher fees than comparable index funds. As a result, the AER often indicates that many actively managed have implicit annual expense ratios that are significantly higher than their stated rates, in many cases 500-600 percent higher, without an equally commensurate return to cover such fees.

Actively managed mutual funds routinely attempt to justify their higher fees based on the alleged benefits that their actively managed funds provide relative to comparable index funds. However, with many actively managed funds showing high R-squared correlation numbers of 90 and above, the contribution, if any, of active management to a fund’s overall performance is greatly reduced, especially from a cost-efficiency perspective.

There are those who argue that funds holding themselves out as providing active management and the purported benefits of same, whose high-R-squared correlation numbers indicate otherwise, are in violation of federal securities laws. Whether or not that is true, the fact remains that in evaluating an actively managed fund, the fund’s fees should be adjusted to reflect the fund’s reduced active management component and the resulting change in the implicit costs of such high R-squared actively managed mutual funds.

Whether you want to frame the question in terms of “best interest,” “prudence,” “suitability, or “fair dealing,” actively managed mutual funds with high R-squared correlation numbers and significant incremental costs compared to equivalent index funds are never in an investor’s best interest. How many of your current 401(k) and personal investments have a five-year R-squared number of 90 or above? A quick check on morningstar.com (under the “Risk” tab) might prove insightful.

As my colleague, Fred Reish, one of America’s leading ERISA attorneys, likes to say, forewarned is forearmed.

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This article is for informational purposes only, and 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.