For the first new blog post since our blog and domain name were recovered, I figured it was only appropriate to re-christen the blog with our popular quarterly “cheat sheet” of the top non-index mutual funds in U.S. 401(k) plans. “Pensions & Investments” publishes an annual list of the top 50 mutual funds used in U.S., 401(k) 401(k) plans based on the cumulative amounts invested in each fund within the plans.
We then perform a quarterly analysis of the actively managed funds from the top ten funds in Pensions & Investments’ list. The forensic analysis, or the “cheat sheet,” for the 4Q of 2020 is shown below.
For those unfamiliar with InvestSense’s Active Management Value Ratio (AMVR), the AMVR calculates an active fund’s cost-efficiency. A fund may produce a positive incremental return relative to a comparable passive benchmark, such as an index fund. However, if the fund’s incremental costs exceed the fund’s positive incremental returns, the fund would actually be an imprudent investment for an investors, as it result in an overall loss for an investor.
The AMVR is simply an adaptation of the common cost/benefit ratio, using the incremental cost/incremental benefit concept from Charles Ellis’ classic, “Winning the Loser’s Game.” Increasing, plaintiff’s attorneys in both ERISA fiduciary breach actions and general fiduciary breach investment actions are using both the correlation-adjusted and risk-adjusted numbers to calculate the damages in their cases.
For example, Vanguard PRIMECAP’s AMVR using the fund’s nominal, or publicly reported, data would be 0.27/0.94, or 0.28. The lower a fund’s AMVR score, the greater the fund’s cost-efficiency. An AMVR score above 1.00 indicates that a fund is not cost-efficient, as its incremental costs exceed its incremental returns. If a fund fails to provide a positive incremental, it does not qualify for an AMVR score, since the fund has underperformed its benchmark.
The AMVR simplifies the cost-efficiency evaluation process. Once an actively managed fund’s cost efficiency has been calculated relative to a comparable benchmark, usually a comparable index fund, the plan sponsor or the ERISA attorney only have to answer two simple questions:
1. Did the actively managed funds provided a positive incremental return?
2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs
If the answer to either of these of these questions is “no,” the actively managed is not cost-efficient and, therefore, does not meet the plan sponsor’s fiduciary duty of prudence.
Using the funds’ 4Q nominal data, three of the funds, failed to provide a positive nominal return at all- American Funds’ Growth Fund of America fund (R-6 class shares), Fidelity Contrafund fund (K class shares) and T. Rowe Price Blue Chip Growth fund (R class shares. The AMVR score for the remaining three funds would have been American Funds Washington Mutual fund (R-6 class shares)-0.10, Dodge & Cox Stock-0.10, and, as previously mentioned, Vanguard PRIMECAP (Admiral class shares)-0.28.
When InvestSense performs a full forensic audit for a 401(k)/403(b) plan, a trust, an attorney or another type of client, we then perform a second analysis using our proprietary metric, the InvestSense Quotient (IQ). Where the AMVR provides more of a quantitative analysis, the IQ provides more of a qualitative analysis, measuring the efficiency of an actively managed fund, both in terms of cost management and risk management, as well as the consistency of performance of a fund.
While an AMVR analysis using a fund’s nominal data provides a quick and simple analysis, it may not provide the depth of analysis that a professional fiduciary, e.g., plan sponsor, trustee, or an attorney needs. Fortunately, there is a relatively easy way of obtaining such additional details. By substituting an actively managed fund’s risk-adjusted incremental return and a fund’s correlation-adjusted incremental costs into the AMVR cost/benefit equation, some funds that appear to be cost-efficient using their nominative data are exposed as cost-inefficient.
Why substitute risk-adjusted incremental return for nominal-based incremental return? Simply because it is a generally accepted fact that risk drives returns, that an investor has a right to expect a level of return commensurate with the additional costs and risks that are generally associated with actively managed mutual funds relative to comparable index funds. This concept is consistent with the prudence standards set out in the Restatement (Third) of Trusts’ Prudent Investor Rule.
Why substitute correlation-adjusted incremental costs for nominal-based incremental costs? This is a little more complicated. However, Ross Miller, the creator of the Active Expense Ratio (AER) metric, provided an excellent explanation. Miller explained the reasoning behind the AER as follows:
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funds engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.(1)
For example, assume the following scenario:
Active Fund > Expense Ratio 1.00
Benchmark Fund > Expense Ratio 0.05
Assuming that the correlation of returns between the funds is 95 percent, I could theoretically achieve 95 percent of the actively managed fund’s return for only 5 percent of the cost of the actively managed fund.
The chart shows how impactful factoring in a fund’s risk-adjusted incremental returns and correlation-adjusted costs can be in evaluating the cost-efficiency of an actively managed fund. None of the three funds that survived the initial AMVR analysis would have a passing AMVR score using the adjusted cost/return numbers. This is due primarily to the 95+ R-squared scores of the funds, which in turn increases the implicit costs associated with each of the three surviving funds.
I am often asked why I I keep writing and talking about cost-efficiency and the AMVR. My answer:
1. To help investors, including pension plan participants, to maximize their investment returns by knowing how to spot and avoid imprudent investments. Studies have consistently shown that the overwhelming majority of actively managed mutual funds are not cost-efficient, with conclusions such as
“[I]ncreasing 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)
“[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.”(3)
“[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”(4)
2. To help investment fiduciaries such as 401(k) plan sponsors and trustees recognize the risks inherent in actively managed mutual funds and avoid unnecessary fiducairy liability exposure. Shortly after the Restatement (Third) of Trusts was released over forty years ago, John Langbein, reporter on the Restatement (Third) of Trusts and noted law professor Richard. A. Posner warned that,
When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.(5)
The Brotherston decision, more specifically the First Circuit Court of Appeal’s words regarding index funds, would suggest that that day has arrived.
The AMVR has received favorable reviews and is reportedly being used in the fields of finance/invest and law. The simplicity and power of the metric have been the two most cited aspects of the metric, consistent with the late John Bogle’s concept of “Humble Arithmetic.” Those willing to take the time to study my writings on the metric and practice the calculation, process will be rewarded with the ability to better protect their financial security and avoid unnecessary fiduciary liability exposure.
For more information about the Active Management Value Ratio and the calculation process, please use the site’s “Search” function and search for “Active Management Value Ratio” and/or “AMVR.”
1. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926
2. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, https://www.ft.com/content/6b2d5490-d9bb-eb37a6aa8ez.
3. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Funds Advisors, L.P. (August 2016).
4. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE 57-58 (1997).
5. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 http://digitalcommons.law.yale.edu/fss_papers/498.
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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.