Numerous studies have concluded that when it comes to investing, American are functionally financially illiterate. Despite these findings, ERISA, the primary legislation regulating American pension plans does not require that plan participants be provided with any sort of investment education.

When the time comes to retire, federal regulators tout laws that allegedly require those advising such retirees to always put the “best interest” of such retirees. And yet, such protections are effectively neutralized by a loophole that allows advisers to restrict their recommendations to the often overpriced and consistently underperforming investment products of their broker-dealer’s “preferred providers,” who pay for the right to have access to the broker-dealer’s brokers.

Fortunately, investors who can perform basic math such as subtraction, can easily protect their financial security by using a metric I created, the Active Management Vaue Ratio™ (AMVR). In many cases, the actual basic calculation process takes less than a minute. The basic information needed to use the AMVR is freely available online.

Personal Retail Investment Accounts
The AMVR is based primarily on the research and concepts of investment experts such as Nobel lauerate Dr. William F. Sharpe, Charles D. Ellis, Burton L. Malkiel. I simply combined their concepts and presented them in a visual context so that they would be easier to understand.

An example of an AMVR forensic analysis is shown below. As Dr. Sharpe suggested, an AMVR analysis always compares an actively managed mutual fund with a comparable index fund. The AMVR then calculates the cost-efficiency of the actively managed fund relative to the index fund by dividing the actively managed fund’s incremental costs by the fund’s incremental returns.

In interpretting an AMVR analysis, an investor only has to answer two simple questions:

1. Did the actively managed fund provide 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 question is “no,” the actively managed fund is not cost-efficient relative to the comparable index fund and is therefore a poor investment choice.

In this example, The answer to both questions is “no.” An investor should continue searching or simply invest in a cost-efficient index fund.

The AMVR analysis also provides two additional points. Actively managed retail mutuall funds often charge investors a “load” at the time of their initial purchase of the funds. These loads are essentially a commission and reduce the amount of an investor’s actual investment in a fund. In this example, the load would have significantly reduced an investor’s end-return from 20.88 percent to 19.48 percent.

The column marked “AER” goes beyond the basic AMVR and is often not needed to determine that an actively managed is not cost-efficient. AER refers to Ross Miller’s Active Expense Ratio. Miller explained the importance of the AER as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds 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.

In this case, the correlation of returns between the two funds happened to be 97 percent. High incremental costs combined with a high correlation of return between ttwo funds always significantly increases expenses that an investor effectively pays, often with no corresponding benefit in return. The investor here could have received a much better return by simply paying the index fund’s expense ratio. The incremental cost of the actively managed fund was just wasted money.

The financial services attempt to avoid any discussion of the cost-inefficiency of their products. Why?

• 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.

Ellis provides additional support for the importance of cost-efficiency, noting that

[T]he incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!

The media also seems to avoid informing the public of the cost-inefficiency issue. However, as the saying goes, “facts do not cease to exist becuase they are ignored.”

Pension Plans and Retirement Accounts
The importance of evaluating cost-efficiency is equally applicable to 401(k) plans and other retirement plans. A key point is that actively managed mutual funds in pension plans should never charge a plan participant a load of any type. Unfortunately, other than that difference, the overwhelming majority of actively manged mutual funds in pension and other retirement prove to be equally cost-inefficient.

The AMVR analysis compares an actively managed mutual fund commonly used in pension and retirement accounts with a comparable index fund. Once again, the answer to the two required questions is “no.” Therefore, the actively managed fund is cost-inefficient, or imprudent, relative to to the comparable index fund.

Unfortunately, this an all too common scenario with regard to investments options within and investment advice provided to pension plans and retirement accounts. This is why there continues to be so much litigation involving these plans and accounts. This situation could, and should, be easily resolved were it not for the greed of the inestment industry and the fact that many plan sponsors do not understand their true fiduciary duties under ERISA.

Once again, we see the impact of high incremental costs and funds with  high correlation of return, here 98 percent. A large percentage of U.S. equity funds have a correlation of returns, or r-squared, number of 95 or above. This results in extremely high implicit fees that investors in actively managed funds are paying, often with no commensurate return.  

Jack Bogle, the founder of The Vanguard Group mutual fund company, had two sayings he often quoted -“Cost Matter” and “You get what you don’t pay for.” The General Accounting Office has noted that each additional 1 percent in fees and costs reduces an investor’s end-return by approximately 17 percent over twenty years. Cost-efficiency matters.

Going Forward
John Langbein served as the official Reporter for the committee that drafted the Restatement (Second) of Trusts (Restatement). Shortly after the release of the revised Restatement, Langbein wrote a law review article on the new Restatement. At the end of the article, he made a bold prediction:

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.  

I would suggest that that day has arrived and that the AMVR will be an indispensable tool in helping both investors and investment fiduciaries maximize their wealth management opportunities through prudent investment choices.

Copyright InvestSense, LLC 2022. All rights reserved.

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