Investor, Protect Thyself: Rating Your Portfolio and Financial Adviser

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The foregoing disclosure was proposed by the Securities and Exchange Commission (SEC) as an alternative to enforcing the registration requirements of the Investment Advisers Act of 1940 against broker-dealers. The Financial Planning Association (FPA) eventually sued the SEC to compel them to enforce the existing law.  The court ruled against the SEC, and the disclosure statement requirement was withdrawn.

Nevertheless, the conflict of interest issues between stockbrokers and customers remains. One would think the SEC would reinstitute the disclosure requirement to at least educate and warn the public, which would clearly be in furtherance of its mission statement. As it stands, there is a heated debate going on between advocates and opponents of a potential universal fiduciary standard. A universal fiduciary standard would require anyone providing investment advice to the public to always put the customer’s/client’s interests first.

Just as in anything in life, there are good players and bad players. Investment advisers are required to always put a client’s interests first. Experience has shown that some investment advisers do not do so. Stockbrokers and other “financial advisers” are generally allowed to put their own financial best interests ahead of those of their customers. Experience has shown that some definitely do so, while other stockbrokers and “financial advisers” do in fact do the honorable thing and put their customers’ best interests first.

The problem is that there is no way for investors and investment fiduciaries, such as trustees and 401(k) plan sponsors, to know whether their financial adviser is putting the customer’s or the adviser’s interests first. As a result, the customer may be at risk due to poorly constructed investment portfolios and unnecessary and excessive costs which reduces their end return.

Fortunately, investors can use forensics to evaluate both their investment portfolio and their financial adviser. While forensics can involve complicated analyses, investors can use three simple strategies to perform meaningful forensic analyses. The information needed to perform these three analyses is available online for free through such sites as, and other financial sites. My preference is, so I will reference that site in this article.

The first analysis is a simple comparison of the five-year annualized returns for a mutual fund and an appropriate benchmark. Most sites will provide such an analysis. On, you simply search for the fund you are analyzing. The fund’s performance information is provided under the “Performance” tab in the “Funds” section. Scroll down and you will find information on the fund’s 3, 5, and 10 year performance. I recommend using the 5 year data, as it helps reduce the chance of skews due to an unusual year, yet is long enough to be a reliable indicator.

If the actively managed fund has underperformed its benchmark, why would an investor choose to invest in the fund, especially when the annual fee charged by an actively managed fund is usually 3-4 times higher than the annual fee for an index fund? Note:  Copy the return information for both the fund and the benchmark, as you will use it in the third analysis.

The second analysis involves a review of the fund’s R-squared rating. Morningstar defines a fund’s R-squared rating as

R-squared measures the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 100. An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark. Thus, index funds that invest only in S&P 500 stocks will have an R-squared very close to 100. Conversely, a low R-squared indicates that very few of the portfolio’s movements can be explained by movements in its benchmark index. An R-squared measure of 35, for example, means that only 35% of the portfolio’s movements can be explained by movements in the benchmark index.

Therefore, R-squared provides us with a means of assessing just how much of a fund’s performance can be attributed to the benchmark’s performance as opposed to the actively managed fund’s management team. This in turn allows us to evaluate the fairness of the actively managed fund’s stated fees, as actively managed funds usually charge annual fees that are 3-4 times higher than passively managed index funds.

Funds with a high R-squared rating are often referred to as “closet index” funds since they provide essentially the same return, albeit at a much higher cost. Thus, investing in a closet index fund makes no sense, as the higher cost of the closet index funds effectively reduces an investor’s end return. Furthermore, the higher a fund’s R-squared rating, the less the contribution of active management and thus the higher the effective fee of the actively managed fund. Professor Ross Miller performed a landmark study that showed that the effective fee for fund with high R-squared rating is often 4-5 times, in some cases even greater, than the fund’s stated annual fee.

On, a fund’s R-squared rating can be found on each fund’s specific page. Click the “Ratings and Risk” tab. Then scroll down to the “MPT Statistics” and the fund’s R-squared rating.

The third and final forensic analysis uses our proprietary metric, the Active Management Value Ratio 2.0™ (AMVR). The AMVR is simply a cost/benefit analysis of an actively managed mutual fund using a fund’s incremental cost and incremental return. For more information on the AMVR and its calculation, click here.

The AMVR effectively measures the cost efficiency of a fund using the additional cost and return of a fund over and above that of the fund’s appropriate benchmark, allowing an investor to focus on the actively managed fund’s value proposition, if any. Remember the five-year annualized return data from the first analysis. If the actively managed fund underperformed the benchmark, then there is no need to perform the AMVR analysis since it would be foolish to invest in the actively managed fund since it failed to provide any benefit to an investor.

If the actively managed fund outperformed the benchmark, there still remains the question of whether the amount of the incremental, or additional, return justified the incremental , or additional, cost. If the incremental cost exceeds the amount of the incremental return, then an investor would actually lose money by investing in the actively managed fund.

Note: While does provide information about a fund’s fees, the fees referenced are generally for retail shares of the fund. If an investor is doing an AMVR analysis on funds within a 401(k) or another type of retirement account, then the investor should read the fund’s prospectus to use the correct fee in the AMVR analysis. Fortunately, usually provides a link to the most current prospectus for a fund on the funds’ morningstar page. The fund’s fee information is usually in the first few pages.

While these three analyses in no way provide a full and complete forensic analysis of an actively managed mutual fund, they can provide meaningful red flags of issues that an investor or investment fiduciary, such as a trustee or a 401(k) plan sponsor, needs to address, either through further self-analysis analysis and/or discussions with their financial adviser regarding the funds themselves and/or possible conflict of interest issues that are financially benefiting the adviser at the investor’s expense.

Bottom line, in matters of investing and investment advice, the best practice for investors is to heed the advice of President Ronald Reagan – “trust, but verify.” Hopefully these three analyses will help investors be proactive and perform the needed verification of both their investment portfolios and their financial advisers.

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This article is not designed or 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.