Investor, Protect Thyself: The InvestSense Investor Self-Defense Strategy

During his term as Chairman of the Securities and Exchange Commission (SEC).(1993-2001), Arthur Levitt focused more on investor protection than perhaps any other recent SEC Chairman. His advice from a1999 speech, “Financial Self-Defense: Tips From and SEC Insider,” is still relevant and valuable to investors today.

There are more ways to invest than ever before. But there also seem to be more ways to be confused – or to be misled.

America’s marketplace is generally honest – but there are some crooks out there. And, there’s only so much that law enforcement and regulatory watchdog agencies, like the SEC, can do.

You’ve got to do your part, too….You also need to be on guard when dealing with investment professionals. The vast majority of people selling securities are honest. But we do have people who walk a fine line between good sales practices and poor sales practice….

An informed investor looks beyond the packaging of a product and also sees what’s inside.1

Sadly, recently the SEC has seemingly focused more on protecting the interests of Wall Street rather than on the protection of investors, one of the stated purposes and goals of the commission. As a result, Chairman Levitt’s admonition to assume greater responsibility for self-protection when dealing with the investment and/or the pension/retirement industries is equally applicable today.

Active versus Passive-Costs Matter
The late John Bogle, founder of the Vanguard Group, was fond of reminding investors that “costs matter.” In the ongoing debate over actively managed funds compared to passively managed index funds, one issue that is undeniable is that actively managed mutual funds, by their very nature, will have higher costs than index funds, specifically trading and management costs.

Advocates of actively managed funds argue that that the higher costs are justified by the fact that actively managed funds produce higher returns for investors. Evidence would suggest otherwise. So the questions are (1) how much higher costs does an actively managed fund have compared to a comparable benchmark index fund, and (2) what impact do the higher costs have on a fund’s performance?

As for a fund’s management fees, those are reflected in a fund’s annual expense ratio/fee. Whether those fees are justified or not are reflected in the fund’s performance relative to a comparable benchmark index fund, as well as the actual amount of active management actually provided by a fund.

As for trading costs, mutual funds are not currently required to provide their actual trading costs to investors. Instead, funds are allowed to group actual trading costs into a generic category of “operating costs,” which are then deducted from a fund’s gross return in reporting a fund’s performance.

Allowing an actively managed fund to “hide” such important information as trading costs prevents investors from being able to compare such costs to make a meaningful evaluation of a fund’s efficiency in managing the fund. As the SEC and other government agencies have noted, such costs do have a significant impact on an investor’s return. Each additional 1 percent in fees and costs reduces an investor’s end return by approximately 17-18 percent over a twenty year period.

Fortunately, Bogle recognized the importance of trading costs. He created a simple metric that allows investors to create a proxy for such cost and compare such costs between funds. Bogle’s metric simply doubles a fund’s reported annual turnover ratio and multiples that number by 0.60. So, if a fund has an annual turnover ratio of 50 percent, Bogle’s metric would result in an estimated trading cost of .0.60 for comparison purposes.

Bogle himself acknowledged that his metric probably understates a fund’s actual trading costs. However, the metric is still valuable in that it provides investors, fiduciaries and attorneys with a means of comparing such costs. As studies and simple mathematics show, the potential impact of such costs is simply too important to ignore.

Investor Self-Defense and the Active Management Value Ratio™
Unfortunately, the sheer number of investment options and the complexity of same make it extremely difficult for investors to independently evaluate the available investment options. Inexplicably, despite the acknowledged importance of pension/retirement plans, such as 401(k) and 403(b) plans, and “retirement readiness,” there is no express requirement that employers provide employees with any type of investment education.

Fortunately, there are simple and extremely effective tools and strategies that investors and pension plan participants can use to independently evaluate investment options. One such tool is a metric I created, the Active Management Value Ratio™ (AMVR). The AMVR allows investors and others to follow Chairman Levitt’s advice and look “beyond the packaging of a product and also sees what’s inside.” The AMVR allows investors, plan participants, fiduciaries and attorneys to evaluate the cost-efficiency of an actively managed mutual fund.

The Supreme Court has stated that the Restatement of Trusts (Restatement) is a key resource in interpreting fiduciary law and resolving questions regarding prudent investing. Fiduciary law requires that a fiduciary always act in the best interests of the beneficiaries and/or other parties whose interests they represent. Even when a fiduciary is not actually involved, the investment standards established by the Restatement ensure that an investor’s best interests are being served.

The AMVR incorporates the Restatement’s prudent investment standards and is simply the basic cost-benefit equation that every economics student learns in their Econ 101 class. The only difference is that the AMVR compares the incremental costs and incremental returns between an actively managed mutual fund and a comparable index fund. Applying simple common sense, actively managed funds whose incremental costs exceed the fund’s incremental returns are deemed to be cost-inefficient, and thus an imprudent investment.

A simple worksheet would be as follows:

In the worksheet above, assume that we are comparing an actively managed mutual fund and a comparable index fund with the following cost and return data:

Active Fund: Annual Expense Ratio 1.00%/5-Year Annualized Return 10.50%

Index Fund: Annual Expense Ratio .0.10%/5-Year Annualized Return 10.00%

As a result, the actively managed fund would have incremental costs of 90 basis points and incremental returns of only 50 basis points. (A basis point is equal to .01 percent.) A fund’s AMVR score is simply its incremental costs divided by the fund’s incremental returns.

Here, the actively managed fund’s AMVR score would be 1.80 (.90/.50). An AMVR score greater than 1.00 indicates that a fund’s incremental costs are greater than its incremental returns, indicating that the fund is not cost-efficient. An AMVR less than zero indicates that the actively managed fund underperformed its benchmark, providing no positive return for an investor.

In interpreting the AMVR, an investor or other user only needs to answer two questions:

  1. Did the fund being evaluated provide a positive incremental return?
  2. If so, did the fund’s incremental return exceed the fund’s incremental costs?

If the answer to either of these questions is “no,” the fund does not qualify as a prudent investment under the prudent investment standards established by the Restatement.

The AMVR calculation process provides another important piece of information regarding the cost-efficiency of an actively managed fund. In the example above, the numbers show that 90 percent of the actively managed fund’s total fee is only producing approximately 5 percent of the fund’s return. This is yet another example of the fund’s cost-inefficiency and further proof that it would not be a prudent investment choice.

Investor Protection Plus
While the AMVR example provided demonstrates the importance of evaluating the cost-efficiency of actively managed mutual funds, the nominal, or reported, numbers may not properly factor in the actual contribution of active management  in the fund’s performance, and thus may understate the implicit efficiencyof the fund’s fees and costs..Investors can avoid this oversight by simply considering an actively managed fund’s R-squared correlation number.

Morningstar states that

R-squared measures the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 10.

If you want a portfolio that moves like the benchmark, you’d want a portfolio with a high R-squared. If you want a portfolio that doesn’t move at all like the benchmark, you’d want a low R-squared.

An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark. 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.

So, by reviewing an actively managed fund’s R-squared number, an investor can get an estimate of exactly how much of an actively managed fund’s performance can be attributable to the fund’s management team, as opposed to the performance of an underlying market index. In our example, the actively managed fund’s R-squared number of 95 would indicate that 95 percent of the fund’s performance can actually be attributable to the performance of the benchmark, with only 5 percent of the fund’s return being attributable to the fund’s management team. In short, a fund’s R-squared score gives investors a totally new perspective on an actively managed fund’s fees and costs, specifically the fund’s annual expense ratio/fee.

Ross Miller created a metric, the Active Expense Ratio (AER). Miller has stated that the AER measures the implicit cost of an actively managed fund’s annual expense ratio/fee by factoring in the fund’s R-squared number. The higher an actively managed fund’s R-squared correlation number, the lower the actual contribution of active management to the fund’s performance and the higher the fund’s AER score.

Using our earlier example and assuming an R-squared correlation number of 95 percent for the actively managed fund, the cost-inefficiency of the actively managed fund becomes even more apparent.

The combination of high incremental costs (90) and a high R-squared correlation number (95) result in an AER of 5.35, over 400 percent higher than the fund’s stated annual expense ratio. This further supports the argument that investors, fiduciaries and attorneys should always factor in an actively managed fund’s R-squared number.

Morningstar provides an R-squared correlation number for each of the funds it analyzes under the “Risks” tab. The only issue with Morningstar’s R-squared number is that they often use the S&P 500 index as the benchmark for all equity funds. Since Morningstar classifies S&P 500 Index funds as large-cap blend funds, the use of the index for other categories of funds is subject to questioning. At InvestSense, we calculate our own R-squared correlation numbers using comparable Vanguard index funds from the same Morningstar style box as the actively managed fund being analyzed.

While advocates of actively managed funds would argue that the results can be manipulated by assigning a high R-squared number to a fund, a simple review of data from the Morningstar Data Research Center will show that a significant percentage  of U.S. domestic equity funds currently have a R-squared number of 90 or above. And yet, inexplicably, the majority of investment holdings in personal investment accounts and pension plans are still in actively managed mutual funds.

Lessons Learned

When people ask me what I do for a living, I tell them that I am a wealth preservation attorney. When they follow-up by asking me what that means, I tell them that I combine my 20+ years legal experience as a securities/RIA compliance director and estate planner with my 30+ years experience as a financial planner to help clients develop a REAL wealth management/preservation program that focuses on the accumulation, protection, and distribution of wealth.

“Get what you can, and keep what you have. That’s the way to get rich.” That Scottish adage essentially sums up my philosophy about wealth management and preservation. I have written various articles on the three aspects of REAL wealth management and preservation, all of which are available on this blog. However, as Chairman Levitt pointed out, investors need to have a better understanding of investing in order to protect their financial security.

In my practices, we provide various comprehensive forensic analyses that calculate the efficiency of an actively managed fund, in terms of both risk management and cost efficiency, as well as a fund’s consistency of performance. However, the AMVR itself provides public investors, fiduciaries and others with a simple, yet effective, means of avoiding unnecessary investment losses due to cost-inefficient actively managed mutual funds.

The issue of cost-efficient investing is gaining increased attention in both the legal and wealth management communities. Studies have consistently concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient, resulting in statements such as

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.2
  • 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.3
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4
  • [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.5

Financial plans often recommend that a customer spend less money than they earn. The AMVR just stands for the proposition of avoiding actively managed funds that are not cost-efficient, funds whose incremental costs exceed their incremental returns.

Advocates of active management will often claim that active management allows mutual funds to cover the higher costs associated with actively managed mutual funds, namely higher annual expense ratios/fees and higher trading costs. The above-referenced studies prove otherwise. Furthermore, given the high R-squared correlation numbers of many U.S. domestic equity-based funds, it can be argued that such funds are “closet index,” or “mirror” funds, further reducing any chance that the fund’s active management can cover their extra costs

Very few investors and investment fiduciaries even consider a fund’s R-squared correlation numbers. Stockbrokers and other investment professionals try to avoid the issue due to the overwhelmingly negative evidence on the performance on the commission-based actively managed funds they sell,

Nevertheless, in addition to the two AMVR questions we previously mentioned, we suggest that all investors and investment fiduciaries doing business with stockbrokers and/or other financial salesmen always include the following two questions as part of their self-defense strategy:

  1. Will you be acting as a fiduciary in advising me/managing my account, with full disclosure of material facts and putting my best interests first?
  2. Will all of the investments you recommend be cost-efficient, with incremental returns exceeding the investment’s incremental cost relative to an appropriate benchmark?

And finally, if the stockbroker or financial adviser answers “yes“ to both questions, ask them if they are willing to put those assurances in writing. One of the first things every law student learns in their first-year contracts class is that a verbal promise is only as good as the paper it is written on.

Notes
1. https://www.sec.gov/news/speech/speecharchive/1999/spch305.htm
2. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
3. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
4. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
5. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).

© Copyright 2019 The Watkins Law Firm/InvestSense. 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.

Posted in Absolute Returns, Active Management Value Ratio, AMVR, Closet Index Funds, Consumer Protection, Consumer Rights, ERISA, Estate Planning, Fiduciary, Fiduciary Standard, Integrated Estate Planning, Investment Advice, Investment Advisors, Investment Fraud, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Retirement, Retirement Distribution Planning, Retirement Plan Participants, Retirement Planning, Uncategorized, Wealth Accumulation, Wealth Distribution, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

Investopedia Top 100 Most Influential Financial Advisor Honor

Honored to be named by Investopedia as one of the Top 100 Financial Advisors for 2019. Unlike a lot of other “top” lists, Investopedia bases its selection largely on criteria such as contributions to online media to educate investors on timely topics such as wealth preservation, wealth preservation and investor self-protection strategies.

Additional information on the Investopedia Top 100 is available at https://bit.ly/31GZrzi.

Posted in Active Management Value Ratio, AMVR, Consumer Protection, Consumer Rights, Fiduciary, Investor Protection, Life Advice, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Retirement Planning, Wealth Accumulation, Wealth Distribution, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , | Leave a comment

One Step to Building More Effective, and Safer, Investment Portfolios

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.

© Copyright 2019 InvestSense, LLC. 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.

Posted in Closet Index Funds, ERISA, Fiduciary, pension plans, portfolio planning, Portfolio Planning, Retirement, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , | Leave a comment

CommonSense InvestSense About…Returns

As an attorney that specializes in wealth management/preservation and asset protection, I often see investors who have suffered unnecessary financial losses due to poorly designed and/or poorly managed investment portfolios. This is especially troubling, for as legendary investment expert Benjamin Graham once noted in his classic, “The Intelligent Investor,”

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

Three key concepts can help investors avoid unnecessary financial losses and help maximize an investor’s returns:

  1. Front-end loads dramatically reduce an investor’s end returns.
    Most stockbrokers and financial advisers recommend actively managed mutual funds for the commissions such products pay them. Commissions on actively managed mutual funds are commonly known as “front-end loads.” Under current law, the maximum front-end load that funds can charge is 5.75 percent of the total purchase price of the mutual fund.

Front-end load charges are automatically deducted at the time of the purchase of the fund, reducing the actual amount of a customer’s actual investment. So, on a $100,000 purchase of a mutual fund that charges a 5.75 percent front-end load, only $94,250 would actually go into a customer’s account.

Many investors are unaware of the cumulative impact of a front-end load. In our example, if we assume an annual return of 10 percent over ten years, the reduced initial investment due to the front-end load reduces an investor’s annualized return to 9.35 percent and a reduced actual dollar amount of almost $15,000 due to the impact of compounding.

Mutual funds are required by law to provide their return information net of fees, including any the impact of a front-end load. That information must appear in any ads published by a fund, as well as in a fund’s prospectus. The problem is that evidence shows that few investors actually look at a fund’s prospectus, and the load-adjusted return information is often buried in an ad’s small print.

2. Expense ratios and so-called “invisible” costs further reduce an investor’s returns. The impact of front-end loads is not the only factor that investors need to consider when selecting mutual funds. Studies have shown that most actively managed mutual funds are not cost-efficient, consistently underperforming comparable no-load index mutual funds due to the impact of the extra costs associated with active management, e.g, higher annual expense ratios and trading costs. Samples of the findings of such studies include the following:

  • 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.

As a result, index funds are usually the better choice for investors. Since mutual funds are not legally required to disclose their actual trading costs, these added costs are often referred to as “invisible” costs that investors forget to factor into their investment decision.

3. The actual contribution of an actively managed mutual fund’s management team is often negligible and, in some cases, actually cost investors. While many investors select mutual funds based on Morningstar’s famous “star” system, the most valuable information provided by Morningstar may actually be an actively managed fund’s R-squared correlation number.

Morningstar defines R-squared as

the relationship between a portfolio and its benchmark…. R-squared is not a measure of the performance of a portfolio….It is simply a measure of the correlation of the portfolio’s returns to the benchmark’s returns…. 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.

While actively managed funds like to tout the presumed advantages of the active management their fund allegedly provides, the evidence suggests that many funds’ returns are due more to the movement of the stock market than an actively managed fund’s management team. Evidence of this fact is supported by the percentage of actively managed funds with R-squared correlation numbers of 90 or above.

As index funds have consistently outperformed their more expensive actively managed counterparts, many actively managed funds have seemingly adopted a “if you cannot beat them, join them” approach to investing in hopes of minimizing both the extent of any potential underperformance relative to index funds and the potential loss of customers from such differences in performance.

© Copyright 2019 InvestSense, LLC. 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.

Posted in Closet Index Funds, Consumer Protection, Investment Advice, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , | Leave a comment

Sound Investment Advice from Jack Bogle…Again

Why write anything? Mr. Bogle says it all.

https://www.yahoo.com/finance/news/vanguard-founder-jack-bogle-apos-194408395.html

Posted in Investment Advice, Investment Portfolios, Portfolio Construction, portfolio planning, Wealth Management | Tagged , , , , | Leave a comment

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 morningstar.com, yahoo!finance.com and marketwatch.com.

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 morningstar.com, 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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The “Secret” Morningstar

I love Morningstar. It is my primary research source. I enjoy the posts of their columnists. But unlike most investors who use Morningstar, I basically ignore their legendary “star” system. Morningstar itself has told investors that their star system is not intended to be used for predictions of future performance. Various studies  have examined the sustainability of a mutual fund’s “stars” rating and found an overall pattern of lack of sustainability.

No, I love the “secret” side of Morningstar, the wealth of valuable information that allows me to evaluate other aspects of a fund, factors that have been shown to provide a meaningful evaluation of a fund’s value. Financial publications like to publish “best of” or “top” list at the end of one year or the beginning of a new year. In most cases, the lists are based on a fund’s nominal, or simple/stated, returns.

The problem with nominal returns is they can often be misleading. For example, actively managed funds often impose a front-end load, or sales charge. The front-end load is immediately deducted every time an investor invests in the fund. The maximum front-end load currently allowed by law is 5.75 percent. That means if you purchase $100,000 of a fund, the amount you will have to invest will only be $94,250.

As a result, the investor who invests in a fund that charges a front-end load will always lag the performance of an investor who purchases a no-load fund, assuming similar performance between the two funds. The odds of similar returns is increasing as many actively managed funds are posting high R-squared, or correlation of returns, numbers.

Funds that essentially track comparable market indices and/or comparable index funds, are referred to as “closet index” funds or “index huggers.” The problem with closet indexing is that investors usually obtain the same, in many cases lower, returns that they could have obtained on a no-load fund, but at a significantly high cost. That is why funds are legally required to provide investors with their load adjusted returns. The impact of front-end loads reducing investor returns even worse over time due to the impact of annual compounding.

Investors should also compare funds’ risk-adjusted returns. A basic principle is that investment returns are a function of risk assumed. Funds are not legally required to publish their risk-adjusted returns, and there are many methods used to calculate risk-adjusted returns. Many investors are unaware that Morningstar publishes a statistic that incorporates both a fund’s risk-related return and tax-efficiency score. It is available under the “Tax” tab on a fund’s Morningstar main page.

“Secret” Morningstar also provides me with valuable information that I use in evaluating a fund’s cost-efficiency. While mutual funds proclaiming to be #1 in performance are common, how many investors have ever seen a mutual fund ad claiming to be #1 in cost-efficiency. Don’t expect to see one anytime soon, as studies have shown that very few actively managed funds are even close to being cost-efficient. In fact, studies consistently find that very few actively managed mutual funds even manage to cover their costs.

As a securities/ERISA attorney, I rely on the Restatement (Third) Trusts for the applicable standards to determine applicable legal compliance for investment fiduciaries, specifically Section 90, otherwise known as the Prudent Investor Rule (PIR). Three key provisions of the PIR are:

  • comment b, which states that fiduciaries must be cost conscious,
  • comment f, which states that fiduciaries must seek either the highest return for a given level of cost and risk, or conversely, the lowest level of cost and risk for a given level of return, and
  • comment h(2), which states that an actively managed mutual funds that is not cost-efficient is an imprudent investment.

Re-read the last bullet point. Now combine that with the previous note that studies have consistently shown that very few actively managed mutual funds are cost-efficient. Funds that are not cost-efficient means that investors effectively suffer a new investment loss. Now take that information and review those “best of” and “top” articles again.

Far too many investors lose money unnecessarily by only evaluating funds based on their nominal, or stated, returns. I refer to my law practice as focusing on wealth preservation. As well-known Scottish proverb states

make as much money as you can, and keep as much as you can. That’s the secret of getting rich.

That is why I created the Actively Managed Value Ratio™ (AMVR). The AMVR is free on various parts of this site and allows investors, investment fiduciaries and attorneys to quickly evaluate the cost-efficiency of an actively managed mutual fund using the same “secret” Morningstar data that I use in my law practice. In other words, the AMVR can help you maximize your investment returns and protect that wealth.

Gura math a theid leat! (“Good luck”)

Posted in Active Management Value Ratio, AMVR, Asset Protection, Closet Index Funds, Common Sense, Consumer Protection, Fiduciary, Fiduciary Standard, Investment Advice, Investment Advisors, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , | Leave a comment

Are Your 401(k) Plan’s Mutual Funds Legally Prudent?

“You get what you don’t pay for.” – John Bogle

Full Disclosure and Total Transparency: I am an attorney. More specifically, I am a wealth preservation attorney and a plaintiff’s securities/ERISA attorney. I primarily offer forensic litigation and consulting services to individuals, trial attorneys and entities such as trusts, estates and pension plans.

The goal of this post is to level the playing field, provide you with some information and a worksheet to help you better evaluate your investment choices, whether in a private investment account or a 401(k) plan or other form of pension plan. For some reason ERISA, the major legislation covering most private retirement plans, does not require that employers provide employees in their pension plans with meaningful investment education programs.

I recently did an interview with Robin Powell of the “The Evidence Based Investor.” Robin is a well-known and well-respected journalist in the U.K. who is leading the movement for evidence-based investing. In the article, I told the story of an American CEO who suggested to me that the reason pension plans do not voluntarily provide meaningful educational programs for workers is that then the workers would realize how bad most pensions plans are and would possibly sue their employers.

I believe that investors have a right to be treated fairly by being provided with a win-win situation, both in private investment accounts and pension plans. There is currently an ongoing debate about whether employees should be required to enroll in their company’s pension plans. In my opinion, that would be a significant, and costly, mistake for employers unless, and until, they ensure that their pension plan is compliant with ERISA and equitable to plan participants. Currently, I would argue that most are neither.

When I work with securities/ERISA attorneys, I explain my four-point investment fiduciary liability system:

  1. The Supreme Court has stated that the Restatement (Third) of Trusts (Restatement) is a valuable resource in resolving fiduciary issues, especially involving ERISA questions.
  2. Section 90 of ERISA (aka the Prudent Investor Rule), comment b, states that fiduciaries have a duty to be cost-conscious.
  3. Section 90 of ERISA, comment f, states that in selecting investments for pension plans and other accounts, fiduciaries have a duty to choose investment that provide the highest level of return for a given level of costs and risks or, conversely, the lowest level of costs and risks for a given level of return.
  4. Section 90 of ERISA, comment h(2). states that fiduciaries should not choose or recommend actively managed mutual funds unless it is “realistic” to assume that such funds will produce sufficient returns to cover the extra costs and risk commonly associated with such funds, i..e., such funds are cost-efficient.

And there is the rub, the investment industry’s “dirty little secret.” Investment ads and  mutual fund companies love to tout investment return numbers. However, even the numbers they tout are often “highly suspect.” Ads touting “we’re #1” or “we’re the best” are common, based on nominal return numbers. How many investment ads have you ever seen touting “we’re the most cost-efficient fund?” Care to guess for the reason for the absence of such ads? The overwhelming majority of actively-managed funds are simply not cost-efficient.

My focus on cost-efficiency is a direct result of the research of investment notables, including icons Charles D. Ellis and Burton G. Malkiel.

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.1

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.”2

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover.3

“there is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4

With that information in mind, I created a simple metric, the Active Management Value Ratio™ 3.0 (AMVR), that allows investors, investment fiduciaries and attorneys to determine whether an actively managed mutual fund is cost-efficient, and therefore compliant with the standards set out in the Prudent Investor Rule. It is usually about this time that stockbrokers point out that they are not required to adhere to fiduciary standards, to put a customer’s financial interest ahead of their own. That’s not always true though. And as I tell people, even if it is not currently legally required that stockbrokers only recommend and use prudent investments in your accounts to protect your financial security, you can still make that a requirement in order to handle your accounts in order to protect your financial security? Your money, your rules.

This is a snapshot of a AMVR analysis between the retail version of a leading actively managed large-cap growth fund, AGTHX, and a comparable Vanguard retail large-cap growth fund, VIGRX.


Incremental Return Analysis
The actively-managed fund actually outperforms the Vanguard fund based on nominal, or stated, return. However, the actively-managed fund imposes a front-end load/fee of 5.75 percent on purchases of retail shares, which is immediately deducted from an investor’s account. As a result, an investor will never receive the stated nominal fee since their account has less money to benefit from the fund’s future returns. In this case, an investor would have received a five-year annualized return of only 14.11 percent over the period from October 1, 2013 to September 29, 2018, not the stated nominal return of 15.47 percent over that same period. Note: All return numbers stated herein will cover the same period.) You get what you don’t pay for!

A common saying in the investment world is that returns are a function of risk. There-fore, in order to get a more accurate evaluation of a fund, the fund’s returns need to be adjusted for the level of risk the fund assumed in achieving the indicated returns. In my practice, I use Morningstar’s risk-adjusted return methodology.

Stockbrokers and mutual funds will often argue that “investors cannot eat risk-adjusted returns.” I find that argument interesting for two reasons. First, it is not unusual for actively-managed funds returns to improve on a risk-adjusted basis. Second, stockbrokers and mutual fund companies have no reluctance to tout a good “star” rating from Morningstar in their marketing programs. Perhaps they are unaware that Morningstar is on record as stating that their “star” system is based largely on a fund’s risk-adjusted returns.

However, here the actively-managed fund under-performs the Vanguard fund on both a load-adjusted and risk-adjusted basis. As a result, the actively managed fund is imprudent based on returns alone when compared to the Vanguard fund.

Incremental Return Analysis
When an actively-managed fund fails to provide a positive incremental return, there is obviously no reason to perform an incremental cost analysis. Investors invest to make money, not underperform another comparable fund.However, I want to do one for the sake of example.

Simple, straightforward math. “My, Dear, Aunt, Sally” from our elementary school math days._All of the information needed to complete an AMVR analysis is available for free online at sites such as morningstar.com, marketwatch.com, and yahoo.com. I like to add trading costs into the AMVR analysis based on Malkiel’s findings, However, an AMVR analysis is still valid without adding a fund’s trading costs.

In this example, the nominal incremental cost between the two funds is 67 basis points (0.67). (Note: A basis point is 1/100th (.01) of one percent.) That means that the actively-managed fund’s incremental, or excess, costs constitutes 71 percent of the fund’s total costs, with the investor receiving absolutely no positive return for such costs. Investors need to remember that each additional 1 percent in fees and costs reduces an investor’s end-return by approximately 17 percent over 20 years. That loss would also need to be adjusted on a percentage basis based on the investment’s overall percentage within the investor’s total portfolio.

Closet Indexing
Closet indexing is a serious problem in investment industries around the world. Closet indexing refers to situations where an actively-managed fund claims that it offers actively-managed funds and charges significantly higher fees based on the purported benefits of active management. However, more often than more, such funds simply track the performance of a comparable, less expensive index fund, wasting an investor’s money. Again, you get what you don’t pay for.

To evaluate the impact of possible closet indexing, I perform a second incremental cost analysis using Ross Miller’s Active Expense Ratio (AER). It is not necessary to perform an AER analysis to benefit from an AMVR analysis. I simply perform the extra analysis due to my clientele and to further protect against cost-efficiency.

A simple explanation of the AER is that the metric uses a fund’s R-squared number, or correlation of returns, to determine the extent to which an actively-managed fund tracks a comparable market index or index fund. The metric than adjusts a fund’s incremental cost number to reflect the effective cost of the fund in light of extent to which the fund’s performance is properly attributable to the active management of the fund, rather than a market index or comparable index fund.

In the immediate case, the fund’s high R-squared number, combined with the level of the fund’s incremental costs, results in an effective annual expense ratio of 5.40 percent, significantly higher than the Vanguard’s expense ratio of 0.17. The resulting incremental cost constitutes approximately 95 percent of the actively-managed fund’s AER-adjusted effective annual expense ratio. High fees with absolutely no positive incremental return.

Bottom line: An underperforming and overpriced fund is never prudent.

Retirement Share Analysis
Another class of mutual funds shares are retirement shares. Pensions plans should never contain mutual funds that impose any sort of front-end, back-end, or any other type of purchase load/fee. Never agree to pay such added fees, on either retail or retirement shares. There is simply no need, as there are excellent no-load mutual funds that do not impose such unnecessary fees.

A longstanding debate in the investment industry is which offers the best retirement shares-Vanguard or Dimensional Fund, more commonly known as DFA. Both are industry leaders that offer low-cost, primarily index-based funds. But I always recommend that investors perform an AMVR analysis in evaluating funds. Once you learn where to locate the limited amount of data needed, you will find that an AMVR takes less than a couple of minutes.

 

 

The retirement shares AMVR analysis compares an institutional DFA large-cap value fund, DFLVX, with a comparable institutional Vanguard large-cap growth fund, VIVIX. Comparing risk-adjusted returns, the DFA fund slightly under-performs the Vanguard fund, thus providing no positive incremental return.

Once again, high incremental costs with no positive incremental returns based on either DFLVX’s nominal, or stated, returns or AER-adjusted returns. An analysis of the fund’s incremental returns shows the fund’s stated expense ratio constitutes 85 percent of the fund’s stated total annual expense ratio and 95 percent of the fund’s AER-adjusted effective annual expense ratio.

Once again, the evidence clearly indicates that this particular fund is not cost-efficient and is thus imprudent relative to the Vanguard fund, in accordance with the standards established by the Restatement (Third) of Trusts and the Prudent Investor Rule.

Cost-efficiency and 401(k) Plans
Each year “Pensions and Investments” (P&I) puts out an informative report listing the top 50 mutual funds in domestic defined contribution plans, such as 401(k) plans. At the end of each calendar quarter, I do an AMVR analysis of the top 10 non-index funds on P&I’s list. Plan participants and plan sponsors might find it interesting to check to see if any of their plan’s investments are on the analysis and, if so, check their current AMVR rating. The most current quarterly analysis is available on Slideshare.

Conclusion
Investors, both individuals and pension plan participants, deserve to be able to have the investment information they need to adequately protect their financial security and “retirement readiness.” Plan sponsors deserve to have the investment information they need to help their plan participants work toward “retirement readiness,” as well as protect themselves against unnecessary and unwanted personal liability.

Funds that are not cost-efficient result in unnecessary investment losses. Unfortunately, most studies indicate that the majority of actively-managed funds do not cover their investment costs, and thus are neither cost-efficient nor prudent.

The Active Management Value Ratio™ provides a simple means of obtaining such information by determining the cost-efficiency of actively-managed mutual funds. The AMVR calculations require limited data, all of which is freely available at various online sites. In our analyses, we do provide one additional metric, our proprietary InvestSense Quotient, which analyses a fund’s efficiency, both in terms of cost and risk management, as well as a fund’s consistency of performance.

One of the key aspects of the AMVR is its simplicity, both in performing the necessary calculations and interpreting the results. Interpreting the AMVR’s results requires just two questions:

(1) Does the fund provide a positive incremental return?
(2) If so, does the fund’s positive incremental return exceed the fund’s incremental costs?

If the answer to either question is “yes,” then the fund is not cost-efficient, and is legally imprudent. It is as simple as that.

The AMVR is an opportunity for investors, attorneys, plan sponsors and other investment fiduciaries to prove the truth of our company’s motto-“the power of the informed investor.”

Notes
1. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e.
2. Ellis, Charles D., “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018, 10.
3.. Malkiel, Burton, “A Random Walk Down Wall Street,” 11th Ed., (W.W. Norton & Co., 2016), 460.
4. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.

                      Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article 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.

Posted in Active Management Value Ratio, AMVR, Closet Index Funds, Consumer Protection, Consumer Rights, ERISA, Fiduciary, Fiduciary Standard, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , | Leave a comment

Variable Annuities: Estate Planning Saboteurs

As a wealth preservation attorney, my practice involves various areas of the law including investment portfolio analysis, asset protection, risk management and estate planning. Three primary wealth saboteurs are investment portfolio mismanagement, tax erosion, and personal liability exposure.

I recently read a story indicating that sales of variable annuities have significantly increased. As I wrote in an earlier post, a key question that every investor should always ask before making any investment is “why?”

That question certainly applies with variable annuities. Variable annuities usually involve two of the three risk saboteurs-portfolio mismanagement and tax erosion. Variable annuities can completely destroy an investor’s estate plan.

Variable Annuities and Tax-Deferred Growth
People usually say that they invested in a variable annuity for opportunity for tax-deferred growth. What they fail to realize is that there are other less destructive means of obtaining tax-deferred growth.

Individual retirement accounts (IRAs) are one source of tax-deferred growth without the excessive costs and restrictions associated with variable annuities. IRAs also allow investors to choose their own cost-efficient investment options, allowing investors to avoid the overpriced and poorly performing investment options usually selected for variable annuities.

With most variable annuities typically have a minimum combined cost of 3 percent or more annually, investors should remember that each additional 1 percent of annual fees and costs of an investment reduces an investor’s end-return by approximately 17 percent over twenty years. That could result in an investor losing more than half of their end-return due to a variable annuity’s fees and costs alone, especially if the annuity owner invests in one of the so-called “living benefit” riders often pitched to prospective variable annuity purchasers.

Variable Annuities and Tax-Erosion
Investors often fail to recognize the difference between tax-deferred and tax-free. Tax-deferred means that at some point, somebody is going to be required to pay taxes on an investment. Tax-free means just that, no tax will ever be required to be paid.

When taxes are paid on gains in a variable annuity, those gain are generally taxed as ordinary income. Tax rates on ordinary income gains are always higher that tax rates on so-called “capital gains.” Explaining capital gains is beyond the scope of this article. Capital gains are generally based on the nature of the investment and/or the length of time an investment has been held by an investor. The takeaway here-capital gains are generally preferred over ordinary income due to lower tax rates.

Two mistakes I constantly see are people putting investments that are already tax-advantaged into tax-advantaged accounts. 401(k)/403(b) accounts and IRAs already provide tax-deferral to investors. So why would anyone buy a variable annuity and put the annuity inside a 401(k)/403(b or IRA account?

The same goes for investing in investments that may qualify for capital gains treatment or pay out capital gains income, e.g., stock and equity mutual funds, inside a variable annuity. All that does is convert capital gains into ordinary income for tax purposes, resulting in higher taxes. A general rule of thumb is to place tax-inefficient investments, into tax-deferred account, thereby deferring taxation of otherwise immediately taxable income.

Another general rule of thumb is to place tax-efficient investment in regular investment accounts to take advantage of any favorable tax options, i.e., capital gains and qualify for a stepped-up basis once the investment owner dies. Variable annuities do not generally qualify for a stepped-up basis once the owner of the annuity dies. This is why variable annuities can effectively destroy an estate plan.

Variable Annuities and Loss of Life Savings
Variable annuities are often pitched with the line that investor will never lose their original investment. Furthermore, a variable annuity owner will never run out of money because they can always annuitize their variable annuity and receive payments based on their original investment and the method they chose when they bought the annuity.

What annuity ads do not mention is that if you annuitize a variable annuity, you lose total control over the value of the annuity. Upon the death of the variable annuity owner or designated annuitant, the balance remaining in the variable annuity goes to the company that issued the variable annuity, typically an insurance company not to the variable annuity owner’s family of other designated beneficiaries.

I doubt very few people would say that they worked all their life just so they can benefit an insurance company. But that’s essentially what variable annuity are, a bet by variable annuity issuer that the annuity owner will annuitize and die before depleting the value within the variable annuity, the sooner the better so they receive greater value.

The Beloved Death Benefit Scam
Anyone being pitched a variable annuity will undoubtedly hear that variable annuities offer a death benefit which ensures that when they die, assuming that they have not annuitized the variable annuity, their designated beneficiaries will receive no less that their invested principle.

Moshe Milevsky, a well-respected expert on variable annuities, exposed the death benefit scam by disclosing that variable annuity issuers were generally charging variable annuity owners an annual expense fee that was ten times the actual inherent value of the annuity’s death benefit. While fees naturally vary between variable annuities, the excessive overcharge issue remains. Google “Moshe Milevsky The Titanic Option” to read the article online.

Due to the historic patterns of the stock market, it is extremely unlikely that a variable annuity owner would ever need to available themselves of the death benefit, leading one of colleagues to utter the best analysis of the death benefit in variable annuities:

A variable annuity owner needs the death benefit like a duck needs a canoe paddle.

Selah.

Conclusion
Two takeaways that anyone considering purchasing a variable annuity should remember. The first is a well-known saying in the investment industry-“annuities are sold, not purchased.” The second comes from an article I recently reading read at a web site entitled “The Balance” (thebalance.com)-

Annuities are a form of insurance, and insurance is a risk management tool—not an investment… For investing purposes, index funds are often a better choice than a variable annuity. For the purpose of a guaranteed outcome, other types of annuities are better. That doesn’t leave many situations where a variable annuity is a smart choice.

Variable annuities can easily destroy a well-done estate plan. As the referenced quote points out, there are other viable and more sensible options for achieving the same goals without destroying one’s estate plan and possibly providing nothing for one’s family and heirs.

For those interested in an analysis of the sales pitches variable annuity salesmen often use, click here.

Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article 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.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

Posted in Estate Planning, Fiduciary, Integrated Estate Planning, Investment Advice, Investor Protection, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Variable Annuities, Variable Annuity Abuse, Wealth Preservation | Tagged , , , , , , , , , , , | Leave a comment

Setting the Record Straight on Asset Allocation

One of the “dirty little secrets” of the investment industry is to deliberately misrepresent the findings of a study on the importance of asset allocation. The study, commonly referred to as the BHB study after the three gentleman who conducted the study, found that asset allocation explained 93.6% of the variation in an investment portfolio’s returns. The study made no representations about the determinants of an a portfolio’s returns, only the variations in a portfolio’s returns.

The study examined three general types of investments – stocks, bonds and cash. Stocks are generally acknowledged as riskier than bonds, and bonds are generally acknowledged as being riskier than cash. So the BHB study should not come as a surprise to anyone. higher allocations to stocks, as compared to bonds and  cash, can be expected to increase a portfolio’s overall volatility, or variation in returns.

Investors who understand the true findings of the BHB study and that fact that it made no representations as to the determinants of a portfolio’s actual returns and better protect their financial security by detecting misrepresentations regard the value of investment recommendations.

For an excellent analysis of the true meaning of the BHB study, click here.

Posted in Absolute Returns, Asset Protection, Consumer Protection, Fiduciary, Fiduciary Standard, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , | Leave a comment