Smart Investment Choices – Using Forensic Analysis to Protect Investors and Fiduciaries

Financial genius is a rising stock market. – Sir John Templeton

Don’t confuse brains with a bull market. – Stock market adage

Three out of four stocks follow the general trend of the stock market. Takeaway: It’s easy to make money when the stock market is enjoying a bull market. The key to effective wealth management is not in managing investment returns, but rather in preserving one’s wealth through the informed management of investment/market risk.

Many people have become aware of forensic analysis due to the popular CSI television series which applies forensic analysis to criminal investigations. Forensics can also provide benefits in other professions. For example, forensic accounting has emerged as a very valuable tool in detecting accounting fraud.

During my securities compliance days, it occurred to me that forensic analysis could also be used to uncover securities related fraud, including financial planning fraud. The increasing use of computer programs to produce asset allocation/portfolio optimization recommendations and other financial advice, and the relative instability of such computer programs, makes forensic analysis especially valuable in protecting investors and pension plans, both for pension plan sponsors and plan participants.

Forensic analysis involves a process commonly referred to as “reverse engineering.” Where engineering involves building things, reverse engineering involves tearing down something, such as a financial plan, a computer program and/or a financial process, into its component parts. The component parts are then analyzed for errors, whether intentional or unintentional, and/or “flags” of potential financial fraud.

The potential value of forensic analysis in connection with investments and financial planning becomes even more important in light of recent studies:

■A study by Schwab Institutional found that 75% of investor portfolios were unsuitable for investors given their financial situation and goals.(1)
■A recent study by CEG Worldwide concluded that over 94% of those holding themselves out as wealth managers were more product salesman than wealth manager.(2);
■Investment fraud is the number crime against the elderly, affecting an estimated 7.3 million older Americans, or one out of every five senior citizens.(3) Since that number only counts the instances of fraud actually reported, the number of victims is undoubtedly higher.

Based upon my personal experience, I would disagree with Schwab’s 75 percent finding. Based on my experience as an attorney, CERTIFIED FINANCIAL PLANNER® professional and an Accredited Wealth Management Advisor(SM), I would put that number at approximately 90% based on issues involving inadequate, or false, diversification and unnecessary and excessive fees and other expenses.

Based upon my twenty-five plus years in the quality of investment advice business, the three most common problems with investment advice involve at least one of the following issues: (1) errors due to the inherent instability of financially related software programs; (2) unnecessary and excessive investment fees and other expenses; and (3) poor portfolio risk management due to “false” diversification. Not surprisingly, the Employee Retirement Income Security Act (ERISA), list avoidance of unnecessary costs and risk management as two of the primary duties of pension plan fiduciaries.

Instability of Financially Related Software Programs
Financial advisers often prepare some sort of financial plan or asset allocation plan suggesting that investors can improve the performance of their investment portfolio, increasing returns while reducing risk, by implementing the adviser’s recommendations. The basic problem with such financial programs is that they are often based on Microsoft Excel and require an extensive amount of calculations that, to be honest, Microsoft was not specifically designed to handle. The resulting instability of the calculation process, both in terms of the actual computer program and the financial formulas, often result in recommendations that are, to be nice, counter-intuitive, or just wrong.

Like many software programs, asset allocation/portfolio optimization software programs are subject to the “garbage in, garbage out” syndrome. Slight errors in the input data can turn mole hills into mountains. To quote one leading expert in the area, asset allocation/portfolio optimization software programs are “error-estimation maximizers.”

One issue with such asset allocation plans is that they often use market indices to represent various assert classes in preparing such plans. Since market indices do have annual expense ratios, the asset allocation recommendations can be misleading.

Another issue with such plans is that financial advisers rarely go back and prepare a plan using the characteristics of the investor’s actual investments. Without such a “real life” plan, investors, pension plan sponsors and plan participants have no way of knowing the true aspects of their investment portfolios, especially whether their portfolios are properly allocated in order to protect them against significant financial losses.

The public is rarely aware of such issues. Far too often an investor or pension plan sponsor is presented with a voluminous, bound presentation and simply assumes that all the information, calculations and representations are correct. After all , they rarely have the capability to verify said information, calculations and representations themselves.

Companies using such software programs, while well aware of such quality of advice issues, often overlook or minimize such issues. When such quality of advice issues are pointed out to companies using such financial software, they often attempt to minimize the problem by saying that the future, or end, value calculation was correct. The problem is, they often are not. Far too often the nicely bound, voluminous document filled with various multi-colored charts and spreadsheets is just a ruse to create a false sense of security within customers.

Bottom line, while I support the concept and value of proper financial planning, in my opinion most written financial plans are simply a waste of paper, especially when customers are paying hundreds, or even thousands, of dollars for such plans. Even if the assumptions used to produce such a plan are correct (and  they often are not), financial and economic conditions are constantly changing, further reducing the value of a written plan. A financial plan might look impressive in a fancy binder, but in reality, it has little, if any, practical value.

Unnecessary and Excessive Investment Fees and Other Expenses

We all know that management fees are high. Poor performance does
not come cheap. You have to pay dearly for it. – Rex Sinquefield

Investment advisers, stockbrokers and other financial advisers often complain about the attention given to investment fees and other expenses. They claim more attention should be given to the (alleged) benefits that their customers receive from their advice.

When the market is rising, financial advisers say “look at me, see how valuable I am.” Then, when markets suffer downturns, or worse, bear markets, those same advisors try to dismiss such losses by blaming the market and claiming that “it’s the market; everyone is losing money.” That is simply not true, as true financial advisers utilize various strategies to protect against significant losses. We will address this issue in more detail in the next section.

Another issue is the fact that a fund’s stated annual expense ratio is often misleading, as it fails to properly reflect the true cost to investors. In his seminal book, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” Charles D. Ellis explains why a fund’s or an investment manager’s stated expense ratio can serious understate the true cost of active management to an investor.

Most funds and investment managers state their management fees in terms of an investor’s invested assets, commonly referred to as “assets under management.” As Ellis points out, stating an investment management fee in this manner makes no sense, since an investor already owns the assets invested.

Ellis suggests that fees should be calculated as a percentage of returns. Furthermore, since low-cost index funds provide a viable investment option for obtaining market returns, Ellis suggests that “the real cost of [actively managed mutual funds] is the incremental cost as a percentage of the incremental value.” Ellis concludes by stating that

Thus, correctly stated, management fees for active management are remarkably high. If you think that the level of fees should be in proportion to the actual benefit the fund shareholder gets, you’ll be surprised to learn that the fees most mutual funds charge – relative to incrementally risk-adjusted returns – are over 100 percent.(4)

Regardless of whether a financial adviser is “good” or “bad,” fees and other expenses directly reduce an investor’s end return. From the perspective of an investor, pension plan sponsor, or pension plan participant, the point to remember is that each 1 percent of fees and expenses reduces an investors end return by approximately 17 percent over a twenty year period.

Financial advisors often “forget” to mention this fact. Investors, pension plan sponsors, and pension plan participant should remember both this fact and the failure of an adviser or consultant to disclose such information to them. The failure to disclose such important information might be considered a breach of the adviser’s or consultant’s fiduciary duty to an investor or pension plan depending on the situation.

 Poor Portfolio Risk Management Due to “False” Diversification

Get what you can and keep what you have; that’s the way to get rich.
Scottish proverb

The essence of investment management is the management of
risks, not the management of returns. – Benjamin Graham

There is a saying on Wall Street, “amateurs focus on returns, experts focus on risk.” Far too many investors and pension plan fiduciaries are guilty of this mistake. While a good pension planner service provider, pension consultant or financial adviser would prevent this from happening, in too many cases they fail to do so because it is in their own financial self interests not to do so. Again, this could very well constitute a violation of their legal duties to their customers.

Pension plan sponsors are held to a so-called “prudent man” standard. One of the key principles under the prudent man standard is the effective diversification of a portfolio of investments. The key idea behind diversification is that by combining investments that behave differently under various economic and market conditions, the overall risk of the investment portfolio is reduced.

Some people incorrectly believe that diversification simply involves in investing a large number of investments. However, as Harry Markowitz, the father of Modern Portfolio Theory, correctly cautioned investors that

Effective diversification depends not only on the number of assets in [an investment portfolio], but also on the ways and degrees in which their responses to economic events tend to reinforce, cancel or neutralize one another.(5)

One of the best ways to determine whether an investment portfolio is effectively diversified is to prepare a so-called correlation of returns matrix. The matrix provides the correlation between each investment in the portfolio. The higher the correlation between two investments, the less diversification protection provided by such investments.

In most cases, I can prepare a correlation of returns matrix for ten funds in less than five minutes. Consequently, I have to wonder why stockbrokers and other financial advisers do not provide a similar matrix for their customers. Advisers often minimize the importance of a correlation of returns matrix, saying customers do not want them and/or would not understand them. Maybe so, but I have had no problem with explaining the significance of them to clients and they quickly understood how to use effectively use such documents and the importance of same.

Personally, based on my experience, I believe that many financial advisers do not provide customers with correlation of return information because it would show customers/clients that the investments recommended to them often have a high correlation of returns, especially among equity-based products. Consequently, customers might realize the true worth of their financial adviser’s advice and the need to realign their investments to gain favorable downside protection against large losses. Remember, 75 percent of stocks move in the general trend of the stock market. Thus, the previous quote, that “financial genius is a rising stock market.”

Over the last decade or so, there has been a notable trend of consistently high correlations of return among equity-based investment, both domestic and international equity-based investments. As an example, over the five-year period of 2009-2013, broad equity-based asset classes had the following correlation of returns:

■S&P 500 (LC) and Russell 2000 (SC) – 94%
■S&P 500 (LC) and MSCI EAFE (Int’l) – 90%
■Russell 2000 and MSCI EAFE – 83%

A ten-year analysis over the period 2004-2013 shows similar high correlations of return:

■S&P 500 (LC) and Russell 2000 (SC) – 93%
■S&P 500 (LC) and MSCI EAFE (Int’l) – 89%
■Russell 2000 and MSCI EAFE – 81%

The pension perspective vis-à-vis correlation of returns information is even more puzzling. Section 404(c) of ERISA allows pension plans to transfer the risk of investing to plan participants without requiring that pension plans provide them with the very information needed by the participants to effectively diversify their portfolios.

Both the Department of Labor and the courts have adopted modern portfolio theory as the standard of assessing whether pension plan sponsors and other pension fiduciaries met the “prudent man” test under ERISA. The cornerstone of modern portfolio theory is the consideration of the correlation of returns among the proposed investments in an investment portfolio.

And yet, there is currently no express requirement that correlation of returns information be provided to pension plan participants, either through a disclosure documents or a plan sponsored investment education class for plan participants. It has been argued that failure to provide such material information could be considered a breach of a pension fiduciary’s duty of loyalty, especially since plan sponsors should use such information in conducting their required “independent investigation and evaluation” of all pension plan investment options. It would not be a surprise to see future litigation on this very issue.

Using Forensics to Protect Investors, Pension Plan Sponsors and Plan Participants
Forensic analysis can be a valuable tool to investors, pension plan sponsors and plan participants in protecting their financial security. Forensic analysis can also help pension plan sponsors document that they have conducted the meaningful independent analysis required by ERISA.

While I use a number of proprietary forensic metrics in preparing forensic analyses, some of them complex, meaningful forensic analysis can be as simple as simple subtraction and division. I have made one of my proprietary forensic metrics, the Active Management Value Ratio™ (AMVR), available to the public. The AMVR provides a simple cost/benefit analysis of an actively managed mutual fund using the fund’s incremental cost and incremental benefit.

For instance, let’s assume we have two mutual funds. Fund A is an actively managed mutual fund, with a five-year annualized return of 22 percent and an annual expense ratio of 1.00 percent. Fund B is an index fund, with a five-year annualized return of 20 percent and an annual expense ratio of 0.22 percent. The incremental cost of Fund A would be 78 basis points (1.00 – 0.22, with 1 basis point equaling 0.01 percent, 100 basis points equaling 1.00 percent). The incremental benefit of Fund A would be 200 basis points (22.0 – 20.0).

There are three ways to interpret a fund’s AMVR score. The first way is in terms of the effective annual fee/cost of the fund’s active management. In the case of Fund A, the incremental benefit, 200 basis points, is costing the investor or the pension plan 78 basis points, resulting in an effective annual fee/cost of approximately 39 percent, significantly higher than the advertised 1 percent annual expense ratio and the index fund’s annual expense ratio of 0.22 percent.

The second way of interpreting a fund’s AMVR score is in terms of relative cost. In the case of Fund A, 78 percent of the fund’s annual expense ratio is only producing 9.1 percent of the fund’s total return. Such an imbalance in cost/benefit value raises obvious questions under a prudence standard.

The third way of interpreting a fund’s AMVR score is by drawing a price analogy between the cost/benefit aspects of each fund. Which would be more desirable to an investor or pension plan fiduciary under a “prudent man” standard, paying $22 for an annual return of 20 percent, or paying $78 for an annual return of 2 percent?

Seems rather obvious, yet statistics indicate over 85 percent of investors choose the latter. Perhaps the results would be different if investors, pension plan sponsors and plan participants took the time to calculate their funds’ AMVR scores. Additional information on the AMVR, as well as a simple worksheet for calculating AMVR can be found on our blog. (

Forensics can provide valuable information for the wealth preservation and wealth preservation process. Investors and pension plan participants can use forensic analysis to effectively accumulate and preserve wealth. Pension plan sponsors and other fiduciaries can use forensic analysis to ensure compliance with their fiduciary duties under ERISA and/or the common law.

Forensics can provide information that investment advisers, stockbrokers, and plan service providers could, and should, provide to customers to allow their customers to make informed decisions to protect their financial security. The failure to provide such material information can often be attributed to said financial advisers and plan service providers putting their financial interest ahead of their customers’ best interests.

Investors, pension plan sponsors and plan participants should always request the various documents mentioned herein, i.e. asset allocation analysis, incremental cost/benefit analysis and correlation of returns matrix, all using the actual investments chosen by an investor or pension plan. If an investor, pension plan sponsor or plan participant cannot or will not provide such documents, thereby preventing an investor or fiduciary from effectively protecting their financial security, perhaps that should serve as a red flag, suggesting that it might be best to consider making a change to a financial adviser/ consultant who is dedicated to putting their customer’s best interests ahead of their own financial best interests.

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.


1. Brooke Southall, “Wirehouse accounts don’t match client goals,” InvestmentNews, March 12, 2007, 12.
2. Charles Paikert, “Poll: Few Advisers are ‘real’ wealth managers,” available on the Internet at =printart.
3. 2010 IPT Elder Investor Fraud Survey, available online at learn/research/?fa=eiffeSurvey.
4. Charles D. Ellis, “Wining the Loser’s Game:Timeless Strategies for Successful Investing” 6th Ed., (New York: McGraw-Hill Education, 2013), 164.
5. Harry M. Markowitz, Portfolio Selection, (Cambridge, MA:Basil Blackwood & Sons, Inc., 1991), 5.

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