The Rest Of the Story: What Mutual Funds Hope Investors and Plan Sponsors Never Realize

When I was growing up, there was a radio broadcaster named Paul Harvey. Harvey had a popular daily show with a segment called “The Rest of the Story,” where he would talk about little known facts about a person or story. At the end of each segment, he would close the story with “and now you know…the rest of the story.”

The purpose of this post is to let investors, investment fiduciaries and attorneys in on “the rest of the story” as it relates to the performance of mutual funds, more specifically the performance of actively managed mutual funds. Actively managed mutual funds are often the primary investment assets in brokerage accounts and pension plans such as 401(k), 403(b) and 457(b) plans. Much of the current litigation involving pension plans involves questions regarding the quality of the actively managed mutual funds in such plans.

Mutual fund advertisements typically tout double digit returns over certain periods of time. But do these numbers performance potentially mislead investors as to the actual contribution of active management to a fund’s performance, especially with regard to the performance of comparable, less expensive, alternatives? I would suggest that “the rest of the story” on actively managed mutual funds paints a far different picture of the benefits, or lack thereof, of actively managed mutual funds.

Passively managed mutual funds, commonly referred to as index funds, typically invest in a stock market index such as the S&P 500. The two most noticeable differences between active managed mutual funds and index funds are the index fund’s significantly lower annual management fees and lower turnover/trading costs. In some cases, the index fund’s lower fees and trading costs result in the index fund outperforming the actively managed mutual fund.

Morningstar is a very popular resource for information on mutual funds. While Morningstar’s performance reports do factor in a fund’s annual expense ratio, they do not factor in a fund’s trading costs. One possible explanation for this oversight is the fact that while mutual fund’s are legally required to publicly disclose their annual expense ratio, funds are not required to publicly disclose their actual trading costs.

The problem with not factoring in a fund’s trading costs into an analysis of a fund is that in some cases, a fund’s trading costs may be more than the fund’s annual expense ratio. Therefore, such information would probably be material to an  investor in choosing which funds to select as part of their portfolios.

Vanguard’s legendary former chairman, John Bogle, agrees as to the importance of a fund’s trading costs. As a result, he created a metric that uses a fund’s reported turnover ratio to quantify such costs. Bogle’s metric doubles a fund’s reported turnover ratio, and then multiple that number by 0.60 to get a proxy for a fund’s trading costs. Critics are point out that Bogle’s metric does not guarantee that the number produced is an accurate representation of the fund’s actual trading costs. While this is true, Bogle’s metric is still viable and valuable in that it uses the same process for every fund and it does allow investors and others to factor in such costs in to their due diligence process for evaluating mutual funds.

As a former securities/RIA compliance director and a securities/ERISA attorney and consultant, I decided to create a metric that allows investors, fiduciaries and attorneys to better evaluate the suitability and overall prudence of actively managed mutual funds. The Active  Management Value Ratio™ 2.0 (AMVR) allows anyone to perform a quick and simple cost/benefit analysis on an actively managed mutual fund.

The AMVR is based on the studies of investment icons Charles D. Ellis and Burton G. Malkiel. Ellis suggests that a more accurate analysis of actively managed mutual funds can be obtained by comparing a fund’s incremental costs to its incremental returns, as incremental costs and returns provide a better picture of the value of a fund’s active management team relative to a comparable, less expensive, index fund. Malkiel studies found that a fund’s expense ratio and turnover were the two most reliable predictors of a fund’s future performance.

The AMVR factors in all of these elements in evaluating the cost efficiency of an actively managed mutual fund.  The emphasis on an investment’s cost efficiency is consistent with the Restatement (Third) of Trust, the resource most often used by the courts in assessing the prudence of a fiduciary’s decisions. While mutual fund companies and stockbrokers are generally not help to the strict requirements of a fiduciary, investors should adopt such standards in order to better protect their financial security by selecting appropriate investments. For more information about the AMVR and the calculation process involved, click here.

Some examples may help to better illustrate the value of the AMVR as a forensic analysis tool. Large cap growth mutual funds are usually the  predominate investment or investment option in brokerage accounts and pension plans. Two of the most popular actively managed large cap growth mutual funds are Fidelity Investments’ Contrafund and American Funds’ Growth Fund of America (GFoA). Therefore, we will analyze both funds with regard to both their retail (Contrafund-FCNTX; GFoA-AGTHX) and retirement shares (Contrafund-FCNKX; GFoA-RGAGX).

Our benchmark fund will be the Vanguard Growth Index fund, using both the retail (VIGRX) and retirement/institutional (VIGIX) shares. The data used in connection with all shares will be based on the data as of December 31, 2015.

The AMVR evaluates a fund’s performance in terms of its five-year annualized returns, both nominal and risk-adjusted returns. Risk-adjusted returns are included to ensure that funds are properly credited when they take less risk in achieving their returns than an otherwise comparable fund. As we will see in one of our examples, a fund’s risk-adjusted return can materially impact a fund’s performance numbers.

Appendix A shows the results of the analyses of the actively managed mutual funds. Contrafund’s A shares and K shares both underperformed their benchmark fund in terms of nominal return performance, resulting in a negative incremental return number for both funds. Funds that fail to provided positive incremental returns do not qualify for an AMVR score.

Contrafund’s A shares and K shares both outperformed their benchmark fund in terms of risk-adjusted return performance, resulting in a positive incremental return number for both funds. Contrafund’s A shares and K shares achieved AMVR scores of 3.39 and 3.03 respectively. However, an AMVR score greater than 1.00 indicates that the fund’s incremental costs exceeded the fund’s incremental return, making the fund imprudent since it would result in an investor losing money due to the excessive fee. The 3.00+ AMVR scores here would indicate that Contrafund’s A and K shares are imprudent using their risk-adjusted returns as well.

GFoA’s  A shares and R-6 shares underperformed their benchmark fund in terms of both nominal and risk-adjusted return performance, resulting in a negative incremental return number for both funds. So just as with Contrafund, GFoA’s A and R-6 shares would be deemed to be imprudent investment choices since they would result in a financial loss for investors based on the date used in the analysis.

The AMVR also allows for other forms of forensic prudence analysis. One additional form of analysis is to compare the percentage of return available from the index funds as compared to the cost of the incremental return added by the actively managed mutual fund. For instance, on the Contrafund A shares, using the share’s risk-adjusted returns, the benchmark fund would provide me with 95 percent of the A shares at approximately one-third the cost (annual expense fee and trading costs). Likewise, I could obtain 96 percent of the K shares for one-fifth the cost of the K shares.

Yet another means of using a fund’s AMVR score is in terms of relative cost. Once again, using Contrafund’s risk-adjusted returns and the fund’s A shares, which would be more prudent, buying the benchmark’s 12 percent return for $33, or buying the A share’s 12.54 return for $113? Likewise, on the K shares, which would be more prudent, purchasing the benchmark’ s 12.16 return or the K share’s 12.65 percent return?

These findings of imprudence are supported by the fact that all four funds have a high R-squared rating, raising the question as to whether they could properly be categorized as “closet index” funds. Closet index funds raise questions about prudence and fiduciary liability due to the fact that closet index funds essentially track or “hug” a market index in terms of performance, yet charge significantly higher fees than a comparable true index fund.

A fund’s R-squared rating is an important factor in evaluating mutual funds, as rating provides another means of determining the prudence of a fund in terms of its cost efficiency. One popular explanation of R-squared comes from Charles D. Ellis, who explains that an R-squared rating of 80 means that 20 percent of the fund is left to justify 100 percent of the fund’s overall fee since 80 percent of the fund’s performance can be attributed to the performance of the market, not the management team of the actively managed mutual fund.

As we have shown earlier, in many cases actively managed mutual funds cannot produce returns that justify the additional costs. In fact, in many cases, actively managed mutual funds cannot even manage to produce positive incremental returns over and above the returns of the market and comparable index funds, let alone the added costs of actively managed funds.

Contrafund A shares and K shares had R-squared ratings of 86.53 and 86.53 respectively. GFoA A shares and R-6 shares had R-squared ratings of 89.51 and 89.52 respectively. While there is no universally mandated R-squared rating for designation of “closet index” status for funds, most people would agree that ratings of 90 and above definitely raise red flags. I personally use an R-squared rating of 90 as the line of demarcation in my practices, but some people use ratings as low as 80 as their threshold for closet index status.

High R-squared ratings raise questions about the value received by an investor in exchange for such fees and the effective annual expense ratio that an investor is paying on such closet index funds. Professor Ross Miller created a metric, the Active Expense Ratio (AER), to address such questions. The high R-squared ratings for the four funds in our examples resulted in high AER ratings for each of the funds – Contrafund A (2.30, 223 percent higher than the fund’s stated annual expense ratio), Contrafund K (1.72, 181 percent higher than the fund’s stated annual expense ratio); GFoA A (1.90, 192 percent higher than the fund’s stated annual expense ratio), and GFoA R-6 (1.18, 257 percent higher than the fund’s stated annual expense ratio).

One last point has to do with GFoA’s A shares. Despite the dismal performance numbers of the shares, the fund charges a front-end sales charge of 5.75 percent for the privilege of receiving such poor performance. That means that investors start  in the hole from the start, as they have to give up 5.75 percent of their investment just to invest  in the fund.

Conclusion
Rex Sinquefield, one of the founders of Dimensional Fund Advisors once said that

We all now that active management fees are high. Poor performance does not come cheap.

What many investors, investment fiduciaries and attorneys did not realize, and in some cases still do not realize, is just how bad the situation really is, how inefficient and expensive actively managed mutual fund truly are. With help from the Active Management Value Ratio™ 2.0, anyone can see for themselves just how inefficient most actively managed mutual funds are , both in terms of costs and performance.

When you consider that each additional 1 percent in fees and other costs reduces an investor’s end return by approximately 17 percent over a twenty year period, and rthen combine that with the loss associated with the consistent underperformance of many actively managed mutual funds relative to less expensive index funds,, it is easy to understand why investors and investment fiduciaries need to become more proactive in managing their accounts and plans in order to better protect their financial security and to ensure that they and/or their plan participants are receiving adequate value for the fees and costs that they are paying.

The litigation involving 401(k) and 403(b) plans, and fiduciary asset management in general, are not going away anytime soon. In many cases, the violations are so obvious that that the cases are the proverbial “low hanging fruit” for litigators. The AMVR provides a means for quantifying and ensuring the selection of prudent investment options.

And now you know…the rest of the story.

© Copyright 2016 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and 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.

Appendix A  (Note: I apologize for the uneven appearance of the charts. WordPress makes if difficult to insert charts. In this case, I thought it was important to include the charts to show how the numbers were calculated and to show the worksheet I use in case readers wanted to perform similar analyses in the future.)

Fidelity Contrafund A Shares
5 Year 5 Year
Annualized Annualized
Nominal Risk-Adjusted
Expenses Total Return Return
Active Fund 12.68 12.54
Exp Ratio 0.71
TO/Trding 35 0.42
Total Fees 1.13
Benchmark 12.96 12
Exp Ratio 0.22
TO/Trding 9 0.11
Total Fees 0.33
IC/IR 0.80 -0.28 0.54
Fidelity Contrafund K Shares
5 Year 5 Year
Annualized Annualized
Nominal Risk-Adjusted
Expenses Total Return Return
Active Fund 12.80 12.65
Exp Ratio 0.61
TO/Trding 35 0.42
Total Fees 1.03
Benchmark 13.14 12.16
Exp Ratio 0.07
TO/Trding 9 0.11
Total Fees 0.18
IC/IR 0.85 -0.34 0.49
American Funds GFOA A (5.75% Sales Charge)
5 Year 5 Year
Annualized Annualized
Nominal Risk-Adjusted
Expenses Total Return Return
Active Fund 12.05 11.64
Exp Ratio 0.65
TO/Trding 29 0.35
Total Fees 1.00
Benchmark 12.96 12.00
Exp Ratio 0.22
TO/Trding 9 0.11
Total Fees 0.33
IC/IR 0.67 -0.91 -0.36
American Funds GFoA R-6
5 Year 5 Year
Annualized Annualized
Nominal Risk-Adjusted
Expenses Total Return Return
Active Fund 12.44 11.58
Exp Ratio 0.33
TO/Trding 29 0.35
Total Fees 0.68
Benchmark 13.14 12.16
Exp Ratio 0.07
TO/Trding 9 0.11
Total Fees 0.18
IC/IR 0.50 -0.70 -0.58