Despite overwhelming evidence that actively managed mutual funds generally under-perform passively managed index funds, the evidence indicates that most investors continue to purchase and hold actively managed funds.  Even when an actively managed fund does outperform its relevant index, the margin is usually slim, often measuring less than 1 percent.  That 1 percent advantage may disappear entirely when the actively managed fund’s annual fees are factored in.

In analyzing the prudence of actively managed mutual funds, I use a proprietary formula, the Active Management Value Ratio™ (AMVR), to determine the cost effectiveness of an actively managed mutual fund. In short, most actively managed mutual funds simply are not cost efficient.

Most investors only think of mutual fund fees in terms of the annual expense fee quoted in ads and prospectuses.  What most investors do not realize is that in breaking down an actively managed mutual fund’s annual fee into its active and passive components, the active component usually exceeds the passive component by a wide margin.

Most investors expect to see a reasonable relationship between the fees they pay and the returns they receive. However, that is usually not the case when it comes to actively managed mutual funds, where it is not unusual to see the portion of the annual fee allocatable to active management, often 60-70 percent of the fund’s annual return, providing only 25-30 percent of the fund’s annual return.

When we apply the AMVR, we often find that the fund’s active fee component either significantly reduces or totally removes the active management component’s contribution to the fund’s overall return. In some cases, the active management component of the fund may actually end up costing an investor money.

These imbalances are also reflected in measurements such as a fund’s active expense ratio (AER).  The AER was developed by Professor Ross Miller of the State University of New York.  Dr. Miller’s study found that due to the fee issues associated with actively managed mutual funds, the effective annual expense ratio for such funds was often significantly higher, often 5-6 times greater, than the fund’s stated annual expense ratio.

Investors often see a stated fee of 1 percent and just dismiss it as being only 1 percent. What investors fail to see is the cumulative impact of fees.  According to a study done by the General Accounting Office, over a twenty year period, each 1 percent of investment fees reduces an investor’s ending return by approximately 17 percent.  So, if you are paying an investment adviser an annual management fee of 1 percent and paying annual 401(k) fees of 1 percent, goodbye 34 percent of your end-return.

This is why variable annuities are such a bad investment decision. If your investment adviser recommends that you purchase a variable annuity (generally imposing an annual fee of 2 percent) and recommends that you retain him to manage the variable annuity for you for an annual fee of 1 percent, goodbye 51 percent of your end-return. Add to that the fact that variable annuity issuers base their annual fee on the accumulated value of the annuity rather than on their actual legal obligation to you, an investor’s best course of action is to just say “no” to variable annuities.  (Please see our white paper under “Variable Annuities” for a more detailed analysis on variable annuities and the questionable and often misleading marketing tricks used to sell them.)