The New Mathematics of Successful Investing

Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened. – Winston Churchill

Facts do not cease to exist because they are ignored. – Aldoux Huxley

Ask any investor or plan sponsor what their returns were on the investments in their portfolios or plans and you will get a number provided to them on their account statement or from their plan service provider. Little do they realize that such performance numbers are usually highly misleading.

As a wealth preservation attorney and a quality assurance consultant to pension plans, one of the common issues I see is the inability of investors and plan sponsors to properly evaluate mutual funds. As a result, investors needlessly suffer reduced returns and plan sponsors face increased liability exposure.

Prudent investing is a basic tenet of successful investing. Being cost-conscious is a core element of prudent investing, as each additional 1 percent in investment fees and costs reduces an investor’s end return by approximately 17 percent over a twenty year period.

Prudent Cost-Conscious Investing
Being cost-conscious in investing does not mean that an investor or plan sponsor must always choose the least expensive investment option. What it does mean is that before an investor or plan sponsor chooses to use actively managed mutual funds in their investment programs,  they must be able to justify the higher costs of actively managed funds  by showing that the funds being considered have a reasonable expectation of providing additional benefits commensurate with such added costs.

I created a metric a couple of years ago, the Active Management Value Ratio™ 3.0 (AMVR), which allows investors and plan sponsors to easily evaluate the cost-efficiency of actively managed mutual funds. The AMVR is a simple cost/benefit metric that compares an actively managed mutual fund’s incremental cost to the fund’s incremental return, if any. For illustrative purposes, let’s assume Fund A, an actively managed fund, has the following cost and returns

  • total annual costs of 1.6 percent, with incremental costs of 1.4 percent,
  • 5-year annualized return of 10 percent, with 1 percent of incremental return

Those figures would result in an AMVR of 1.40 (1.40/1.00), meaning that the fund’s incremental costs exceeded the fund’s incremental returns, resulting in a net loss for an investor. Funds whose incremental costs exceed their incremental returns are not cost-efficient. An actively managed fund that fails to provide any positive incremental return is also not cost-efficient since an investor would have paid higher costs without receiving any benefit at all.

Some additional investment math based on the AMVR calculations provides even further insight into the cost-efficiency of Fund A. For instance, 87 percent of the fund’s total fee/cost (1.40/1.60) is only producing 10 percent of the fund’s returns. Hardly cost-efficient.

The benchmark in our example has total annual fees/costs of .20 percent and a 5-year annualized return of 9 percent. So, what would be the more prudent investment choice, paying $20 (.20 fees/costs) for a 5-year annualized return of 9 percent, or $140 (1.40 fees/costs) for an additional 1 percent in annualized return? The answer seems obvious; and yet sales of actively managed mutual funds continue to far surpass those of passive/index funds.

Interpreting Investment Returns
I recently posted a video discussing how some mutual funds use various types of returns to mislead investors and plan sponsors about the performance of their investment products. A little investment math shows why investors and plan sponsors need to have a better understanding of the various types of investment returns.

Fund A (actively managed ) 
annual fees/costs – 1.60 percent
20-year annualized return – 10 percent
front-end load (aka “sales charge) – 5.75 percent
5-year R-squared – 95

Fund B (index fund)
annual fees/costs – .20 percent
20-year annualized return – 10 percent

After 20 years the accumulated value of each fund would be as follows (assuming an initial balance of $10,000).

Nominal return:
Fund A – $56,044
Fund B – $64,870

Load-adjusted return:
Fund A – $52,821
Fund B – $64,870

Active Expense Ratio adjusted return (closet index factor of 7.7 percent here)
Fund A – $14,852
Fund B – $64,870

My experience has been that very few investors, plan sponsors, investment fiduciaries take to calculate the Active Expense Ratio for actively managed funds, even though the closet indexing problem is growing, as actively managers try to avoid losing customers due to large variances from index funds’ returns.

Given some recent questionable decisions by the courts in ERISA excessive fees actions, even some judges are overlooking the issue or are unaware of the problem as it relates to reasonableness of fund fees. Publicly marketing a fund as being actively managed, and charging higher fees based on such representations while actually acting as a “closet index” fund, raises issues regarding the violation of federal securities laws, which the courts have also failed to address

The Restatement (Third) Trusts and court decisions state that cost-consciousness is a key element in successful investing. New investment products and new marketing strategies have resulted in the need for new investment mathematical techniques to accurately evaluate investment strategies and protect investors and investment fiduciaries. Given the potential significance of the numbers involved and potential liability issues for investment fiduciaries under the expanding application of fiduciary standards, an investment in time learning about the new mathematics of investing and calculating same would itself be a prudent investment.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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