Each year “Pensions and Investments” publishes a list of the top 50 mutual funds used by defined contribution (DC) plans. The rankings are based solely on the amount of money invested in each fund within DC plans.

I do an analysis of the top 10 tens non-index funds using my proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR) The AMVR is based on the studies of Charles Ellis and Burton Malkiel. The AMVR measures the cost-efficiency of a fund, as cost consciousness is a fiduciary duty under Sections 88 and 90 the Restatement (Third) Trusts. Funds that do not provide a positive incremental return for investor, or whose incremental costs exceed their positive incremental returns, are deemed to be cost inefficient since the investor would suffer a net loss under either scenario.

This years top 10 non-index based funds used by DC plans are:

Fidelity Conta K(FCNKX) – LCG
American Funds Growth Fund of America R-6 (RGAGX) – LCG
American Funds Fundamental Investor R-6 (RFNGX) – LCB
American Funds Washington Mutual R-6 (RWMGX) – LCV
Dodge & Cox Stock (DODGX) -LCV
Vanguard PRIMECAP Admiral (VPMAX) -LCG
Fidelity Growth Company K (FGCKX) -LCG
T. Rowe Price Blue Chip Growth (RRBGX) – LCG
MFS Value R-6 (MEIKX) -LCV
Fidelity Low Price Stock K (FLPKX) – MCV

Each of the funds was analyzed using Ellis’ incremental cost/return analysis approach, using the following Vanguard funds as their benchmarks:

Vanguard 500 S&P 500 Index Fund Admiral (VFIAX) – Large Cap Blend
Vanguard Growth Index Fund Admiral (VIGAX) – Large Cap Growth
Vanguard Value Index Fund Admiral (VVIAX) – Large Cap Value
Vanguard Midcap Value Index Fund Admiral (VMVAX) – Midcap Value

A fund’s incremental cost number is based on a combination of a fund’s annual expense ratio and its trading costs. Since funds are not required to disclose its actual trading costs, such costs are estimated using John Bogle’s trading costs metric.

A fund’s incremental return number is based on a fund’s risk-adjusted return. Many investment industry professional ignore risk related returns, with the oft heard criticism that “investors can’t eat risk-adjusted returns.” However. interestingly enough, many actively managed funds actually post lower standard deviations, and thus improve their return numbers when a risk-adjusted calculation is performed. Secondly, many actively managed funds have no problem touting their Morningstar “star” rating in marketing their funds. Morningstar is on record as stating that their star ratings are based on risk-adjusted returns.

That said, four of the ten funds failed to provide a positive incremental returns over the past five-year period, January 1, 2013 to December 31, 2017:

American Funds Fundamental Investors
Dodge & Cox Stock
T. Rowe Price Blue Chip Growth
Fidelity Low Price Stock

One fund, Fidelity Growth Company, did produce a positive incremental return. However, the fund’s incremental costs exceeded its incremental return, so the fund is deemed cost inefficient since an investor would suffer a net loss.

The remaining five funds produced positive incremental returns that exceeded their incremental costs, thus qualifying them for an AMVR score. Since AMVR measure incremental costs relative to incremental returns, the lower the AMVR score the better. The five funds and their AMVR scores were:

Vanguard PRIMECAP Admiral – .07
American Funds Growth Fund of America R-6 – .58
Fidelity Conta – .59
American Funds Washington Mutual – .76
MFS Value – .87

The optimal AMVR score would be greater than zero, but less than 1.oo since 1.00 would indicate that the fund’s incremental costs equal its incremental return.

The final fiduciary prudence consideration is the “closet index” fund screen. A familiar fiduciary axiom is that it is never prudent to waste a client’s money. Likewise, by its very nature, a closet index fund is never cost efficient or prudent. All ten funds had a correlation of 90 or above relative to their Vanguard benchmark fund. The correlations were as follows:

Fidelity Conta – 96
American Funds Growth Fund of America – 97
American Funds Fundamental Investor – 98
American Funds Washington Mutual  – 96
Dodge & Cox Stock – 90
Vanguard PRIMECAP Admiral – 95
Fidelity Growth Company – 94
T. Rowe Price Blue Chip Growth- 97
MFS Value – 98
Fidelity Low Price Stock – 93

While there is no universally agreed correlation number that classifies a mutual funds as a closet index fund, most experts agree that a correlation of 90 or above can be considered an indication of closet index status.

Conclusion
Just as the plaintiff’s bar has become more of the Restatement (Third) Trust’s position regarding a fiduciary’s duty to be cost conscious, so too must plan sponsors and other ERISA fiduciaries recognize such fiduciary duty and evaluate their plan’s investment option to maximize the effectiveness of their plan and reduce the potential for liability exposure. both for the plan and themselves.

As this study shows, it is possible for actively managed funds to achieve an acceptable AMVR score, thereby indicating that a fund is cost efficient in terms of incremental costs and incremental. returns. However, even when a favorable AMVR score is obtained, plan sponsors and other investment fiduciaries still need to address the closet index issue by comparing the costs of an actively managed fund, including the fund’s trading costs, to an appropriate benchmark to ensure that they avoid the closet index “trap.”