Each quarter InvestSense, LLC, performs an updated forensic analysis of the top ten non-index funds in the “Pensions & Investments” list of the top 50 mutual funds in U.S. defined contribution plans. InvestSense uses its proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR) to perform the analysis.
The AMVR is a simple cost/benefit analysis using the incremental costs and incremental returns of an actively managed mutual fund, as compared to a comparable benchmark, typically an index fund or market index. The AMVR is based upon the research of investment experts such as Charles D. Ellis and Burton Malkiel, as well as the fiduciary standards established by the Restatement (Third) of Trusts (Restatement) and the Prudent Investor Rule (PIR). The principles established by the Restatement and the PIR have been endorsed by the courts as the applicable standards in fiduciary law.
2Q 2018 401(k) Top 10 Mutual Funds Active Management Value Ratio™ 3.0
The Restatement stresses the importance of cost-efficiency in choosing actively managed mutual funds. Three key sections from the Restatement that every investment fiduciary should be aware of are:
- Section 90, comment b, which states that a fiduciary has a duty to be cost-conscious.
- Section 90, comment f, which states that a fiduciary has a duty to search for the highest return for a given level of costs and risk.
- Section 90, comment h(2), which states that actively managed mutual funds should only be recommended when “realistically evaluated return expectations” establish that the returns from a fund will compensate an investor for the additional costs and risks generally associated with actively managed mutual funds.
As the exhibit shows, seven of the ten funds would result in a positive AMVR score, meaning the fund produced both positive incremental returns and that those returns exceeded the fund’s incremental costs. Three of the funds failed to produce positive incremental returns.
The AMVR reflects a fund’s incremental costs relative to a fund’s incremental returns. Therefore, a low AMVR score is the goal. An AMVR score between 1 and zero indicates that a fund is cost-efficient. An optimal AMVR score would be between 50 and zero. In this example 4 of the 10 fund’s AMVR scores would be considered optimal.
2Q 2018 401(k) Top 10 Mutual Funds AER-Adjusted Active Management Value Ratio™ 3.0
Given the Restatement’s mandate for the selection of cost-efficient investment options, investment fiduciaries also need to evaluate investments in terms of potential “closet index” fund status and the cost-efficiency implications of such a designation. Closet index funds are funds that hold themselves as providing the alleged benefits of active management, albeit at a much higher cost, but whose actual returns closely track, or in many cases underperform, the returns of comparable, significantly less expensive index funds.
Professor Ross Miller created a metric, the Active Expense Ratio, to expose potential closet index funds and their high costs. Professor Miller’s studies found that actively managed funds with high R-squared numbers often have effective annual expense ratios that are 400%-500% higher than the fund’s stated annual expense ratio. Higher expense ratios reduce an investor’s end-return. Each additional 1 percent in fees reduces an investor’s end-return by approximately 8.5 percent over a 10-year period and approximately 17 percent over a 20-year period.
In our, all ten of the funds had a R-squared number over 90, most were 95 or greater. As a result, the funds’ AER effective annual expense ratios rose dramatically and rendered all but one of the funds as cost-inefficient, since their AER-adjusted incremental costs far exceeded their incremental returns. Even the sole surviving cost-efficient fund, Vanguard PRIMECAP Admiral shares failed to score in the optimal range, just slipping in 0.86.
There are those in the investment industry that discount the importance of the AER and other metrics that have been created to address the increasing concern over closet indexing and its impact on investor’s returns. However, the plaintiff’s bar is successfully including such issues in their pleadings and some courts have recognized the legitimacy of the closet indexing issue. Prudent retirement plan sponsors and other investment fiduciaries would be wise to include a closet index screen as part of their due diligence process.
For more information about the AMVR and the calculation process, click here.
The courts have expressly recognized the value of the Restatement in interpreting fiduciary law. The Restatement stresses the importance of fiduciaries selecting cost-efficient mutual funds. To that end, the Restatement has essentially established a simple three-step screen for identifying cost-efficient investments. By using a combination of the Restatement and the Active Management Value Ratio™ 3.0, plan sponsors and other investment fiduciaries can identify prudent choices for plan participants and their beneficiaries, while reducing their personal fiduciary liability exposure as well.
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