Glad to get the feedback from people who like and are actively using the Active Management Value Ratio™ 3.0 (AMVR). I though I would share some of the frequently asked questions (FAQs) in case they help others using the AMVR metric.
Is the AMVR intended to be used to predict a mutual fund’s future performance?
No. Investment fiduciaries are held to very high fiduciary duties, including the duties of loyalty and prudence. The purpose of the AMVR is to analyze the cost-efficiency of an actively managed mutual fund. Funds that are not cost-efficient waste investors’ money. “Wasting beneficiaries’ money is imprudent.”
Why do some AMVR slides show three types of returns, while other slides only show two types of returns?
Slides for shares of mutual funds that charge a front-end load, or commission, show (1) a fund’s stated, or nominal return; (2) a fund’s return adjusted for the fund’s front-end load; and (3) a fund’s risk-adjusted return.
Most mutual funds do not charge a front-end load on retirement shares offered through pension plans such as 401(k) and 403(b) plans. Therefore, slides for shares of retirement shares only show a fund’s five-year annualized nominal and risk-adjusted returns.
Is cost-efficiency that important? Doesn’t the law require stockbrokers and other financial advisers to watch out for that sort of thing, to always put a customer’s financial “best interests” first?
“Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.”
“[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”
Investment fiduciaries are required to always put their client’s “best interests” first, to always put a customer’s financial interests ahead of their own.
Inexplicably, there are currently two different standard for professionals providing investment advice to the public. Stockbrokers are not generally not held to a fiduciary standard. As a result, they can put their own financial “best interests,” i.e., commissions, trips, ahead of the customer’s best interest. Investment advisers are held to the aforementioned fiduciary standard of putting a customer’s “best interests” first.
Does the AMVR provide any other information about cost-efficiency?
Yes. Here, the the fund’s AMVR using the fund’s TER (traditional expense ratio) would be 0.73%. The fund’s AMVR using the fund’s AER (active expense ratio) would be 7.44%.
Look at the % fee/% return line on the AMVR chart. 83%/6% indicates that 83% of the actively managed fund’s costs are only producing 6% of the fund’s risk-adjusted return.
Another analogy would be to “monetize” the funds’ annual costs in another way. Which would you prefer to pay-$18 for a return of $7.26, or $111 for a return of 7.73%, 93 extra basis points in costs for 47 extra basis points of return?
Is the AMVR the same thing as the Sharpe ratio?
No. The AMVR compares a mutual fund’s costs to the fund’s returns.
The Sharpe ratio compares a mutual fund’s risk to the fund’s returns.
Why are a fund’s trading expenses included in the calculation of AMVR? Aren’t a mutual fund’s trading expenses part of a mutual fund’s expense ratio?
No. Trading expenses are part of a mutual fund’s operating expenses, which are not included as part of a mutual fund’s expense ratio. Trading expenses reduce a mutual fund’s return and are often higher than a fund’s expense ratio.
The importance of trading expenses cannot be emphasized enough. Often referred to a part of a mutual fund’s “hidden” expenses, studies have consistently recognized the importance of trading expenses on mutual funds’ returns.
A Wall Street Journal article, “The Hidden Costs of Mutual Funds,” estimated that the average trading costs of actively managed funds are 1.44 percent of a fund’s total assets. The Morningstar Investment Research Center reports that as of March 2019, the average expense ratio of U.S. domestic mutual funds is 1.11 percent.
Each additional 1 percent in fees and costs reduces an investor’s end return by approximately 8 percent over 10 years, 17 percent over 20 years. Using the above-referenced expense ratio and trading cost numbers, investor’s would be looking at a loss of 20 percent and 43 percent respectively. That’s is why trading costs are a part of the AMVR’s cost-efficient calculation.
For example, at the end of each calendar quarter, InvestSense, LLC, calculates the cost-efficiency of the top ten 401(k) mutual funds, based on “Pensions & Investments’” annual list of the top fifty mutual funds in U.S. defined contribution plans, based on cumulative invested dollars in said plans.
At the end of the fourth quarter for 2018, two funds had identical five-year annualized returns. However, one fund had a turnover ratio that was 600% higher than the other fund, indicating higher trading costs. Costs are anti-performance, negative returns. Therefore, the turnover/trading numbers helped the investor make a more-informed decision and, hopefully achieve higher returns.
As stated in the earlier Burton Malkiel quote, his studies have concluded that a fund’s expense ratio and its trading costs are the two most reliable indicators in predicting a mutual fund’s future performance. He went on to say that “[h]igh expenses and high turnover depress returns.”
As the late Vanguard legend, John Bogle, was fond of saying – “costs matter.”
What is AER and why is it included in calculating a fund’s AMVR?
A fund’s Active Expense Rating, or AER number, helps investors detect and avoid co-called “closet index funds. “Closet index” funds are actively managed funds whose returns are essentially the same as a comparable index fund, but charge much higher fees than the index fund.
As Ross Miller, the creator of the AER explained:
Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.
A fund’s AER number is based on a fund’s R-squared number. Morningstar states that R-squared reflects the percentage of a fund’s movements that are explained by movements in its benchmark index, [rather than any contribution by active management.]
An R-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s returns could be attributed to an index fund rather than the active fund’s management team. If an investor is paying an annual expense fee of 1% for an actively managed mutual fund that only contributes 2 percent of the fund’s total return, and a comparable index fund is producing 98% of the fund’s return, while charging an annual expense fee of just 0.20% percent, the effective annual expense ratio for the actively managed fund is significantly higher than the stated 1%.
I noticed you use Vanguard index funds as the benchmarks in your AMVR analyses? Can funds from other fund families be used for benchmarking purposes?
Absolutely. Every so often I run a screen on the Morningstar Investment Research Center application to see how Vanguard funds measure up for benchmarking purposes. ERISA’s stated purpose is to protect plan participants. Plan sponsors talk about “retirement readiness,” about helping plan participants reach their retirement goals. The best way to do that is to provide plan participants with mutual fund that provide them with cost-efficient investment options.
I recently ran my Morningstar cost-efficiency screen on all nine of Morningstar’s equity box categories. Here is the screen I ran for the large-cap growth category (1516 funds), both for Vanguard’s large cap Growth Index retail shares (VIGRX) and retirement shares (VIGAX):
|Nominal Return (5-yr) >=||422||392|
|Load-adj. Return (5-year) >=||358||335|
|Expense Ratio <||9||6|
|R-squared < 90||3||1|
The 3 funds that passed the VIGRX screen were Vanguard Growth Index Admiral shares, Vanguard Growth Index institutional shares, and Vanguard Growth Index Investor shares. The only fund that passed the VIGAX screen was…Vanguard Growth Index Admiral shares. Pretty strong evidence.
People can argue all they want about using Vanguard index funds for benchmarking purposes. If the goal is truly about helping promote the participants’ “retirement readiness,” then Vanguard is clearly the best choice. The First Circuit Court of Appeals recently gave further support to the use of index funds, both for benchmarking purposes and within plans, in their decision in Brotherston v. Putnam Investments, LLC.
In deciding on benchmarks, I would strongly suggest that investment fiduciaries, such as plan sponsors, and investors run similar screens on the funds they are considering. Most public libraries now offer the Morningstar Investment Research Center program for free in their digital library.
Can I use the AMVR to evaluate exchange traded funds (ETFs)?
Can I use the AMVR on the subaccounts in a variable annuity?
Yes. Variable annuity subaccounts usually track the performance of the retail version of the mutual fund. Just be sure to use the information on the fund contained in the variable annuity’s prospectus.
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