What is the first thing you consider when selecting investments? There is a familiar saying in the investment industry – “amateur investors focus on investment returns; professional investors focus on investment risk.
Studies have shown that three out of four stocks tend to follow the general trend of the market. Consequently, professional investors know it is not that difficult to make money when the overall market trend is positive.
Secondly, investment professionals understand the opportunity costs inherent in investment losses. Investment losses reduce the amount of an investor’s principal that is available to fully participate in market recoveries. Furthermore, to totally cover investment losses, an investor has to earn more than the loss suffered since the investor’s account will be lower due to the investment loss. For instance, an investor would need a gain of 25 percent.to recover from a 20 percent loss,
As usual, I like to follow Apple’s famous slogan and “think different.” I like to approach wealth management with a “think outside the box” perspective, to create “deliberate disruptiveness” to change things for the better.
The first thing I look for in evaluating a mutual fund is the fund’s R-squared correlation number. As usual, there is a method to the madness.
Addressing the Problem of “Closet indexing”
In my practices, my primary focus is on fiduciary law, more specifically potential breaches of a fiduciary’s duties and strategies to prevent such breaches. The problem of closet indexing is gaining attention worldwide. Canada and Australia are the most recent countries to address the issue.
A mutual fund’s R-squared correlation number is a key factor in determining whether a fund is a potential “closet index” fund. A closet index fund is generally described as an actively managed mutual that has a high correlation of return to a comparable index fund, yet has fees and costs that are significantly higher than those of the index fund. By definition, closet index funds are cost-inefficient and, therefore, legally imprudent.
The legal imprudence of a closet index fund is even more evident when a closet index fund’s annual costs and fees are recalculated factoring in the fund’s R-squared correlation number. The argument is that the higher a fund’s R-squared number, the lower the implicit contribution of an actively managed fund’s management team to a fund’s performance.
The two most commonly used metrics in determining a fund’s closet index status are the Active Expense Ratio (AER) and Active Share. While the two metrics are used for similar purposes, they use distinctly different approaches. The AER metric focuses on the impact of an actively managed fund’s R-squared correlation number relative to the fund’s overall cost-efficiency. Active Share focuses on the overlap between the investment portfolios of an actively managed fund’s investment portfolio and a comparable benchmark fund.
According to Ross Miller, the creator of the AER, the metric indicates the implicit cost of an actively managed fund’s active component. As an actively managed fund’s R-squared correlation number increases (indicating less of a contribution from the fund’s management) and/or the fund’s incremental costs increase, the fund’s AER number increases.
Active Share’s focus on the overlap between the two funds’ investment portfolios is obviously important relative to being labeled a “closet index” fund. However, many have argued that Active Share overlooks the more important issue, that being how effectively a fund’s management team manages the non-overlapping portion of the actively managed fund’s investment portfolio in terms of both performance and cost-efficiency.
Exposing “Closet Index” Funds Using the Active Management Value Ratio™
At the end of each calendar quarter, I use the Active Management Value Ratio™ (AMVR), a proprietary metric, to calculate the cost-efficiency of the top ten actively managed mutual funds in U.S. defined contribution pension plans. The funds are chosen based on “Pensions and Investments” annual report on defined contribution plans..
A key component in calculating a fund’s AMVR is the fund’s AER. Given the fact that more attorneys are factoring in a fund’s AER in calculating damages in ERISA and securities litigation cases, investment fiduciaries and financial advisers should also factor in such numbers in providing recommendations to clients and selecting investment options for pension plans.
In calculating a fund’s AER, I typically use Vanguard index funds for benchmarking purposes. There are those who argue that it is “unfair” to compare Vanguard funds to actively managed funds since the two types of funds operate on different types of business platforms. My response is that legally the “best interest” of the investor/plan participant is/should be the only concern under both ERISA and federal/state securities laws. Therefore, such arguments have absolutely no merit.
As the chart shows, a fund’s high R-squared correlation number, combined with the incremental costs resulting from Vanguard funds’ low cost and fees, often results in significant increases in a fund’s AER and incremental costs relative to a comparable benchmark index mutual fund.
Regardless of whether the situation involves the “best interest” standard under either the legally accepted fiduciary standard or the SEC’s recently adopted Regulation “Best Interest,” costs have to be considered in recommending an investment to the public or managing a pension plan. There is a direct, negative relationship between a fund’s R-squared correlation number, a fund’s incremental costs, and the fund’s cost-efficiency.
There is no universally agreed upon level of R-squared that designates an actively managed mutual fund as a closet index fund. I use an R-squared correlation number of 90 as my threshold indicator for closet index status. Others avoid the whole closet index debate and simply calculate a mutual fund’s cost-efficiency using the AMVR and answer two simple questions:
(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?
(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?
If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and unsuitable/imprudent and should be avoided.
Based on the chart above and the funds’ risk-adjusted five-year returns, only four of the ten funds even produced a positive risk-adjusted incremental return relative to their benchmark: Fidelity Contrafund, Fidelity Growth Company, T. Rowe Price Blue Chip Growth, and T. Rowe Price Growth Stock. Of those funds, only three produced an AMVR rating less than 1.0, indicating their nominal incremental return exceeded their nominal incremental costs.
For litigation and consulting purposes, InvestSense recommends that attorneys and pension plan sponsors use an AMVR score based on a fund’s AER-adjusted incremental costs and risk-adjusted incremental returns. Using those standards, none of the three referenced funds posted an AMVR of 1.0 or less, indicating that they were cost-efficient over the five-year period analyzed. The respective AMVR scores were Fidelity Growth Company (2.04). T. Rowe Price Blue Chip Growth (3.67), and Fidelity Contrafund (6.83).
The pension plan and mutual fund industries do not like to discuss the issues of correlations of return, closet indexing or cost-efficiency. A quick glance at Morningstar’s data shows that many U.S. equity-based mutual funds have a high R-squared correlation number, resulting in significantly higher implicit annual expense ratios than the funds stated annual expense ratios. As a result, studies have consistently shown that very few actively managed mutual funds are cost-efficient:
- 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.1
- 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.2
- [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.3
- [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.4
It is generally agreed that effective diversification within an investment portfolio is a valuable means of risk management and the avoidance of large investment losses. The cornerstone of effective diversification is combining various investments that behave differently under various economic and market conditions, investments that have varying/low correlations of returns.
And yet, inexplicably, ERISA does not require 401(k)/404(c) plans to provide plan participants with correlation data on the investment options in their plan. Without such information, plan participants have a difficult time determining whether they have effectively diversified their plan accounts to reduce the chance of large losses, thereby improving their opportunity to achieve the much touted goal of “retirement readiness.”
For more information about the Active Management Value Ratio™ and the calculation process required, visit the following blogs:
1. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
2. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e.
3. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
4. Mark Carhart, On Persistence in Mutual Fund Performance, 52 J. FINANCE, 52, 57-8 (1997).
© Copyright 2019 The Watkins Law Firm. All rights reserved.
This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
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