At the end of each calendar quarter, InvestSense calculates new Active Management Value Ratio™ (AMVR) data for our clients. We also publish for the public an AMVR analysis of the top ten actively managed mutual funds in U.S. 401(k) plans, based on “Pension and Investments” magazine’s annual survey.

InvestSense recommends to clients that they calculate their AMVR data using the same standard being used increasingly by ERISA plaintiff attorneys in arguing and settling cases, that being Active Expense Ratio (AER) adjusted incremental costs divided by risk adjusted return adjusted incremental returns. In short, the AMVR allows investment fiduciaries, such as 401(k)/403(b) plan sponsors and trustees, and ERISA plaintiffs’ attorney to quantify fiduciary prudence and use the results as evidence.

One reason that ERISA plaintiffs’ attorneys are using the AMVR is the fact that properly calculated and utilized,  the AMVR creates questions of fact in a legal action. Since judges can only decide questions of law, not questions of fact, the AMVR may help reduce the number of  ERISA cases dismissed summarily by the courts or other legal tribunal. We also provide the simple nominal, or reported, incremental cost and incremental return data on funds in a plan for those willing to take the risk of unnecessary fiduciary liability exposure.

In interpreting the quarterly data, a user should remember to begin by analyzing the data in terms of two simple questions:

1. Did the mutual fund provide a positive incremental return relative to the comparable benchmark that was used by a fiduciary or financial adviser in evaluating the mutual funds in question?

2. If a fund did provide a positive incremental return relative to the comparable benchmark used, was the positive incremental return provided greater than the fund’s incremental costs?

If the answer to either of these questions is “no,” then the Restatement (Third) of Trusts states that it would be an imprudent investment choice. The Supreme Court has recognized the Restatement as the authority in resolving fiduciary and investment prudence issues.

The Restatement’s position becomes even more important when one examines the findings of various studies on the issue of the cost-efficiency of actively managed mutual funds, including

• 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

I am record as saying that I believe that the issue of cost-efficiency is going to gain greater attention in ERISA litigation going forward, especially if the current Putnam litigation results in pension plans having the burden of proof on the issue of causation in ERISA excessive fees and fiduciary breach actions. The fund companies know, and have known for some time, that their actively managed mutual funds are generally not cost-efficient, especially when many of said funds have R-squared correlation numbers of 90 or above, thereby supporting an argument that they are simply “closet index” funds. Closet index funds, aka “index huggers” and “mirror funds,” are actively managed mutual funds that essentially track the performance of comparable market indices, yet charge investors significantly higher fees and charges for such similar performance.

Going Forward
Once again, the third quarter AMVR “cheat sheet” results serve to remind investment fiduciaries of three key important fiduciary issues:

1. Actively managed mutual funds with high R-squared correlation numbers often indicate potential “closet index” funds. Closet index funds are imprudent by definition.
2. Actively managed mutual funds with high R-squared correlation numbers and high incremental costs typically result in high Active Expense Ratio numbers. Per Ross Miller, the creator of the metric, a fund’s AER number indicates the implicit cost of the fund, as opposed to its stated annual expense ratio.
3. The very nature of actively managed mutual funds, higher management fees and trading costs, usually results in actively managed mutual funds underperforming comparable index funds.

As one of America’s leading ERISA attorneys, Fred Reish, is fond of saying, “forewarned is forearmed.”

Notes
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).

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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.