Q3 2020 AMVR/InvestSense Quotient “Cheat Sheet”

The quarterly AMVR/InvestSense Quotient “cheat sheet” analyzes the non-index mutual funds in the top ten mutual funds used in U.S. 401(k) plans, based upon the Top 100 list compiled annually by “Pensions and Investments.” For the 3Q 2020, only six of the top ten funds were actively managed funds.

The Active Management Value Ratio (AMVR) is based largely on Charles Ellis’ classic, “Winning the Loser’s Game.” Ellis provided the blueprint for the AMVR with his observation that

[t]he incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.

Academic studies have consistently shown that that the overwhelming majority of actively managed funds are not cost-efficient, with conclusions such as

“99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.”

“[I]ncreasing 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.”

The AMVR simplifies the cost-efficiency evaluation process. Once an actively managed fund’s cost efficiency has been calculated relative to a comparable benchmark, usually a comparable index fund, the investor, plan sponsor or the ERISA attorney only has to answer two simple questions:

1. Did the actively managed funds provided a positive incremental return?
2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs

If the answer to either of these of these questions is “no,” the actively managed fund is not cost-efficient and , therefore, does not meet the plan sponsor’s fiduciary duty of prudence.

People frequently ask me what “CAC” stands for and why I include it in the AMVR/IQ calculations. “CAC” stands for “Correlation-Adjusted Costs.” The reason I include such calculations is to help investors, investment fiduciaries and attorneys to recognize potential “closet index funds.” The problem of “closet index” funds and the harm they create has been aptly described by Martijn Cremers, creator of the Active Shares metric, as follows:

“a large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by for fees for active management that they do not receive or receive only partially.”

“Closet indexing raises important legal issues. Such funds  are not just poor investments; they promise investors a service that they fail to provide. As such, some closet index funds may also run afoul of federal securities laws.”

Funds with high R-squared numbers or low tracking numbers are naturally candidates for “closet index” status. Closet index funds are never prudent under the Restatement (Third) of Trusts’ fiduciary standards. most notably Section 90, comments b, f, and h(2). SCOTUS recognized the Restatement as the legal authority for addressing fiduciary issues in Tibble v. Edison International.

The Correlation-Adjusted Cost calculations are based on Ross Miller’s Active Expense Ratio (AER) metric. A fund’s AER score shows the implicit cost of a fund’s expense ratio based on the fund’s incremental costs and the fund’s R-squared correlation to a comparable index fund. Miller explained the reasoning behind the AER as follows:

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active fund management together in a way that understates the true cost of active management. In particular, funs 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.

“RAR” refers to a fund’s risk-adjusted returns. Factoring in the riskiness of a fund is important since the standard belief in the investment industry is that return is a function of risk. Investors should expect a higher return if their fund’s manager assumes greater risk in managing their money.

The truth is that there is no exact way to measure a fund’s risk. In accordance with general investment practices, the AMVR uses a fund’s standard deviation number as a proxy for the fund’s “risk.”

An actively managed mutual fund that fails to provide an investor with a positive incremental return, i.e., has underperformed a comparable index fund benchmark, is not eligible for an AMVR score since it provided no benefit to an an investor.

A fund’s AMVR score provides a quantitative analysis of an actively managed fund. A fund’s InvestSense Quotient (IQ) provides a qualitative analysis of the fund by factoring in a fund’s efficiency, both in terms of cost management and risk management, as well as a fund’s overall consistency of performance.

The Q3 2020 AMVR numbers speak for themselves. Three key takeaways for investors, investment fiduciaries and attorneys are:

1. While funds and advisers often calculate a fund’s AMVR score based on a fund’s nominal, or stated, incremental costs/fees and incremental returns, InvestSense and plaintiff’s attorneys calculate a fund’s AMVR score based on a fund’s correlation-adjusted costs and risk-adjusted returns, as they provide a truer picture of such data. In this case, only two of the six funds provided positive incremental returns over the most recent five-year period (October 1, 2015-September 2020) and qualify for an AMVR score.

The “cheat sheet” numbers support my contention that arguing cost-efficiency, or more appropriately cost-inefficiency, instead of simply absolute costs of actively managed mutual funds, could help plaintiff’s attorneys create a genuine issue of fact, thereby reducing the chances of dismissal of their cases.

2. Given the high R-squared correlation numbers for each of the six funds, an argument can be made that these funds are closet index funds. While no universal number exists for classifying a fund as a closet index fund, an R-squared correlation number of 90 or above is certainly suspect. Morningstar uses a much lower R-squared threshold, 70, and to designate a fund as being highly correlated to the benchmark used in calculating the fund’s R-squared number.

3. The data for the retirement shares of the T. Rowe Price’s Blue Chip Growth Fund (RRBGX) shows the impact that a combination of high incremental costs and high R-squared correlation numbers can have on the overall prudence of a fund. In the case of RRBGX, the combination of the fund’s high incremental costs (1.18) and high R-squared (97) resulted in RRGBX’x AER score/implied incremental costs increasing by over 800%, significantly impacting the overall cost-efficiency of the fund.

For more information about the Active Management Value Ratio and examples of the the AMVR worksheet, click here and here. As John Bogle said, the power of “Humble Arithmetic.”

(c) Copyright 2020, 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 facts and circumstances. If legal or other professional assistance is needed, the services of an attorney or other appropriate professional adviser should be sought.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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