We provide two sets of data so that users can choose which data to use. The nominal data is based on the publicly disclosed data. The second set of data is the nominal data adjusted for risk and the funds’ R-squared, or correlation of returns, number. InvestSense believes that the adjusted data provides a more accurate, and thus a more meaningful comparison for users.
At the end of each calendar quarter, InvestSense updates the Active Management Value Ratio ™ “cheat sheet.” The “cheat sheet” provides data that allows fiduciaries, investors and attorneys to calculate the cost-efficiency of the top non-index funds from “Pensions & Investments” annual list of the top ten mutual funds in U.S. 401(k) plans, based on the cumulative invested assets within each fund within the plans.
Since fiduciaries are required to continually monitor their investment selections for continued prudence, we have chosen to switch our time frame from five years to three years. This reflects a more timely and prudent review process.
The Active Management Value Ratio (AMVR) is simply a fund’s incremental cost divided by its incremental return. Interpreting the AMVR is equally easy. Once an actively managed fund’s cost efficiency has been calculated relative to a comparable benchmark, usually a comparable index fund, the plan sponsor or the ERISA attorney only have to answer two simple questions:
1. Did the actively managed fund provide 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 is not cost-efficient and, therefore, does not meet the plan sponsor’s fiduciary duty of prudence. The AMVR also allows the user to determine with other regulatory compliance standards, including the SEC’s Reg BI’s “best Interest” standard and FINRA’s “suitability,” “fair dealing” and “high commercial standards” standard.
The AMVR is based on the prudence standards set out in the Restatement (Third) of Trusts1 (Restatement) and the research and finding of several well-known and respected investment experts.
Comparison of actively managed and index funds: ‘[T]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.“-Nobel laureate, Dr. William F. Sharpe2
Comparison of incremental costs and incremental returns: So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!-Charles D. Ellis3
Adjusting incremental nominal costs for correlation of returns between an actively managed fund and a comparable benchmark index fund, using Ross Miller’s Active Expense Ratio metric: 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.4
As for adjusting a fund’s nominal returns for risk, that us consistent with the Restatement’s position that prudent investing requires that investors that assume greater cost and/or risk should receive a commensurate return for the assumption of such additional cost and risks.5
the 1Q 2021 AMVR ‘cheat sheet” shows two of the funds passing the AMVR’s prudence standard, a score of 1.0 or less, using the fund’s nominal returns- American Funds’ Washington Mutual R6 shares and Dodge and Cox Stock. However, when the correlation-adjusted costs (CAC) and risk-adjusted return (RAR) number are used, only Washington Mutual passes the AMVR’s prudence standards. Dodge and Cox Stock’s failure to pass on the adjusted number is due to a high R-squared correlation of returns number (97) and a high standard of deviation number (23.40).
Too many fiduciaries, investors ands attorneys overlook or do not understand the significance that a fund’s correlation of returns numbers can have in determining the overall prudence of a fund. As Charles D. Ellis has pointed out by example, an R-squared number of 95 leaves the remaining 5 percent of the fund’s return having to try to justify 100 percent fund’s incremental costs. The odds of that happening are extremely unlikely, especially on a consistent basis, given the current high correlation of returns between most U.S. actively managed and comparable index equity funds.
Several weeks ago I publicly published the following AMVR forensic analysis comparing Fidelity Contrafund K shares (FCNKX), one of the most widely offered investment options in 401(k) and 403(b) plans, with Fidelity’s popular Large Cap Growth Index Fund (FSPGX).
The reaction has been immediate, from various groups, including fiduciaries, investors and attorneys. Steve Jobs said the secret to a memorable presentation is to create an “OMG” moment. This one analysis may turn out to be the OMG moment for the Active Management Value RatioTM .
Courts in 401(k)/403(b) fiduciary breach actions have consistently stated that the failure of a plan to choose the least expensive funds as investment options for a plan is required by ERISA. Courts often cite Judge Doty’s statement in Meiners v. Wells Fargo6 for support of this principle, with Judge Doty stating that plan participants must show “more” than just absolute fees to establish a breach of a plan sponsor’s fiduciary duties under ERISA.
The AMVR provides that “more” in a simple, yet powerful way. The AMVR and its focus on cost-efficiency is consistent with both ERISA’s and the Restatement’s focus on cost-consciousness. The AMVR is consistent with the SEC’s Reg BI and its focus on costs as a factor in determining “best Interest.” The AMVR is consistent with FINRA’s requirement that stockbrokers deal fairly with customers and always act consistently with high commercial standards.
SCOTUS has endorsed the Restatement as a resource that the courts often use in resolving fiduciary questions. Professor John Langbein served as the Reporter on the committee that wrote the current Restatement. Professor Langbein and Professor Richard Posner wrote an article article shortly after the new Restatement was released, over forty years ago, that I believe sums up the current fiduciary prudence controversy in the courts.
When market index funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such accounts. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.7
However, aside from legal aspects of the metric, numerous people have suggested that the most powerful aspect of the AMVR is that it just plain, common sense. When an investment’s incremental costs exceed its incremental return, the investment is obviously not prudent.
SCOTUS currently has a case before it, Hughes v. Northwestern University, which would allow the Court to resolve the current inequitable and divided interpretation of ERISA in various federal courts. Langbein and Posner’s foresight is over forty years old. The common sense approach of the AMVR shows the importance of factoring in cost-efficiency in determining the prudence of an investment. Hopefully, SCOTUS will hear the Northwestern University case and consider all these factors in order to make ERISA and fiduciary prudence meaningful again.
1. Restatement (Third) Trusts (American Law Institute)
2. William F. Sharpe, “The Arithmetic of Active Investing,” available online at https://web.stanford.edu/~wfsharpe/art/active/active.htm.
3. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at https://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c
4. Ross M. Miller, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol. 5, No. 1, First Quarter 2007. https://ssrn.com/abstract=972173
5. Restatement, Section 90, cmt. h(2)
6. Available online at MEINERS v. WELLS FARGO & | Civil No. 16-3981… | 20170526d63| Leagle.com
7. John H. Langbein and Richard A. Posner, Measuring the True Cost of Active Management by Mutual Funds, Journal of Investment Management, Vol 5, No. 1, First Quarter 2007 https://digitalcommons.law.yale.edu/fss_papers/498
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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 facts and circumstances. If legal or other professional assistance is needed, the services of an attorney other appropriate professional adviser should be sought.
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