Cost-Efficiency and Correlation of Returns: The Often Overlooked Factors in Fiduciary Investing

“Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs….The best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.”1

Ask a plan sponsor, trustee or other investment fiduciary about their investment selection process, and they will probably quote you annualized return, nothing more, because they do not bother to properly select and monitor investments. Probably because in too many cases they do not know how to properly select and monitor investments.

This may seem harsh, but the evidence supports my theory. Take Dr. Sharpe’s quote for example. How many fiduciary investors bother to compare potential actively managed fund choices with a comparable index fund? How many fiduciary investors simply blindly follow whatever advice their adviser recommends, again because they do not know to properly evaluate the funds themselves?

SCOTUS has recognized the legitimacy of the Restatement of Trusts as a resource in addressing fiduciary questions. Section 90 of the Restatement, commonly known as the Prudent Investor Rule, stresses two consistent themes, cost-efficiency and risk-management through diversification. With regard to cost-efficiency, the Restatement states that

Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs,…If the extra costs and risks of an investment program are substantial, those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…2 – Restatement (Third) Trusts [Section 90 cmt h(2)]

Because the differences in the totality of  the costs…can be significant, it is important for the [fiduciary] to make careful overall cost comparisons, particularly among similar products of a specific type being considered for a [plan’s] portfolio.3

Investment icon Charles D. Ellis has contributed immeasurably to the wealth management industry over the years, especially in the area of prudent and cost-efficient investing. One of Ellis’ greatest contributions has been the recommendation that

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!4

With that in mind, it should come as no surprise that studies have consistently found that the overwhelming majority of act5ively managed mutual funds are not cost-efficient.

  • “99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.”5
  • “[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.6
  • “[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.”7
  • “[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”8

Several years ago I created a metric, the Actively Managed Value RatioTM (AMVR), based upon Ellis’ research and findings. The metric is simple, yet powerful. I use it in both my forensic investment analysis and my 401(k)/403(b) compliance consulting practices.

To further demonstrate the power of the AMVR, I often present the AMVR as an analogy to passing in football. When a football team throws a pass,, three things can happen, two of which are bad – a completion, an incompletion, or an interception.

The same soft of analogy can be used with regard to investing in actively managed mutual funds. Using the AMVR and Ellis’ incremental cost/incremental return technique for illustration purpose, investing in actively managed mutual funds results in one of four results – incremental returns greater than incremental costs (cost-efficient investing), or one of three scenarios in which incremental costs exceed incremental returns (cost-inefficient investing), what I call the AMVR Triple Option

In AMVR Analysis Triple Option #1, the actively managed fund simply underperforms the comparable benchmark index fund. Other than computing damages, there is no reason to even factor in the fund’s incremental costs in determining prudence given the active fund’s underperformance.

In AMVR Analysis Triple Option #2, the actively managed fund manages to produce a positive return. However, the fund’s incremental costs clearly exceed the fund’s incremental return by well over 100 percent. As a result, the active fund would still be an imprudent investment choice.

AMVR Analysis Triple Option #3 is the one that the plaintiff’s bar is increasingly using to argue a breach of fiduciary duties by investment fiduciaries. This option involves a metric, Ross Miller’s Active Expense Ratio, which factors in the R-squared, or correlations of returns number, between an actively managed fund and a comparable benchmark index fund.

Why factor in an active fund’s correlation of returns number? Miller explains that

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, 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.9

Over the past ten to fifteen years, there has been a definite trend of increasing correlation of returns between U.S. domestic equity funds. As a result, there has been a an increasing correlation of returns between U.S. domestic equity funds and index funds.

In some cases, the high correlation of returns may have been due to a deliberate attempt by actively managed funds trying to avoid large differences in performance so as not to potentially lose investors to index funds. Funds that engage in such practices have come to be known as “closet index” funds and “index huggers.”

In this example, the correlation of returns between the active fund and the index fund was 97. As the graphic shows, active funds that have high incremental costs and/or a high correlation of returns number will see a dramatic increase in their effective expense ratio, as well a dramatic decrease in their AMVR/cost-efficiency score.

A fund’s R-squared, aka correlation of returns, number also plays a factor in the Restatement’s other consistent theme, risk management through effective diversification. The key to effective diversification is to create an investment portfolio consisting of investments that are not highly correlated, investments that counter balance each other during varying market and/or economic conditions, the hope being the avoidance of large financial losses. So while most investors ,including fiduciary investors, believer that investing is an active, offensive process that focuses on returns, Ellis has long maintained that

“Even though most investors see their work as active, assertive, and on the offensive, the reality is and should be that stock and bond investing alike are primarily a defensive process. The great secret for success in long-term investing is to avoid serious losses.”10

Going Forward
Cost-efficiency and the AMVR are simply common sense. And yet, when I show plan sponsors and trustees the AMVR Triple Option slides, they usually immediately respond positively and say that, for the first time, they understand the prudent investment process. Unfortunately, at that point they also realize that they have not been following a prudent process and that their plan/trust, and themselves, face unlimited liability.

The AMVR is a simple, yet powerful tool that can produce a win-win situation for both beneficiaries/trustees and plan participants/plan beneficiaries for investment fiduciaries that are willing to invest a little time and learn to properly use the AMVR.

1. William F. Sharpe, “The Arithmetic of Active Investing,” available online at
2. Restatement (Third) Trusts, Section 90, cmt h(2). (American Law Institute)
3. Restatement (Third) Trusts, Section 90, cmt m. (American Law Institute)
4. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at
5. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
6. Charles D. Ellis, The Death of Active Investing, Financial Times, January 20, 2017, available online at Ellisa, Charles D., “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018e.
7 Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
8. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
9. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4
10. Charles D. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018)

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ 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 and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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