What was the fund’s stated return?
At that point, many people, both investment professionals and ordinary investors, stop their AMVR analysis of the actively managed fund in question, unnecessarily exposing themselves to potential financial losses and/or legal liability. When InvestSense provides pension plans and attorneys with consulting services and forensic audits, we re-calculate a fund’s incremental returns using risk-adjusted returns and the fund’s incremental costs using the Active Expense Ratio (AER) metric.
Many people are unfamiliar with the AER. Created by Ross Miller, the AER factors in the implicit impact of a fund’s correlation of returns to the benchmark used in the AMVR analysis. The importance of this step in an AMVR analysis is that the higher the active fund’s correlation of returns to the applicable benchmark, the less contribution that the actively managed fund’s management is actually providing to the active fund’s overall performance. As Professor Miller explained,
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.1
The AER also helps identify and avoid so-called “closet index” funds. Closet index funds are, by definition, cost-inefficient, charging excessive fees for underperformance. As one noted expert explained,
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.3
Over the last decade or so, there has been a definite trend of extremely high correlation of returns between U.S. domestic equity funds and comparable index funds. Professor Miller’s study found that the AER number for most U.S. domestic equity funds was often 400-500 percent higher than the fund’s publicly stated expense ratio, sometimes even higher.
Today, it is not uncommon to find that most U.S. domestic equity funds have high R-squared, or correlation, numbers of 90 percent of more. The higher a fund’s R-squared number and its incremental costs, the higher the fund’s AER number will be.
Charles D. Ellis, one of America’s most respected investment experts, stressed the importance of an actively managed fund’s correlations of returns numbers by pointing that on a fund that has an R-squared number of 95, that leaves the remaining 5 percent of the fund’s return having to try to justify the fund’s incremental costs. The odds of that happening are extremely unlikely, especially on a consistent basis, given the high correlation between the funds.
Active Management Value RatioTM 4.0
Active Management Value RatioTM (AMVR) 4.0 differs from AMVR 3.0 in the methodology used to calculate AMVR. In AMVR 3.0, we divided incremental cost by incremental return. Several legal colleagues and retired judges suggested that I “flip” the calculation to make it more similar to the Sharpe Ratio and, hopefully, make it easier to gain greater admissibility in the courts.
The main purpose of the AMVR is to establish whether a certain actively managed mutual fund is cost-efficient or not relative to a comparable, less expensive index fund. By establishing the cost-inefficiency of an actively managed mutual fund, the plaintiffs’ ERISA attorney creates a “material issue of fact,” which should prevent the court from dismissing the plan participants’ case.
Courts decide issues of law; juries decide questions of fact. While most 401(k)/403(b) actions are bench trials, I believe that may change in the near future, in part because of AMVR slides like the one shown here. I believe the AMVR would help juries answer the fundamental question- are an actively managed fund’s incremental costs greater than incremental returns?
When people ask me about the AMVR, I tell them that the AMVR addresses the basic question every investor should ask about an actively managed mutual fund:
Does the actively managed fund provide a commensurate return for the additional costs and risks an investor is asked to assume?
This come directly from the the “Prudent Investor Rule,” Section 90 of the Restatement (Third) of Trusts, comment h(2).
So what story does this AMVR “cheat sheet” slide tell us? This slide presents information on the six non-index funds from the top ten mutual funds used in U.S. defined contribution plan, based on invested assets, from “Pensions & Investments” annual survey. FIrst of all, the high R-squared correlation numbers should alert us to the possibility of “closet index” funds.
Next, 5 out of the 6 funds fail to provide a positive incremental return relative to a comparable Vanguard index fund based on nominal returns. Nominal returns are the simple return numbers you see on online services such as Morningstar. A fund obviously does not provide a commensurate return when it underperforms the benchmark fund.
To be cost-efficient, a fund’s AMVR has to be positive and greater than 1.00, showing that a fund’s nominal incremental returns are greater than the fund’s incremental costs. Here, Dodge and Cox Funds’s nominal AMVR score would be 8.93 (4.20./0.47).
However, ERISA plaintiff attorneys and others would argue that the use of nominal return numbers does not present an accurate picture of the situation. Many argue that investment performance figures are misleading unless they are adjusted for both risk and correlation of returns.
Here we see that adjusting for risk, using standard deviations, two funds produce positive annualized return, Dodge & Cox Stock Fund (2.69) and T. Rowe Price Blue Chip Growth (0.14). Those numbers are expressed in terms of basis points (bps). A basis point is one one-hundredth (0.01) of one percent. One hundred basis points equals one percent.
In our example Dodge and Cox had a higher standard deviation (19.14%) than the benchmark fund, Vanguard’s Large Cap Index Fund (VIGAX) (16.24). That explains Dodge & Cox Stock Fund’s lower risk-adjusted incremental return number.
The incremental costs numbers are calculated using the Active Expense Ratio (AER) mentioned earlier. The AER estimates a fund’s active weight/contribution, then determines the active’s fund’s inferred effective expense ratio. In essence, it indicates whether a fund’s incremental returns justify the fund’s incremental costs and, if not, the inferred additional costs.
High incremental costs combined with a high correlation of returns number significantly increase a fund’s AER number. Here, the combination of a high correlation number (97) combined with a moderately high incremental costs number (47 bps) resulted in an AER of 3.00, as compared to its nominal, or stated, expense ratio of 52 bps
As a result, Dodge & Cox Fund’s AMVR of 0.89 would technically classify it as cost-inefficient since its AMVR is less than 1.00. An investor should look for other options that provide a higher AMVR score.
As for the T. Rowe Price Blue Chip Growth Fund, the small positive risk-adjusted incremental return was completely overwhelmed by the fund’s high AER, the result of the combination of its high incremental costs (1.16 percent, or 116 bps) and high correlation of returns (98), resulting in an AER of 9..23. The fund’s AMVR would be its risk-adjusted incremental return (0.14) divided by its correlation-adjusted costs (9.23), 0.01, well-below the 1.00 required for cost-efficient status.
To borrow from the Oracle of Omaha:
Rule No. 1 – With regard to actively managed mutual funds, only invest in funds that provide a commensurate return for the additional costs and risks an investor in such finds is asked to assume.
Rule No. 2 – Calculate such additional cost and risks based upon a fund’s risk-adjusted returns and correlation-adjusted costs.
Rule No. 3 – Never forget Rules No. 1 and No. 2.
Very few actively managed mutual funds will ever pass this test using the “humble arithmetic” of the AMVR, simply because most actively managed funds are not cost-efficient. As a result, investors and plan participants will be directed back toward the relative safety and financial security of index funds, and investment fiduciaries will avoid unnecessary and unwanted fiduciary liability exposure.
1. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
2. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133.
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This article 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.