Right now, the DOL and the SEC are trying to define “prudence” and “best interest,” respectively. I am on record as saying that the simplest and most logical step would be one, universal standard of prudence, using the Investment Advisor’s Act of 1940 as the model.
Since I do not expect the warring factions to agree on something so simple and logical, I continue to advocate my metric, the Active Management Value Ratio™ 4.0 (AMVR), as a simple, yet powerful, way to evaluate the prudence of an actively managed mutual fund.
While some would argue that fiduciary prudence can be evaluated on an investment’s returns alone, the fiduciary standards set out in the Restatement (Third) of Trusts. (Restatement) “Prudent Investor Rule” would disagree. Section 90 of the Restatement, more commonly known as the “Prudent Investor Rule,” emphasizes the importance of cost-efficiency as a factor in the prudence of fiduciary investments. Bottom line – alpha without cost-efficiency is meaningless.
Comments b, f, h(2) and m of Section 90 are notable on this issue, particularly comment h(2). Comment h(2) states that a fiduciary should not recommended or select an actively managed fund unless it can fairly and objectively be expected that the active fund will provide a commensurate return for the additional costs and risks associated with such fund. Research has consistently shown that the overwhelming majority of actively managed funds are not, however, cost-efficient.
The AMVR evaluates the cost-efficiency of an actively managed fund relative to a comparable benchmark index fund. The AMVR is based primarily on the research and concepts of investment icon, Charles D. Ellis, who stated 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!1
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?
To answer that question, an investor and/or investment fiduciary simply has to answer two simple questions:
- Does the actively managed fund provide a positive incremental return relative to a comparable index fund?
- If so, does the actively managed fund’s positive incremental return exceed the actively managed fund’s incremental costs?
If the answer to either of these questions is “no,” then the actively managed fund is not a prudent investment choice relative to the benchmark index fund.
An investor and/or investment fiduciary will have to pose those two questions in one of three scenarios. In the first scenario, the actively managed fund fails to produce a positive incremental return, i.e., has underperformed the benchmark index fund.
This is obviously an easy example of cost-inefficiency, as an investor in the actively managed fund would receive no commensurate return for the additional costs, let alone for any additional risk from the active fund.
In the second example, the actively managed fund does provide a positive incremental return. however the active fund’s positive incremental return is exceeded by the fund’s incremental costs. Once again, the active fund fails to provide a commensurate return relative to the benchmark index fund.
The “New” Fiduciary Prudence Equation
AMVR 4.0 introduces a new factor into the prudence debate, correlation of returns. The AMVR uses Ross Miller’s Active Expense Ratio (AER) in calculating an active fund’s correlation-adjusted expense rati
So why calculate an actively managed fund’s correlation-adjusted expense ratio? As Miller explains,
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.2
Martijn Cremers, creator of the Active Share metric, goes further, stating that actively managed mutual funds are arguably guilty of investment fraud.
[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
At the end of each calendar quarter, I publish my AMVR “cheat sheet” on the non-index funds in “Pensions & Investments” annual list of the top mutual funds used in defined contribution plans, based on the amount of invested assets. The slide below shows the results for the 2Q 2021.
Using only an active fund’s incremental costs and its R-squared/correlation number, Miller’s research found that actively managed funds that combine high R-squared scores with high incremental costs often have implicit expense ratios that are 400-600 percent higher, in some cases even higher, than their publicly stated expense ratios. The AMVR forensic analysis slide below, involving a fund with an R-squared score of 97, provides an example of how correlation of returns can impact an active fund’s implicit cost-efficiency.
While some dismiss the importance of an active fund’s correlation of returns number, common sense indicates otherwise. For example, the active fund in this example had an R-squared/correlation number of 97. This suggests that an investor in the index fund could achieved 97 percent of the return of the active fund for less than 10 percent of the active fund’s cost, the essence of cost-efficiency.
At the same time, the high R-squared/correlation number indicates that either the active did not actually provide much active management or the active management provided was not very effective. Either way, the results support Cremers accusations.
Calculating an actively managed fund’s AMVR score is simple and straightforward, similar to the calculation process for the Sharpe Ratio. Whereas the Sharpe ratio divides return by standard deviation, the AMVR divides an actively managed funds incremental risk-adjusted return (RAR) by the fund’s incremental correlation-adjusted costs, i.e., the fund’s AER number.
The reasoning behind using correlation-adjusted costs has already been discussed. Ellis himself suggested using risk-adjusted returns because, the argument goes, an investment’s return is supposed to be a function of the risk assumed by an investor.
An active fund that fails to provide any positive incremental return automatically earns an AMVR score of zero. Otherwise, as mentioned earlier, an actively managed fund’s AMVR score is calculated by dividing the fund’s incremental risk-adjusted return by the fund’s incremental correlation adjusted costs. The higher a fund’s AMVR score, the greater the fiduciary prudence/cost-efficiency of the actively managed fund.
In our example, the active fund’s incremental correlation-adjusted costs greatly exceed the fund’s incremental risk-adjusted returns, earning the active fund an AMVR score of zero. Therefore, the actively managed fund would be deemed to be an imprudent investment choice relative to the benchmark index fund.
Some ERISA plaintiff’s attorneys have already implemented the AMVR and AER metrics into their practices in calculating damages. Investment fiduciaries should consider the potential impact of the combination of the AMVR and AER metrics on their potentisl liability exposure, especially given the fact that SCOTUS could very easily impose the burden of proof regarding causation/fiduciary prudence on plan sponsors in 401(k)/403(b) litigation as a result of the Northwestern University 403(b) case currently pending before the Court.
Plan sponsors should perhaps heed the warning issued by John Langbein, who served as the reporter for the commission that drafted the revised Restatement (Third) over forty years ago:
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.4
Or, as the First Circuit Court of Appeals recently commented,
Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry “wolf.”5
1. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online athttps://www.forbes.com/sites/investor/2014/03/13/letter-to-the-grandkids-12-essential-investing-guidelines/#cd420613736c.
2. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
3. 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.
4.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 http://digitalcommons.law.yale.edu/fss_papers/498.
5. Brotherston v. Putnam Investments, LLC,, 907 F.3d 17, 39 (1st Cir. 2018).
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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.
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