Costs, Correlations and Prudent Fiduciary Investing

The financial adviser tells you that a fund has a five-year compound return of 20 percent.

The fund’s advertisement tells you that the fund has a five-year compound return of 20 percent.

Morningstar tells you that the fund has a five-year compound return of 20 percent.

So why I would possibly tell you not to buy the fund? Because the fund might not be cost efficient, its incremental costs may exceed its incremental returns. Any investment whose incremental costs exceed its incremental returns is never a prudent investment.

[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.1

Closet indexing has become an international issue for the very reasons stated above. Closet indexing refers to a situation where a fund charges a high expense ratio, citing the benefits of the fund’s active management. However, the fund shows a high correlation of returns to a much less expensive, comparable index fund with the same, or better, returns.

Financial advisers and actively managed mutual funds do not like to talk about the costs associates with their funds. Research has consistently shown that the overwhelming majority of actively managed are not cost efficient.

  • 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.7
  • Increasing 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.8
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.9
  • [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.10

Correlations Matter
Financial advisers and actively managed funds also do not like to discuss the relationship between a fund’s implicit expense ratio and its correlation of returns with comparable index funds.

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.2

This quote from Ross Miller, creator of the Active Expense Ratio metric (AER), is one of the three core foundations of my metric, the Active Management Value Ratio AMVR. Using only a fund’s R-squared/correlation data and the fund’s incremental costs relative to a comparable index fund, the AER provides investors and investment fiduciaries with both a fund’s percentage of active management and its implicit expense ratio.

This information is important given the recent trend of actively managed funds to show correlations of returns of 90 or above, many 95 or above, relative to comparable index funds. Many have theorized that the high correlation of return numbers reflects an attempt by actively managed funds to reduce the risk of underperforming comparable, less expensive index funds and possibly losing customers.

The bottom line is that actively managed mutual funds do not adjust their expense ratios in line with their correlation of returns numbers, even though the value of their active management is arguably less. For example, the effective, or implicit, expense ratio of a fund with an R-squared/correlation number of 95 is naturally higher since 95 percent of the fund’s return can be attributed to the market instead of the fund’s active management team.

Miller found that the correlation of return numbers do not reflect a one-to-one percentage of a fund’s active management weight. The AER provides a metric for calculating the percentage of active management provided by a fund, what Miller refers to as “active weight.” Miller then simply divides the incremental costs of an actively managed fund by its active weight number.

What Miller found is that an actively managed fund’s implicit expense ratio, its AER, is often 3-4 times higher, sometimes even higher, than its publicly advertised expense ratio. This obviously has potentially important implications for the cost-efficiency, and prudence, of an actively managed fund.

Putting It All Together – The Active Management Value Ratio

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.”3

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

These two quotes, one from a Nobel laureate Dr. William F. Sharpe and the other from investment icon Charles D. Ellis, provide two of the core foundations for my metric, the Active Management Value Ratio (AMVR). The third core foundation for the AMVR is the Ross Miller’s regarding the AER and correlation-adjusted expense ratios. The AMVR provides investors and investment fiduciaries with a simple, but powerful method of evaluating the cost-efficiency of an actively managed relative to a comparable index fund.

Cost-efficiency is a simple enough concept to understand. Do the projected costs of a project exceed the projected benefits of the project? In the case of the AMVR, the question is whether the investment’s incremental costs exceed the investment’s incremental returns. Even better, the AMVR only requires simple, basic math skills, what John Bogle referred to as “humble arithmetic.”:

This emphasis on cost consciousness and the cost-efficiency of investments is consistent with the fiduciary principles set out in the Restatement (Third) of Trusts. The importance of costs and cost-efficiency is also a core concept in the SEC’s new Regulation Best Interest (Reg BI). In discussing Reg BI’s provisions regarding costs as a factor in recommending investments, former SEC Chairman Jay Clayton stated that

A rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes utility.5

[A]n efficient investment strategy may depend on the investor’s utility from consumption, including…(4) the cost to the investor of implementing the strategy.6

One comment was particularly interesting regarding its applicability to the concept of InvestSense.

W]hen a broker-dealer recommends a more expensive security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that the higher cost is justified (and thus nevertheless in the retail customer’s best interest) based on other factors….7

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:

  1. Does the actively managed fund provide a positive incremental return relative to a comparable index fund?
  2. 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. As far as the actual formula for the AMVR,

AMVRTM = Incremental Correlation-Adjusted Costs/Incremental Risk-Adjusted Returns

To illustrate the value and power of the AMVR in assessing cost-efficiency, let’s look at two well-known actively managed funds, American Funds’ Growth Fund of America retail shares (AGTHX) and Fidelity Contrafund retirement K shares (FCNKX

AGTHX is an actively managed fund that is classified as a Large Cap Growth fund. Like most actively managed mutual funds AGTHX charges investors a front-end load/commission. The front-end load is assessed at the time of each initial purchase, effectively reducing the investor’s actual purchase.

The chart below shows the results of an AMVR forensic analysis of the 3-year compound return of AGTHX, using the Vanguard Large Cap Growth Index fund (VIGRX) as the benchmark. Two points to note are (1) the fact that AGTHX fails to provide a positive incremental return, indicating that it is not cost-efficient relative to VIGRX, and (2) the impact of the front-end in reducing AGTHX’s 3-year annualized compound return.

The final point to note is the dramatic increase in AGTHX’s expense ratio (0.65) when the fund’s R-squared/correlation of returns number, in this case 98, is factored into the equation (5.44). The combination of high incremental costs and a high R-squared number basically ensures that a mutual fund will not be considered cost-efficient.

The chart below shows the results of an AMVR forensic analysis of the 3-year compound return of FCNKX, using the Vanguard Large Cap Growth Index fund retirement shares (VIGAX) as the benchmark. Once again, FCNKX fails to provide a positive incremental return, indicating that it is not cost-efficient relative to VIGAX, and (2) the dramatic increase in FCNKX’s expense ratio, from, 0.77 to 6.40, when the fund’s R-squared/correlation of returns number, 98, is factored into the equation.

With SCOTUS scheduled to hear a key ERISA case during the Court’s upcoming term, Hughes v. Northwestern University, which focuses on issues of cost and burden of proof regarding fiduciary prudence, 401(k) and 403(b) plan sponsors should carefully consider the chart above.

Going Forward

Facts do not cease to exist because they are ignored – Aldous Huxley

As noted earlier, financial advisers, plan sponsors, and the financial services industry in general like to talk about returns, but not about cost-efficiency and correlation of returns. The evidence presented in this post demonstrates why this is so.

However, the plaintiff’s bar is going to continue to press plan sponsors, plan advisers, and financial adviser on these issues since, realistically, these parties essentially have no valid defense to challenges based on cost-inefficiency issues, especially when confronted with simple and straightforward AMVR analyses.

As I tell plan sponsors and investment fiduciaries, the best defense is to be proactive in analyzing, selecting, and monitoring the investment options within your plan or investment account portfolios. With the increase in reliance on pre-packaged model portfolios by plan sponsors, plan advisers and other investment fiduciaries, that advice becomes even more valuable.

I always give my consulting clients the following advice based on the Oracle of Omaha’s well-known adage:

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. (Restatement (Third) of Trusts, Section 90, cmt. h(2)

Rule No. 2 – Calculate such additional cost and risks based upon a fund’s incremental risk-adjusted returns and incremental correlation-adjusted costs. (Ellis, Sharpe, and Miller)

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. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What they Pay For?:The Legal Consequences of Closet Index Funds
2. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
3. William F. Sharpe, “The Arithmetic of Active Investing,” available online at
4. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,” available online at
5. “Regulation Best Interest: The Broker-Dealer Standard of Conduct,” Release No. 34-86031; File No. S7-07-18,, 378.
6. Ibid., 378.
7. Ibid., 279.

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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