THE ACTIVE MANANAGEMENT VALUE RATIO™:QUANTIFYING FIDUCIARY PRUDENCE

James W. Watkins, III, J.D., CFP®, AWMA®InvestSense, LLC

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Incremental Cost/Return Analysis

[R]ational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index. – Charles D. Ellis

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Incremental cost/Return Analysis

When you do this, you’ll quickly see that the incremental fees for active management are really, really high – on average, over 100 percent of incremental returns. – Charles D. Ellis

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Expense Ratio and Trading Costs

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover. – Burton Malkiel

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The Restatement on Fiduciary DutiesA fiduciary’s duties are basically derived from the common law of trusts. Therefore, the courts often turn to the Restatement of Trust as a resource in deciding cases involving fiduciary questions of law.

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Cost EfficiencyAccording to the Restatement

Implicit in a [fiduciary’s] duties is a duty to be cost-conscious.

Because the differences in the totality of costs [of funds] can be significant, it is important for [fiduciaries] to make careful overall cost comparisons, particularly among similar products of a specific type being considered for [an investment] portfolio.

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Cost EfficiencyIf the extra costs and risks of an investment program are substantial, those added costs must be justified by realistically evaluated return expectations….[Can] the gains from the course of action in question be reasonably expected to compensate for its additional costs and risks?

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The Active Management Value Ratio™

AMVR™ Analysis

FeesTotal Fees

Annual Return

Active Fund 10%

Expense Ratio 1.00

TO/Trading Cost 50% 0.60

Total Active Cost 1.60

Benchmark 9%

Expense Ratio 0.16

TO/Trading Cost 3% 0.04

Total Benchmark Cost 0.20

IC/IR 1.40 1%

% Fees/%Return 87% 10%

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Interpreting the AMVRAn active fund is not prudent/cost-efficient if

(1) it fails to provide a positive incremental return in relation to the benchmark; or(2) it provides a positive return, but its incremental costs are greater than its incremental return.

Either case insures that an investor would lose money on their investment.

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The Key Prudence Question TIAA-CREF identified the key prudence question in an article addressing 403(b) fees, stating that

“Plan sponsors are required to look beyond fees and determine whether the plan is receiving value for the fees paid.”

That sound advice is equally applicable to all investors and investment fiduciaries, including 401(k) and 403(b) plan sponsors, in order to insure the prudence of their investments.

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