WEALTH PRESERVATION USING THE ACTIVE MANAGEMENT VALUE RATIO 2.0™

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

Incremental Cost and Returns

“The real cost of any alternative [investment] is the incremental cost as a percentage of the incremental value. So rational 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 risk-adjusted incremental returns above the market index.” Charles Ellis, “Winning the Loser’s Game”

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The Active Management Value Ratio 2.0™

“The two variables that do the best job in predicting the future performance [of mutual funds] are expense ratios and turnover. High expenses and high turnover depress returns….” – Burton Malkiel “A Random Walk Down Wall Street”

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The Active Management Value Ratio 2.0™

The Active Management Value Ratio 2.0™ is a simple cost/benefit analysis based on an investment’s incremental cost and incremental return, two variables that provide a more accurate evaluation of the contribution of a fund’s active management component.

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Incremental Cost and Returns Incremental cost = Annual expense ratio of active fund

less annual expense ratio of benchmark/index fund.

Incremental return = Annual compound return of active fund less annual return of benchmark/index fund.*

*To provide a more meaningful evaluation, I recommend using five-year annualized returns to avoid misleading impact of any data skew.

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The Active Management Value Ratio 2.0™

Fund A – 5 year annualized return = 20% Fund A – Annual expense ratio = 1.00% Fund A – Turnover ratio = 50%

Benchmark – 5 year annualized return = 18% Benchmark – Annual expense ratio = 0.22% Benchmark – Turnover ratio = 6%

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Turnover RatioMutual funds are not required to disclose their actual trading costs. Yet, such costs often have a significant impact on an fund’s return, and thus cannot be ignored.

The AMVR 2.0™ uses John Bogle’s method of calculating a fund’s trading costs - [stated turnover ratio x 2] x 0.60.

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Calculating the AMVR 2.0™ -No Incremental Return

Fund ExpensesTotal Costs

5 Year Annual Return

Actively Managed Fund 18.00> Annual Expense Ratio 1.00> Trading Costs 0.60> Active Fund Total Expenses 1.60

Index Fund 20.00> Annual Expense Ratio 0.17> Trading Costs 0.04> Index Fund Total Expenses 0.21Incremental Cost/Return 1.39 0

Active Management Value Ratio 2.0™

Incremental Cost = 1.60% - 0.22% = 139 bp* Incremental Return = 20% - 18% = 200 bp*

AMVR = 139/200 = 0.70 or 70% effective annual fee for the active management component, versus 1% stated annual fee.

*One basis point (bp) equals .01%

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Calculating the AMVR 2.0™ -Incremental Cost > Incremental Return

Fund ExpensesTotal Costs

5 Year Annual Return

Actively Managed Fund 21.00> Annual Expense Ratio 1.00> Trading Costs 0.60> Active Fund Total Expenses 1.60

Index Fund 20.00> Annual Expense Ratio 0.17> Trading Costs 0.04> Index Fund Total Expenses 0.21Incremental Cost/Return 1.39 1.00

Calculating the AMVR 2.0™ -Incremental Return > Incremental Cost

Fund ExpensesTotal Costs

5 Year Annual Return

Actively Managed Fund 22.00> Annual Expense Ratio 1.00> Trading Costs 0.60> Active Fund Total Expenses 1.60

Index Fund 20.00> Annual Expense Ratio 0.17> Trading Costs 0.04> Index Fund Total Expenses 0.21Incremental Cost/Return 1.39 2.00

Interpreting the AMVR 2.0™Interpreting the AMVR 2.0 simply involves answering two questions: Does the fund provide a positive incremental return?If so, is the fund’s incremental return greater than the fund’s incremental costs?

If the answer to either question is “no,” then the fund is unsuitable, since the investment would result in a loss for an investor.

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