“The Lie of the Pie”: Mutual Fund Marketing “Trickeration”

by James W. Watkins, III

The financial services industry likes to use charts…a lot of charts. Attorneys do not like charts. Charts can be confusing and misleading, sometimes deliberately so. One judge told me that after I had argued the connection between charts and “weaseleze,” in a trial, he always grinned when an attorney tried to introduce a chart.

I tend to use the terms “weasel words” and “weaseleze” a lot. The terms come from Scott Adams’ book, “Dilbert and the Way of the Weasel.” Adams defines weaseleze as

Words that make perfect sense when individually, but when artfully arranged, they become misleading or impenetrable. Weaseleze is often used in advertising, legal work, employee performance reviews, and dating.1

One of the services I provide is fiduciary oversight services. Part of those services includes a forensic fiduciary audit. I tend to see a lot of weaseleze during such audits, often in connection with charts and diagrams. Lee Munson, author of “Rigged Money,” best described the use of weaseleze in connection with charts and diagrams with his phrase “the lie of the pie,”2

During a recent fiduciary audit of a 401(k) plan, the chairman of the investment committee politely questioned my findings, stating that they had followed the recommendations of their plan adviser.

I asked to see the documentation that the plan adviser had provided to the plan. I immediately recognized an ad that the adviser had provided in support of his recommendations. The ad is one used by a major mutual fund company claiming that their funds have beaten S&P 500 Index funds over an extended period of time.

I reminded the investment committee that they have a fiduciary duty to conduct their own objective investigation and evaluation of the funds chosen for their plan. Then I explained why mutual fund companies choose ads comparing their funds to market indices, rather than comparable index funds, knowing that they are arguably misleading.

First, the S&P 500 Index is technically classified as a large cap blend index. Prior to the Hughes v. Northwestern University (Northwestern) decision, the 401(k) industry, the investment industry, and even some courts objected to any comparison between actively managed funds and index funds, claiming that such comparisons were improperly comparing “apples and oranges.”

The Northwestern finally discredited such arguments. However, the use of the S&P 500 Index, or any other market index, to benchmark funds that are inconsistent with a fund’s classification is obviously comparing “apples and oranges.” This often results in misleading comparisons and potential liability exposure for plan sponsors and other investment fiduciaries.

Second, I have seen ads where the mutual fund company’s ads compare their funds to the S&P 500 Index’s returns without including the reinvestment of the Index’s dividends. Historically, over 40 percent of the Index’s returns can be attributed to the reinvestment of its dividends.

Excluding dividends in performance illustrations obviously creates misleading comparisons.

  • Over the ten-year period 2012-2021, the total return of the S&P 500 Index without the reinvestment of dividends was 251.67 percent (13.40 percent annualized) versus 325.33 percent with reinvestment of dividends (15.57 percent annualized).
  • Over the twenty-year period 2002-2021, the total return of the S&P 500 Index without the reinvestment of dividends was 301.13 percent (7.193 percent annualized) versus 488.87 percent with reinvestment of dividends (9.27 percent)

One mutual fund company is known for consistently engaging in this practice. Fortunately, their charts immediately raise red flags for attorneys and fiduciaries to investigate.

Finally, the decision to benchmark against market indices rather than comparable market indices suggests that the fund company is trying to prevent plan sponsors and other investment fiduciaries from performing a cost-efficiency evaluation of their funds.

Section 90 of the Restatement sets out several relevant cost-efficiency standards in determining whether a fiduciary has fulfilled its fiduciary duty of prudence, including

  • A fiduciary has a duty to be cost-conscious.3
  • In selecting investments, a fiduciary has a duty to seek either the highest level of a return for a given level of cost and risk or, inversely, the lowest level of cost and risk for a given level of return.4
  • Due to the impact of costs on returns, fiduciaries must carefully compare funds’ costs, especially between similar products.5
  • Due to the higher costs and risks typically associated with actively managed mutual funds, a fiduciary’s selection of such funds is imprudent unless it can be shown that the fund is cost-efficient.6

The fact that mutual fund companies and plan advisers would attempt to avoid cost-efficiency comparisons is not surprising. Studies have consistently concluded that the overwhelming majority of actively managed mutual funds 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

What is troubling from a legal standpoint is that a plan adviser would knowingly try to expose their client, the plan, to unnecessary fiduciary liability exposure. While they typically feign surprise when they are confronted with this evidence, they known exactly what they are doing.

More often than not, their advisory contract with the plan also includes a fiduciary disclaimer clause. Fortunately for plans, the Supreme Court has ruled that such clauses do not prevent plans from suing plan advisers.

The Active Management Value Ratio™3.0
For all the foregoing reasons, I advise my fiduciary compliance clients to simply ignore any and all mutual fund ads and perform their own fiduciary compliance analyses using the Active Management Value Ratio (AMVR).

Based upon the Restatement and the studies of investment icons such as Nobel laureate Dr. William F. Sharpe and Charles D. Ellis, I created a simple metric, the Active Management Value Ratio™ (AMVR), that allows investors, investment fiduciaries and attorneys to quickly determine the cost-efficiency of an actively managed mutual fund.

In analyzing an investment option, Nobel laureate William F. Sharpe has noted that

[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.11

Building on Sharpe’s theory, investment icon Charles D. Ellis has provided further advice on the process used in evaluating the cost-efficiency of an actively managed mutual fund.

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!12

The AMVR metric provides extremely useful information regarding the cost-efficiency of an actively managed mutual fund using just a fund’s nominal, or publicly reported, costs and returns. However, an investor’s analysis should not end there if they want a truly accurate cost-efficiency analysis of an actively managed mutual fund.

There is a direct, negative relationship between a fund’s r-squared correlation number, a fund’s incremental costs, and the fund’s cost-efficiency. Morningstar states that “r-squared reflects the percentage of a fund’s movements that are explained by movements in its benchmark index, [rather than any contribution by the fund’s management team.]”13

Professor Ross Miller did a study on the impact of closet indexing, focusing primarily on the relationship between an actively managed mutual fund’s R-squared number, “closet index” status, and the resulting overall financial impact of the two. “Closet index” funds are actively managed funds whose returns are essentially the same as a comparable index fund, but who charge much higher fees than the index fund. The higher an actively managed fund’s r-squared number, the greater the likelihood that the actively managed fund can be classified as a closet index fund.

An r-squared rating of 98 would indicate that 98 percent of an actively managed mutual fund’s returns could be attributed to the performance of a comparable index fund rather than the active fund’s management team.

In fairness, Professor Miller has noted that there is not a one-to-one correlation between an actively managed fund’s r-squared number and the percentage of the active management provided.

There is no universally agreed upon level of r-squared that designates an actively managed mutual fund as a closet index fund. I use an R-squared correlation number of 90 as my threshold indicator for closet index status.

Miller’s findings were extremely interesting, namely that

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds 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.11

As a result of his study, Ross Miller, created the Active Expense Ratio (AER) metric. A fund’s AER number is based on a fund’s r-squared number.

Since many investors are unfamiliar with the AER metric, a frequent question I receive is why even calculate an AER-adjusted AMVR. One of the benefits of calculating an actively managed fund’s AER number is that the calculation process results in calculating the actual percentage of active management provided by the actively managed fund in question. Miller refers to this measurement as a fund’s “active weight.14

Deriving a fund’s “active weight” number provides valuable insight into the amount of active management provided by a fund purporting to provide active management, especially since such funds higher fees are based on the purported benefits of active management. However, Miller claims the primary benefit of calculating a fund’s AER number is that the AER provides investors with a quantitative analysis of the implicit cost of the fund’s active management component. The AER accomplishes this by simply dividing an actively managed fund’s incremental cost by the fund’s active weight number.

In many cases, once a fund’s r-squared correlation number is factored in, the fund’s AER is significantly higher than the fund’s stated expense, often as much as 400-500 percent higher. Investors and investment fiduciaries should remember John Bogle’s advice on investment costs, “you get what you don’t pay for,” as well as the fact that simple mathematics proves that each one percent in fees and expenses reduces an investor’s or fiduciary’s end-return by approximately seventeen percent over a twenty-year time period.

Once AMVR is calculated for an actively managed fund, the investor or fiduciary only needs to answer two simple questions:

(1) Does the actively managed mutual fund provide a positive incremental return relative to the benchmark being used?

(2) If so, does the actively managed fund’s positive incremental return exceed the fund’s incremental costs relative to the benchmark?

If the answer to either of these questions is “no,” the actively managed fund is both cost-inefficient and unsuitable/imprudent according the the Restatement’s prudence standards and should be avoided. The goal for an actively managed fund is an AMVR number greater than “0” (indicating that the fund did provide a positive incremental return), but equal or less than “1” (indicating that the fund’s incremental costs did not exceed the fund’s incremental return).

Prudent plan sponsors and other investment fiduciaries do not knowingly waste money by offering and/or investing in cost-inefficient investments. It may require a little more work, but by using the AMVR metric, alone or in combination with Miller’s AER metric, investors can better protect their financial security and investment fiduciaries can hopefully avoid unnecessary personal liability exposure.

Going Forward

Facts do not cease to exist because they are ignored.
Aldoux Huxley

As one commentator noted in 1976 after the Restatement (Second) Trusts was released made the following observation:

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.15

Over forty years later, the First Circuit echoed such sentiments in the Brotherston decision, when it offered the following advice:

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.”16

One of the rewarding things about my posts is receiving constructive feedback from readers. A member of a plan investment committee recently wrote me a very nice email, including the following questions and comment:

In your opinion, should our advisor provide [AMVR] calculations as part of their service?

[The AMVR] should be THE comparison that every investor uses to evaluate a fund.

My response as to requiring plan advisors to provide AMVR analyses on their recommendations has, and always be, yes. Why would any plan adviser refuse to provide such simple analyses unless they are not committed to putting a client’s best interests first?

However, insist that they follow the AMVR format used by InvestSense, including risk-adjusted returns and correlation-adjusted costs, using the Active Expense Ratio. In most cases they will provide the calculations based on nominal returns and costs, but they refuse to provide the adjusted data.

As for the AMVR being THE leading metric for complying with one’s fiduciary prudence duty, let’s just say I’m obviously biased. For what it is worth, more fiduciaries and attorneys are reportedly using the metric.

Copyright InvestSense, LLC 2022. All rights reserved.

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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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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