“Facts do not cease to exist because they are ignored” – Aldoux Huxley
I have recently learned that some people are using my metric, the Active Management Value Ratio™ (AMVR), to misrepresent the value of actively managed mutual funds. The AMVR was simply intended to show that a mutual fund’s stated annual expense ratio and its effective annual expense ratio can be significantly different when analyzed on the basis of incremental costs and incremental returns.
The AMVR was never intended to be used to reflect an actively managed mutual fund’s return to an investor, as the AMVR only looked at a fund’s annual expense ratio. Actively managed obviously have additional costs, particularly trading costs and any front-end loads (e.g. commissions) that most actively managed mutual funds charge.
In the example that I typically use with explaining the AMVR, the fund has an incremental cost of 78 basis points (a basis point equals .01 percent, 100 basis points equal 1.00 percent) and an incremental return of 200 basis points. By conveniently forgetting to factor in the costs of trading expenses, some professionals are suggesting that the balance of 122 basis points would represent a substantial profit for an investor.
Such deliberate misrepresentations are deplorable and yet another example of why the Securities and Exchange Commission needs to adopt a universal fiduciary standard to require that financial advisers always act in an investor’s best interests. Depending on the type of actively managed mutual fund being considered, trading costs can exceed the fund’s annual expense ratio. Consequently, not factoring in such costs can result in significantly misleading recommendations.
In order to reduce the possibility of such misleading representations, I have revised the AMVR to specifically include a fund’s trading costs. Unfortunately, and inexplicably, the Securities and Exchange Commission does not require a mutual fund to provide the public with its actual trading costs, only its turnover ratio.
A 2013 study by Kadlec, Evans, and Edelen found that the average round-trip trading costs for mutual funds was 1.44 percent. The study, reported in the paper, “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” also reported that round-trip trading costs were less for larger cap stocks (0.90 percent) than for small cap stocks (2.92 percent).
If we re-examine the scenario that I use in my typical AMVR example and use the average round-trip trading cost of 1.44 percent from the Kadlec, Evans and Edelen white paper, along with the average annual expense ratio of actively managed mutual funds, 1.12 percent, we see that the combined costs are greater than the 200 basis point example used in my example, preventing the misrepresentation of any alleged superior performance of the mutual fund in the example.
This finding is consistent with numerous studies concluding that most actively managed mutual funds underperform passive managed, or index, mutual funds. Over the past ten to fifteen years, we have seen an increase in so-called “closet index,” or “index hugger” mutual funds, funds whose performance can be attributed primarily to the performance of a comparable index rather than the contributions of the fund’s manager. By adopting such a management style, fund managers can reduce the possibility of significant divergences from their applicable index and, thus, a potential loss if investors.
Therefore, the new worksheet of the Active Management Value Ratio™ 2.0 is as follows
Annual Fees Annual Return
Actively Managed Fund
Annual Expense Ratio
Annual Trading Costs
Active Fund Total
Annual Expense Ratio
Annual Trading Costs
Benchmark/Index Fund Total
Incremental % Comparison
Using the typical scenario from my earlier AMVR articles, but including the average trading costs from the Kadlec, Evans and Edelen paper and the average annual expense ratio, the new worksheet would appear as follows:
Annual Fees Annual Return
Actively Managed Fund 20.00
Annual Expense Ratio 1.12%
Annual Trading Costs 1.44%
Active Fund Total 2.56%
Benchmark/Index Fund 18.00
Annual Expense Ratio 0.22%
Annual Trading Costs 0.04%
Benchmark/Index Fund Total 0.26%
Incremental Cost/Return 2.30% 2.00
Incremental % Comparison 90% 10%
Each fund will naturally produce different results depending on its unique attributes and performance. If history holds true, some actively managed funds will provide positive incremental returns, while most actively managed funds will fail to do so. Investors considering actively managed funds should also consider the impact of any front-end loads charged by an actively managed mutual fund.
Currently, most front-end loads are in the range of 4-4.5 percent. These charges are deducted directly from an investor’s initial contribution, putting an investor immediately at a disadvantage from passively managed/index funds, which generally do not charge load fees. For example, an investor investing $100,000 in an actively managed fund charging a 4 percent load fee would start with only $96,000, while the investor in a passive/index fund would start out with their full $100,000 investment.
One last thought about the new Actively Management Value Ratio™. As I mentioned earlier, mutual funds are not required to provide their actual trading costs. In using AMVR 2.0, investors and professionals have several options. One is to use the average trading cost of 1.44 percent reported in the Kadlec, Evans and Edelen study. The problem I have with using that approach is that the paper itself noted variance in such trading costs.
Another approach would be use a flat rate of 1 percent for costs. This would be closer to the round-trip trading costs reported for large cap stocks, so arguably fairer for large cap mutual funds and consistent with the findings in the Kadlec, Evans and Edelen study.
A final, and more flexible, approach would be to use John Bogle’s suggested metric for calculating a fund’s trading costs. Bogle uses a constant trading cost of 60 percent in his metric. Most people would consider this to extremely conservative, especially in light of the findings in the Kadlec, Evans and Edelen study.
Bogle’s metric is simple: (2 times a fund’s turnover) times 0.60. So a fund with a turnover ratio of 100 percent would have implied trading costs of 1.20 percent. I favor this approach since it is based on a fund’s actual turnover and thus is more fund specific. The only difference in my calculations is that I use 90 percent for trading costs instead of the 60 percent cost Bogle uses, as I rely on the more recent findings of the Kadlec, Evans and Edelen study.
Other studies of mutual fund costs have noted costs such as opportunity costs and impact costs. Investors and investment professionals can add those costs to their AMVR™ analyses if they choose to do so. I find that annual expense ratios and trading costs are the two largest annual expenses, so they usually suffice to point out the cost issues associated with actively managed funds. The AMVR™ 2.0 is just another attempt to further my blog’s motto – “the power of the informed investor.