The Active Management Value Ratio (AMVR) is a variation of the popular cost-benefit analysis metric commonly uased in the business world the evaluate projects. The AMVR uses the incremental costs and incremental returns between an actively managed mutual fund and an index fund to evaluate the cost-efficiency, or cost-inefficiency, of an actively managed fund relative to a comparable index fund.
The AMVR allows plan sponsors, trustees, and other investment fiduciaries to avoid unwanted fiduciary liability. The AMVR allows attorneys and investors to easily assess the prudence of actively managed mutual funds in terms of investment prudence.
"Active Management Value Ratio", "AMVR" and the "InvestSense" logo are trademarks of InvestSense, LLC.
The Active Management Value Ratio: The New Science of Benchmarking Investment Prudence
1. THE ACTIVE MANAGEMENT VALUE
RATIO™: THE NEW SCIENCE OF
BENCHMARKING INVESTMENT
PRUDENCE
JAMES W. WATKINS, III. J.D., CFP®, AWMA®
INVESTSENSE, LLC
InvestSense
2. The Active Management Value Ratio
The Active Management Value Ratio™ (AMVR) is a
version of the popular cost/benefit analysis metric
commonly used in the business world. The AMVR
uses the incremental costs and incremental returns
between two funds as its input data.
The AMVR allows investment fiduciaries, attorneys,
and investors to compare the cost-efficiency between
two funds. The AMVR is commonly used to compare
the cost-efficiency and prudence between an actively
managed mutual fund and a comparable passive, or
index, fund.
InvestSense
3. The AMVR
The AMVR is based on :
1. the fiduciary prudence standards established
by the Restatement (Third) of Trusts, including
Section 90, more commonly known as the
Prudent Investor Rule; and
2. the studies of investment icons such as
Charles D. Ellis, Nobel laureate Dr. William F.
Sharpe, and Burton G. Malkiel.
InvestSense
4. The Prudent Investor Rule
The AMVR is based primarily on three comments
contained in the Prudent Investor Rule:
1. A fiduciary must be cost-conscious. (cmt. a)
2. A fiduciary must look for the highest return for a
given level of cost and risk, or the lowest level
of cost and risk for a given level or return. (cmt.
f)
3. Actively managed funds that are not cost-
efficient are imprudent. (cmt. h(2))
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5. The AMVR and Sharpe
“The best way to measure a manager’s
performance is to compare his or her return
with that of a comparable passive alternative.” –
Dr. William F. Sharpe, “The Arithmetic of Active
Investing”
InvestSense
6. The AMVR and Ellis
“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 the incremental fees for
active management are really, really high – on
average, over 100% of incremental returns.” –
Charles D. Ellis, “Letter to the Grandkids -12
Essential Guidelines for Investing”
InvestSense
8. Calculating the AMVR - Costs
1. Nominal, or publicly stated, costs
2. Active Expense Ratio (AER) – Correlation-
adjusted costs
The AER helps to identify potentially imprudent
“closet index” funds and to calculate the actual
amount of active management being provided by
an actively managed fund.
InvestSense
9. Active Expense Ratio
A high R-squared number and/or a high
incremental cost number will result in a higher
AER number.
The active fund in this example had an R-
squared number of 98, indicating that 98% of the
fund’s performance was attributable more to the
benchmark than the active fund’s management
team
InvestSense
10. The AER and Miller
“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…. 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
indexes.” – Ross Miller, “Evaluating the True Cost
of Active Management by Mutual Funds”
InvestSense
11. The AMVR and “Closet Indexing”
“Closet index” funds are actively
managed funds that essentially provide
the same performance of a comparable
index fund, but charge a much higher
fee than the index fund. They are cost-
inefficient, and, therefore, imprudent
investment options.
InvestSense
12. Calculating “Closet Indexing”
To detect possible “closet indexing” or “index
hugging,” InvestSense calculates a fund’s
effective annual expense ratio based on a
fund’s Active Expense Ratio (AER) number.
The AER is based on an actively managed
fund’s R-squared number, or correlation of
return, and the incremental cost between an
active fund and a passive benchmark fund.
InvestSense
13. Calculating the AMVR - Returns
The AMVR analyzes three types of mutual fund
returns:
1. Nominal, or stated, returns;
2. Load-adjusted returns*; and
3. Risk-adjusted returns.
* Retirement shares should not impose front-end
loads, or sales charges. Therefore, AMVR
analyses on retirement shares only show
nominal and risk-adjusted returns
InvestSense
14. Interpreting the AMVR
Prior to calculating a fund’s AMVR score, the
user needs to answer two initial questions:
1. Did the actively managed fund provide a
positive incremental return?
2. If so, did the positive incremental return
exceed the fund’s incremental costs?
If the answer to either question is “no,” the active
fund is cost-inefficient and does not qualify for a
AMVR score.
InvestSense
15. Interpreting the AMVR – Cost Efficiency
The basic AMVR formula is incremental costs
divided by incremental returns. The resulting
AMVR score reflects the cost-inefficiency of the
active fund in terms of the cost-premium an
investor is being charged relative to the
comparable benchmark fund.
An AMVR score of 1.50 indicates that an investor
in the active fund is paying a cost premium of 50
percent relative to the same return available via
the index fund.
InvestSense
16. Interpreting the AMVR – Cost-Efficiency
In calculating the AMVR, InvestSense uses the
active fund’s AER correlation-adjusted costs, as it
provides a truer representation of the implicit
costs incurred by an investor.
InvestSense
17. Interpreting the AMVR – Damages
The Department of Labor and the General
Accountability Office have found that each
additional 1 percent in fees/costs reduces an
investor’s end-return by 17 percent over a 20-year
period.
By using an active fund’s incremental costs and
incremental returns, the AMVR can be used to
project future investment losses.
Negative incremental returns are treated as
opportunity costs and added to costs.
InvestSense
18. Advantages of the AMVR
Cost-efficiency provides a much better indication of
a fund’s fiduciary prudence, as cost-efficiency:
1. can eliminate the argument over what
constitutes an acceptable benchmark by using
comparable index funds that actually incur costs;
(Restatement (Third) of Trusts, Section 100)
2. can provide a truer evaluation of the inherent
value of a fund, thereby eliminating the issue of
misleading results based solely on a fund’s
returns;
3. can improve an investor’s return by identifying
and avoiding “closet index” funds.
InvestSense