With the pending release of the SEC's Reg BI, the issues of prudence and FINRA's fair dealing requirement are sure to receive considerable attention. The Active Management Value Ratio is a valuable metric to assist in the forensic analysis of actively managed mutual funds.

1. QUANTIFYING “PRUDENCE” & “FAIR DEALING”:
THE ACTIVE MANAGEMENT VALUE RATIO™
JAMES W. WATKINS, III, J.D., AWMA®
INVESTSENSE, LLC

2. Defining “Prudence”
The generally accepted definition of
investment prudence is acting
“with the care, skill, prudence, and
diligence under the circumstances then
prevailing that a prudent man acting in a
like capacity and familiar with such matters
would use in the conduct of an enterprise
of a like character and with like aims….”

3. Defining “Fair Dealing”
FINRA Rule 2111 SM-2111-.01 (formerly
NASD Rule 2310) states that
“Implicit in all member and associated person
relationships with customers and others is the
fundamental responsibility for fair dealing.
Sales efforts must therefore be undertaken…
with particular emphasis on the requirement
to deal fairly with the public.”

4. The Scott Epstein Decision
“As relevant here, NASD Rule IM-2310-
2(a)(2) provides that ‘sales efforts must be
judged on the basis of whether they can be
reasonably said to represent fair treatment
for the persons to whom the sales efforts are
directed . . . .’”
“Epstein abdicated his responsibility for fair
dealing when he put his own self-interest
ahead of the interests of his customer.”

5. Prudence and the AMVR
Recent ERISA court actions have argued over
the proper way to evaluate mutual funds,
including comparisons over funds’
> business platforms
> annualized returns
> expense ratios
> assets under management
> popularity

6. Prudence and the AMVR
“[t]he best way to measure a manager’s
performance is to compare his or her
return with that of a comparable passive
alternative.” – Nobel Laureate William F.
Sharpe

7. Prudence and the AMVR
“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.” – Charles
D. Ellis

8. Prudence and the AMVR
The Active Management Value Ratio™
(AMVR) ignores all the irrelevant collateral
issues and focuses on what really matters
– the cost-efficiency, or the true benefit, if
any, provided to investors.
The AMVR essentially says “I don’t care
how you did it, but whether you actually
provided a real incremental benefit to me
at all.”

9. Prudence and the AMVR
The following slides explain how attorneys and
investment fiduciaries can interpret the AMVR
calculation process and use the AMVR as a
forensic analysis/risk management tool.
The two funds shown on the slides are two of
the most popular mutual funds in terms of
invested assets, both in terms of retail shares
and retirement shares.

10. Fees
Total
Fees AER
Annual
Return
Active Fund
Expense Ratio 0.64 5.40 15.47 Nominal
TO/Trading Cost 25% 0.30 0.30 14.11 Load Adjusted
Total Active Costs 0.94 5.70 12.94 Risk Adjusted
Benchmark
Expense Ratio 0.17 0.17 15.34 Nominal
TO/Trading Cost 3% 0.10 0.10 14.06 Risk Adjusted
Total Bmark Costs 0.27 0.27
IC/IR 0.67 5.43 (1.12)
% Fees/% Return 71% 95% NA

11. AMVR Annual Returns
The AMVR examines three types of returns:
1. Nominal, or stated, returns.
2. Load-adjusted returns, showing the impact
of any front-end fees charged by a fund.
3. Risk-adjusted returns.
AMVR uses risk-adjusted returns in its
calculations. Here, the fund failed to even
provide a positive incremental return.

12. Fees
Total
Fees AER
Annual
Return
Active Fund
Expense Ratio 0.64 5.40 15.47 Nominal
TO/Trading Cost 25% 0.30 0.30 14.11 Load Adjusted
Total Active Costs 0.94 5.70 12.94 Risk Adjusted
Benchmark
Expense Ratio 0.17 0.17 15.34 Nominal
TO/Trading Cost 3% 0.10 0.10 14.06 Risk Adjusted
Total Bmark Costs 0.27 0.27
IC/IR 0.67 5.43 (1.12)
% Fees/% Return 71% 95% NA

13. AMVR Nominal Fees
The AMVR combines a fund’s annual
expense ratio and the fund’s turnover/
trading costs in calculating a fund’s total
costs.
While trading costs are factored into a
fund’s stated return as part of a fund’s
operating costs, they are not broken out
separately, preventing investors from
comparing such costs for each fund.

14. AMVR Nominal Fees
Since funds are not legally required to provide
investors with the fund’s actual trading costs,
the AMVR uses a metric created by John
Bogle as a proxy for such costs.
Trading costs = (fund turnover x 2) * 0.60

15. AMVR Nominal Fees
Bogle’s metric allows investors to compare
the efficiency of the management of two
funds. If two funds have comparable
annualized returns, but the trading costs of
one of the funds is twice that of the other
fund, that is information that most investors
would find valuable. As Mr. Bogle often
said, “costs matter.”

16. Fees
Total
Fees AER
Annual
Return
Active Fund
Expense Ratio 0.64 5.40 15.47 Nominal
TO/Trading Cost 25% 0.30 0.30 14.11 Load Adjusted
Total Active Costs 0.94 5.70 12.94 Risk Adjusted
Benchmark
Expense Ratio 0.17 0.17 15.34 Nominal
TO/Trading Cost 3% 0.10 0.10 14.06 Risk Adjusted
Total Bmark Costs 0.27 0.27
IC/IR 0.67 5.43 (1.12)
% Fees/% Return 71% 95% NA

17. AMVR AER-Adjusted Fees
The AMVR also calculates a fund’s fees using
Ross Miller’s Active Expense Ratio (AER)
metric. The AER reveals the implicit cost of a
fund’s active management component and
helps investors avoid potential “closet” index
funds, funds that closely track comparable
indices and/or index funds, but charge
substantially higher fees than comparable
index funds.

18. AMVR Fee Calculations
A common question about AMVR calculations
is why trading costs are included in fee
calculations. The AMVR can also be
calculated solely on the basis of the funds’
annual expenses ratios, both nominal and
AER-adjusted. When InvestSense prepares
reports for clients, we provide data using both
approaches and let the client decide how to
utilize the data.

19. Fees
Total
Fees AER
Annual
Return
Active Fund
Expense Ratio 0.74 5.48 15.47 Nominal
TO/Trading Cost 29% 0.35 0.35 14.81 Risk Adjusted
Total Active Costs 1.09 5.83
Benchmark
Expense Ratio 0.17 0.17 15.34 Nominal
TO/Trading Cost 3% 0.10 0.10 14.06 Risk Adjusted
Total Bmark Costs 0.27 0.27
IC/IR 0.80 5.56 0.75
% Fees/% Return 73% 95% 5.0%

20. Calculating the AMVR
InvestSense calculates a fund’s AMVR
score by dividing a fund’s AER-adjusted
incremental cost by the fund’s risk-
adjusted incremental return.
The goal is an AMVR score between one
(1) and zero (0). This indicates that a fund
is cost-efficient, that the fund’s costs were
less than the fund’s returns

21. Calculating the AMVR
The AMVR requires an investor to ask two
preliminary questions:
1. Did the fund provide a positive
incremental return?
2. If so, did the fund’s incremental return
exceed its incremental costs?

22. Calculating the AMVR
If the answer to either question is “no,” the fund
is not cost-efficient and no AMVR is needed
The AMVR formula: AMVR = AER IC/RAR IR
Using the second fund:
Nominal AMVR = .80/.75 = 1.07
AER-adjusted AMVR = 5.56/.75 = 7.41

23. Fees
Total
Fees AER
Annual
Return
Active Fund
Expense Ratio 0.74 5.48 15.47 Nominal
TO/Trading Cost 29% 0.35 0.35 14.81 Risk Adjusted
Total Active Costs 1.09 5.83
Benchmark
Expense Ratio 0.17 0.17 15.34 Nominal
TO/Trading Cost 3% 0.10 0.10 14.06 Risk Adjusted
Total Bmark Costs 0.27 0.27
IC/IR 0.80 5.56 0.75
% Fees/% Return 73% 95% 5.0%

24. The Cost-Efficiency Quotient
The Cost-Efficiency Quotient (CEQ) is a
proprietary metric of InvestSense that
measures a fund’s cost-efficiency. The
CEQ is calculated by dividing a fund’s fee
percentage by its return percentage.
Using the second fund:
Nominal CEQ would be 14.6.
AER-adjusted CEQ would be 19.0.

25. The Fiduciary Prudence Score
InvestSense also uses a proprietary metric,
the Fiduciary Prudence Score (PFS), which
measures the performance of an actively
managed fund based on the fund’s efficiency,
both in terms of cost and risk management,
as well as the fund’s overall consistency of
performance.

26. Going Forward
In analyzing the decisions of investment
fiduciaries, there are two key questions:
1. Were the fiduciary’s decisions prudent?
2. If the fiduciary is FINRA registered, did
the fiduciary put his/her self interests
ahead of the customer/plan participants,
thereby violating their duty of fair dealing?

27. Going Forward
So, when using the AMVR for forensic
analysis, the two key questions become
1. Are cost-inefficient investment options
prudent ?
2. Do recommendations to buy cost-
inefficient investments violate a
stockbroker’s duty of fair dealing with
customers/plan participants?

28. Going Forward
The importance of prudence will gain even
more importance under the SEC’s proposed
Reg BI. Reg BI states that in order to meet
Reg BI’s “best interest” requirement, anyone
offering investment recommendations to the
public must exercise “reasonable diligence,
care, skill and prudence.” (emphasis added)

29. Going Forward
The Restatement (Third) of Trusts will
undoubtedly be referenced in connection
with Reg BI’s prudence requirement.
Comment h(2) of Section 90 of the
Restatement essentially states that it
would be imprudent for anyone to
recommend an actively managed mutual
fund that is not cost-efficient.

30. Going Forward
The Restatement’s position is even more
interesting, given the various studies that
have concluded that the overwhelming
majority of actively managed mutual funds
are not cost-efficient. As one study noted:
“[T]here is strong evidence that the vast
majority of active managers are unable to
produce excess returns that cover their
costs.”