This document discusses fiduciary duties, FINRA suitability rules, and a proposed metric called the Active Management Value Ratio (AMVR) for evaluating actively managed mutual funds. The AMVR compares an actively managed fund's excess costs and returns to those of a passive index fund to determine if the active fund provides any incremental benefit. Funds that do not may violate suitability requirements and fiduciary duties to act in clients' best interests. The AMVR is presented as a tool to help advisers avoid liability by quantifying suitability and clients' best interests.

1. James W. Watkins, III, J.D. CFP®, AWMA®
InvestSense, LLC
Managing Member/CEO

2. Fiduciary Status
Duty of Loyalty
[A] fiduciary shall discharge his duties
with respect to a plan solely in the
interest of the participants and
beneficiaries and for the exclusive
purpose of:
(i) providing benefits to participants and
their beneficiaries; and
(ii) defraying reasonable expenses of
administering the plan…
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3. Fiduciary Status
Duty of Prudence
[A] fiduciary shall discharge his duties
with respect to a plan 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
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4. Suitability
FINRA’s New Suitability Rule 2111
essentially codifies and clarifies case law
interpretations of prior Rule 2111.
Three suitability obligations:
(1) Reasonable-basis suitability
(2) Customer-specific suitability
(3) Quantitative suitability
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5. Reasonable-Basis Suitability
“A broker must perform reasonable
diligence to understand the nature of the
recommended security or investment
strategy involving a security or securities,
as well as the potential risks and rewards,
and determine whether the
recommendation is suitable for at least
some investors based on that
understanding.”
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6. Customer-Specific Suitability
“A broker must have a reasonable basis to
believe that a recommendation of a
security or investment strategy involving a
security or securities is suitable for the
particular customer based on the
customer’s investment profile.”
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7. Institutional Customer Suitability
(1) For an institutional customer, a
member or associated person must have a
reasonable basis to believe that the
institution is capable of evaluating
investment risks independently, both in
general and with regard to particular
transactions and investment strategies
involving a security or securities, and
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8. Institutional Customer Suitability
(2) the institution affirmatively indicates
that it is exercising independent judgment
in evaluating the member’s or associated
person’s recommendations.
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9. Suitability Factors
FINRA’s new suitability Rule 2111 adds
some new factors that brokers must
consider in determining suitability:
customer’s age, investment experience,
time horizon, liquidity needs and risk
tolerance. The new factors are in addition
to the old factors, for example other
investments, financial status and needs,
tax status and investment objectives.
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10. Duty of Fair Dealing
Implicit in all relationships with customers
and others is the fundamental
responsibility for fair dealing with the
public…. The suitability rule is fundamental
to fair dealing and is intended to promote
ethical sales practices and high standards
of professional conduct.
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11. The Long Arm of FINRA Rule 2010
“A member, in the conduct of his business,
shall observe high standards of
commercial honor and just and equitable
principles of trade.”
No definition of terms. 2010 is left
deliberately vague to allow regulators to
address conduct on an “as needed” basis.
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12. “Suitability”…or “Best Interests”
FINRA: The suitability rule requires that a
broker’s recommendations must be
consistent with his customers’ best
interests and prohibits a broker from
placing his or her interests ahead of the
customer’s interests.
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13. “Suitability”… or “Best Interests”
Securities and Exchange Commission:
“In interpreting the suitability rule, we have
stated that a [broker’s] ‘recommendations
must be consistent with his customer’s
best interests.’”
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14. The Active Management Value Ratio™
The Active Management Value Ratio™
(AMVR) is a simple cost/benefit analysis that
uses an actively managed mutual fund’s
incremental (excess) costs, both in terms of
annual fees and transaction costs, and
incremental (excess) return as input data.
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15. The Active Management Value Ratio™
Index funds are a “commodity product”
providing the market rate of return with no
more than market risk.
“When a reliable commodity product is
available, the real cost of any alternative is
the incremental cost as a percentage of
the incremental value.” – Charles Ellis,
“Winning the Loser’s Game”
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16. The Active Management Value Ratio™
“The two variables that do the best job in
predicting future [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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17. Calculating the AMVR 2.0
Actively Managed Fund
5 Year Annual Return - 18.61%
Annual Expense Fee - 1.00%
Turnover Ratio - 50%
Index Fund
5 Year Annual Return - 20.00%
Annual Expense Fee - 0.17%
Turnover Ratio - 3%
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18. Calculating the AMVR
Fund Expenses
Total
Costs
5 Year
Annual Return
Actively Managed Fund 18.61
> Annual Expense Ratio 1.00
> Trading Costs 0.60
> Active Fund Total Expenses 1.60
Index Fund 22.00
> Annual Expense Ratio 0.17
> Trading Costs 0.04
> Index Fund Total Expenses 0.21
Incremental Cost/Return 1.39 0
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19. Interpreting the AMVR 2.0
1.Does the fund provide a positive incremental
return?
2. If so, is the incremental return greater than
the incremental costs of the fund?
If the answer to either question is “no,” then
the fund is neither suitable (reasonable-basis
suitability) nor in an investor’s best interests.
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20. Liability Issues Going Forward
Brokers and other financial advisers try to
justify the higher fees generally charged
by actively managed funds by arguing that
such funds provide higher returns for an
investor.
But studies such as SPIVA and various
academic articles consistently show that
that argument has no merit.
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21. Liability Issues Going Forward
According to Standard & Poor’s most
recent SPIVA (S&P Index Versus Active)
report, for the 5 and 10 year periods
ending 12/31/2014, 80.82% and 76.54% of
all actively managed mutual funds,
respectively, underperformed comparable
index funds.
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22. Liability Issues Going Forward
Actively managed mutual funds that have a
history of failing to provide a positive incremental
return for investors raise questions under
(a) a fiduciary’s duty to act prudently and in a
client’s best interests;
(b) FINRA’s reasonable-basis suitability
requirement (Rule 2111);
(c) FINRA’s Rules of Fair Practice, including the
duty to deal fairly with the public.
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23. Liability Issues Going Forward
The Active Management Value Ratio 2.0™
helps identify actively managed mutual
funds that fail to provide an investor with
any incremental benefit, whether this is
due to the fund’s underperformance or the
fact that the fund’s incremental costs
exceed the fund’s incremental return.
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24. Liability Issues Going Forward
The Active Management Value Ratio 2.0™
allows investors, investment fiduciaries
and other financial advisers to effectively
quantify both “suitability” and “best
interests” to ensure that the public is
treated fairly and to help investment
fiduciaries and financial adviser avoid
unwanted and unnecessary liability
exposure.
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