This document introduces the Active Management Value Ratio (AMVR) as a tool for quantifying the prudence of actively managed funds. The AMVR compares the incremental fees of an active fund to its incremental returns over a benchmark. It notes that fiduciaries have a duty to consider costs, and active funds are imprudent if their higher fees cannot be justified by higher returns. The document provides an example AMVR calculation and explains that funds are imprudent if they do not provide positive incremental returns or if their incremental fees exceed returns.

1. THE ACTIVE MANANAGEMENT VALUE RATIO™:
QUANTIFYING FIDUCIARY PRUDENCE
James W. Watkins, III, J.D., CFP®, AWMA®
InvestSense, LLC
InvestSense

2. Incremental Cost/Return
Analysis
[R]ational investors should consider the
true cost of fees charged by active
managers not as a percentage of total
returns but as the incremental fee as a
percentage of the risk-adjusted
incremental returns above the market
index. – Charles D. Ellis
InvestSense

3. Incremental cost/Return
Analysis
When you do this, you’ll quickly see that
the incremental fees for active
management are really, really high – on
average, over 100 percent of incremental
returns. – Charles D. Ellis
InvestSense

4. Expense Ratio and Trading
Costs
Past performance is not helpful in
predicting future returns. The two variables
that do the best job in predicting future
performance [of mutual funds] are
expense ratios and turnover. – Burton
Malkiel
InvestSense

5. The Restatement on Fiduciary
Duties
A fiduciary’s duties are basically derived
from the common law of trusts. Therefore,
the courts often turn to the Restatement of
Trust as a resource in deciding cases
involving fiduciary questions of law.
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6. Cost Efficiency
According to the Restatement
Implicit in a [fiduciary’s] duties is a duty to be
cost-conscious.
Because the differences in the totality of costs [of
funds] can be significant, it is important for
[fiduciaries] to make careful overall cost
comparisons, particularly among similar products
of a specific type being considered for [an
investment] portfolio.
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7. Cost Efficiency
If the extra costs and risks of an
investment program are substantial, those
added costs must be justified by
realistically evaluated return
expectations….[Can] the gains from the
course of action in question be reasonably
expected to compensate for its additional
costs and risks.
InvestSense

8. The Active Management Value
Ratio™
AMVR™ Analysis
Fees
Total
Fees
Annual
Return
Active Fund 10%
Expense Ratio 1.00
TO/Trading Cost 50% 0.60
Total Active Cost 1.60
Benchmark 9%
Expense Ratio 0.16
TO/Trading Cost 3% 0.04
Total Benchmark Cost 0.20
IC/IR 1.40 1%
% Fees/%Return 87% 10%
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9. Interpreting the AMVR
An active fund is not prudent/cost-efficient if
(1) it fails to provide a positive incremental return
in relation to the benchmark; or
(2) it provides a positive return, but its
incremental costs are greater than its
incremental return.
Either case insures that an investor would lose
money on their investment.
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10. The Key Prudence Question
TIAA-CREF identified the key prudence question
in an article addressing 403(b) fees, stating that
“Plan sponsors are required to look beyond fees
and determine whether the plan is receiving value
for the fees paid.”
That sound advice is equally applicable to all
investors and investment fiduciaries, including
401(k) and 403(b) plan sponsors, in order to
insure the prudence of their investments.
InvestSense