Each year various publications put out their lists of "top" or "best" mutual funds. I always enjoy going through such lists and performing a forensic analysis of the funds on such lists to get a better analysis of each fund.
One of my favorite lists is the list published by "Pensions & Investments," one of the leading publications in the ERISA arena. The list published by "Pensions & Investments" is not based on performance, but rather the fund's assets under management, the most popular funds used in 401(k) plans.
I decided to do a quick analysis on the top ten funds listed on the most recent list. Since four of the funds offered various levels of fees within their fund, I actually compared fourteen funds, using both the high and low fee for the four funds in question. The funds analyzed were:
Fidelity Contrafund (PCNKX) American Funds Growth Fund of America (RGAAX and RGAGX) Fidelity Growth Company (FGCKX) Dodge and Cox Stock (DODGX) Fidelity Low Price (FLPKX) American Funds Fundamental Investors Inc ((RFNAX and RFNGX) American Funds Washington Mutual Investors Fund (RWMAX and RWMGX) Price Growth Stock Fund (RRGSX) Price Equity Income Fund (RRFDX) MFS Value (MEIGX and MEIKX)
The first test was relatively simple – performance relevant to its benchmark the most recent five year period. If a fund did not outperform its relevant benchmark, in other words did not provide an investor with added return, investing in such a fund would not be prudent. After all, why would an investor be willing to pay money for nothing.
Somewhat surprisingly, of the fourteen funds analyzed, only three funds passed this screen – Fidelity Contrafund, Fidelity Growth Company and Price Growth Stock Fund. The second test was for prudence in terms of cost efficiency, using a fund's R-squared rating and subsequent effective annual expense ratio. Over the past ten to fifteen years, we have seen an increase in so-called closet index funds, or "index huggers, as fund managers attempt to reduce the risk of losing investors due to significant differences in returns of their funds and less expensive index funds.
R-squared measures the degree to which a fund track its relevant index. Funds with a high R-squared rating are often referred to a "closet index" funds since their returns generally track the returns of similar index funds, albeit at higher expense levels. While there is no generally accepted R-squared score to signify "closet index" fund status, I use 90. Some use a higher score, some a lower score, but to me a fund that tracks its index by 90 percent is not worth the higher costs.
Of the fourteen funds analyzed, only three had an R-squared rating below 90 – Fidelity Contrafund, Fidelity Growth Company and Price Growth Stock Fund. Interestingly, even their R-squared rating were relatively high – Contrafund (89.73), Price Growth Stock (86.77) and Fidelity Growth Company (84.71).
Funds with a high R-squared rating often have effective annual expense ratios significantly higher than their publicly stated annual expense ratios. This is simply due to the facts that a higher R-squared ratio indicates a lower active management component of the fund. When a fund's additional costs for active management is adjusted for the lower active management component of the fund, the effective annual expense ratio for a fund can increase significantly.
For example, American Funds offer six levels of its R shares. The most recent prospectus indicates that for the three funds analyzed, R-1 shares charge an annual expense fee of approximately 1.40 percent, including an annual 12b-1 charge of 1 percent, while their R-6 shares have an annual expense ratio of 0.22 percent and no 12b-1 fee. Once R-squared ratings are factored in, the annual expense ratio picture changes significantly:
-American Funds Growth Fund of America R-1 – stated annual expense ratio 1.43 percent, effective annual expense ratio 4.30 percent. -American Funds Growth Fund of America R-6 – stated annual expense ratio 0.22 percent, effective annual expense ratio 1.29 percent.
-American Funds Fundamental Investors Inc. R-1 – stated annual expense ratio 1.41 percent, effective annual expense ratio 6.40 percent. -American Funds Fundamental Investors Inc. R-6 – stated annual expense ratio 0.22 percent, effective annual expense ratio 1.76 percent.
-American Funds Washington Mutual Investors R-1 – stated annual expense ratio 1.39 percent, effective annual expense ratio 5.36 percent. -American Funds Washington Mutual Investors R-6 – stated annual expense ratio 0.22 percent, effective annual expense ratio 5.36 percent.
-MFS Value R-1 – stated annual expense ratio 1.63 percent, effective annual expense ratio 8.52 percent. -MFS Value R-6 – stated annual expense ratio 0.22 percent, effective annual expense ratio 4.00 percent.
The effective annual expense ratios were calculated using InvestSense's proprietary metric, the Active Management Fee Factor™. Ross Miller's Active Expense Ratio also uses a fund's R-squared rating and be used to calculate a fund's effective annual expense ratio. Based on my experience, both metrics generally provide similar results.
When I perform a forensic analysis for a client, we finish the analysis with two proprietary metrics, The Active Management Value Ratio™ (AMVR) and the Fiduciary Prudence Score™. Both metrics require that a fund outperform their appropriate benchmark, that they provide an incremental return for an investor. Since only three of the fourteen funds provided an incremental return, we would only do an AMVR and Fiduciary Prudence Score for those funds.
Again, the annual list published by "Pensions & Investments" is not based on qualitative measures. The list simply identifies the top mutual funds used by 401(k) plans based on a fund's assets under management.
The purpose of this white paper has been to point out that "top" and "best" lists of investments should not be blindly relied on by investment fiduciaries and investors. As the paper shows, fiduciaries and investors can perform a meaningful analysis by simply investing a little time in looking up the relevant numbers through free online sources such as Morningstar and Yahoo. The investment in time may prevent unnecessary financial losses and improve one's overall financial security.