In my previous post, I discussed the applicable standard of care that financial advisors owe their clients. In this post, we will discuss some of the questionable and misleading practices that currently exist in the financial services industry.

Fees and other costs directly reduce an investor’s return. Simple math shows that each additional 1 percent in fees and costs reduces an investor’s end return by approximately 17 percent over a twenty year period. Therefore, it is important for investors to have accurate information about their investments’ fees and costs.

The annual expense ratios stated by many mutual fund companies are often misleading in terms of effective cost of their actively managed mutual funds. I have previously written about the Active Management Value Ratio™ (AMVR), a proprietary metric that uses an investment’s incremental costs and returns to evaluate the cost efficiency of an actively managed mutual fund. Assume two funds: Fund A is an actively managed mutual fund with a five-year annualized return of 22 percent and a stated annual expense ratio of 1 percent; Fund B is an index fund with a five-year annualized return of 20 percent and an annual expense ratio of 0.22.

Fund A’s incremental cost would be 0.78 (1.00 – 0.22) and its incremental return would be 2.00 (22.00 – 20.00). Fund A’s AMVR score would be 39 percent (0.78/2.00), indicating an effective fee of 39 percent for the active management component of Fund A. The effective fee for Fund A would actually be 39.22 percent (39 + 0.22), hardly prudent. Another way of looking at Fund A’s fees would be that 78 percent of the fund’s total fee is only producing 9 percent of the fund’s total return. Again, hardly prudent.

Another way of evaluating an actively managed fund’s annual fee is by using Professor Ross Miller’s Active Expense Ratio (AER). The AER compares the active component of a fund with the incremental costs of the fund to calculate a fund’s effective annual expense ratio. In our example, if we assume that Fund A has an R-squared rating of 95, then Fund A’s AER, its effective annual expense ratio, would be 4.18 percent, significantly higher than the fund’s stated annual expense ratio of 1 percent.

Another important aspect of investing is effective diversification of one’s investments. Effective diversification is a proven risk management strategy that allows investors to hopefully avoid large investment losses. Effective diversification requires financial advisors and their clients to analyze the relationship between various investments’ returns, their correlation of returns, in order to combine investments that behave differently in various economic and market conditions.

Unfortunately, many financial advisors are misleading clients on the diversification within their investment portfolios by telling clients that diversification based on asset classification, e.g., large cap growth, small cap value, mid cap growth, rather than correlation of returns, is effective diversification. In fact, such “false” diversification can be proven by the patterns of increasing correlation of returns among equity-based investments over the past ten to fifteen years. Even more concerning is the fact that such investments have shown an increasing correlation of returns during times of turbulence in the market, times when effective diversification is needed to avoid large losses.

Arthur Levitt, former head of the Securities and Exchange Commission, once warned investors that they have to take greater responsibility in protecting their financial security. The securities industry is filled with various investment scams, with new ones appearing all the time. The key is for investors to become more educated and more proactive, including taking action to address investment fraud when it happens to them.

To learn more about James Watkins, visit CommonSense InvestSense.