The Active Management Value Ratio 2.0: An Investor's New BFF

Many people will tell you that they are (A) intimidated by investing, (B) confused about investing, or (C) both, plus much more. Many investors will also admit that they are afraid to ask their financial advisers questions and would rather pretend to understand rather than to "embarrass" themselves with "foolish" questions.

As a result, many investors are exposed to unnecessary invest risk. Fortunately, there is a simple metric that investors can use to evaluate the soundness of their investments, both in personal accounts and retirement accounts such as 401(k)s and 403(b)s.

The Active Management Value Ratio 2.0? (AMVR) metric only requires the ability to add and subtract and three pieces of data, all of which are available online for free at sites such as Morningstar's and Yahoo!Finance's online sites.

The AMVR is a simple cost/benefit analysis. What separates the AMVR from other cost/benefit analyses is that the AMVR uses a fund's incremental, or added, costs and the fund's incremental returns, if any. The AMVR compares an actively managed mutual fund to a low cost index mutual fund whose investment objective is the as the actively managed fund.

To calculate a fund's incremental costs, you need a fund's annual expense ratio and its trading costs. Funds a re required to disclose their annual expense ratio, so this info is easily found at the mentioned online sites. Funds are not required to disclose their trading costs, so investors can calculate such costs by doubling  the fund's disclosed turnover ratio, and then multiply that number by 0.60.

To calculate a fund's incremental return, an investor simply needs to obtain the performance of both an actively managed mutual fund and a comparable index fund over a certain period of time. I recommend that investors use the five-year performance of the funds as it is long enough to possibly give a more accurate representation of the fund's performance. However, investors should always remember that past performance is no guarantee of an investment's future returns.

An example may help. Fund A, an actively managed fund an annual expense ratio of 1 percent, a turnover ratio of 50 percent (or a trading cost of 0.60 percent), and a five-year annualized return of 20 percent. Fund B, an index fund, has an annual expense ratio of 0.20 percent, and a turnover ratio of 5 percent (or a trading cost of 0.06 percent), and a five-year annualized return of 19 percent.

Using these number would result in an incremental cost of 134 basis points (1.60-.26) (1 basis point equals .01 percent) and an incremental return of 100 basis points (20.00-19.00). Since the incremental cost of the actively managed mutual funds is greater its incremental return, or benefit, an investor would lose money by investing in the actively managed fund. Similarly, if an actively managed fund fails to provide any incremental return, or benefit, for an investor, the fund should be rejected.

In cases where an actively managed mutual fund provides an incremental return greater than its incremental costs, the investor can then evaluate the fund in terms of factors such as risk and consistency of performance.

The AMVR is a simple, yet powerful metric that can help investors effectively evaluate investment options and better protect their financial security.