“Suitability,” “Best Interests” and the Active Management Value Ratio 2.0

James W. Watkins, III, J.D. CFP®, AWMA®InvestSense, LLC

Managing Member/CEO

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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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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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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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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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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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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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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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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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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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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“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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“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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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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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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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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Calculating the AMVR 2.0

Actively Managed Fund5 Year Annual Return - 18.61%Annual Expense Fee - 1.00%Turnover Ratio - 50%

Index Fund5 Year Annual Return - 20.00%Annual Expense Fee - 0.17%Turnover Ratio - 3%

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Calculating the AMVR

Fund ExpensesTotal 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 0.21Incremental Cost/Return 1.39 0

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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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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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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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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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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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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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