Advisor Blog

We've previously written about the insurance sales scams called "Be Your Own Bank" and "Infinite Banking".  But, the recent lies produced by the salesmen hawking a similar concept under the name "Circle of Wealth" go beyond what we've seen before.

A "calculator" sent by the promoter of the scheme to insurance salesmen that he's trying to convince to use his system compares the performance of an Indexed Universal Life (IUL) policy to a hypothetical S&P 500 index fund.  Of course, the comparison is made over a very short time period that includes the 2008 stock market meltdown.  We once heard an insurance salesman claim that "if you take away the good years, the stock market really hasn't done very well."  Brilliant!  Here's a great example of that type of thinking. 

Beyond this, the "analysis" makes the following assumptions for the mythical S&P 500 index fund used in the comparison:

• Adds a 5.64% sales charge
• Adds a 1.5% "management fee"
• Assumes 100% annual turnover
• Assumes that all capital gains distributions are short-term and taxed at 28%

The truth is that anyone can purchase the Vanguard 500 Index without any sales charge and the annual expense ratio is 0.17% (less than that for share classes with larger minimum investments).  According to Morningstar, it has a 4% annual turnover ratio.  Since the fund invests in the S&P 500 index and companies very rarely spend a year or less as part of the index, most of the distributions are taxed at the advantageous long-term capital gains rate (currently a maximum of 15% - maybe going to 20% next year).

Another recent article in Investment News addressed outflows from American Funds due to real or perceived performance issues. In the article, American Funds spokesman Chuck Freadhoff stated "We don't feel that over the long term, investors will do as well with a passive investment as they will active management, and we have the long-term track records to back that up."

We disagree with Mr. Freadhoff, so we looked for the "long-term track records" that he mentioned. In doing so, we found this document. At first glance, it looks impressive. But, upon further examination there are some glaring issues. First, the performance numbers on the first page don't take sales loads into account. That's misleading, since most investors in these funds pay them. At least that is disclosed at the top of the page and the second page contains load-adjusted returns. A bigger issue, however, is comparison to inappropriate benchmarks. For example, comparing value funds to the S&P 500 Index (dominated by growth companies and, at best, a blend of growth and value). American Funds could have chosen a value index, like the Russell 1000 Value, but that wouldn't have made the comparison look as good. Even more egregious is the comparison of their emerging markets fund to a world ex-US index instead of an emerging markets index that would have shown that it underperformed. This is very misleading.

As indexing and passive portfolio management has gained in popularity and active managers have acknowledged how difficult it is for them to outperform an appropriate benchmark index net of expenses, more and more active managers are behaving like passive managers.  Simply put, they are constructing portfolios that are highly diversified and correlated to their benchmark index with minimal tracking error.  They look and perform much like an index fund, but with the vastly higher expenses of an actively managed fund.  This, unsurprisingly, is a recipe for underperformance.

A recent study conducted by Yale professors Martijn Cremers and Antti Petajisto concluded that as few as 20% of supposedly active managers actually manage money on a truly active basis.  Their opinion is that the others are not providing sufficient value for the high fees that they charge.  And, of course, there is no guarantee that true active management can outperform the benchmark.  But, it is almost a guarantee that "closet indexing" while charging fees consistent with active management will underperform.

How do you spot a "closet indexer"?  Look at the fund's R-squared statistic.  This measures the fit of a regression line between the fund's performance and the index.  If it's above 0.95, the fund is tracking the index very closely.  That's fine if it's designed to do so, but it may indicate a problem if you're paying a high fee for active management.