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A popular way to lose money - Eureka Report article

August 4, 2008
A popular way to lose money
By Scott Francis

PORTFOLIO POINT: With a portfolio similar to the index, but higher fees than index funds, Colonial First State Imputation Fund stumbles on its promise to make money for investors.

Colonial First State is an iconic part of the Australian funds management landscape. As a successful boutique manager it grew through the 1990s on the back of strong investment performance ... until it was bought out by Commonwealth Bank. This transaction was famous for some of the large payments made to senior Colonial staff including to Chris Cuffe, now a director of Third Link Investment Managers, and Peter Smedley, now chairman of OneSteel.

This "Close up" looks at the Colonial First State Imputation Fund, a long-running Australian share fund that is one of the most popular funds with Australian retail investors. The fund describes its strategy as a "GDP-plus" approach: selecting companies that will grow earnings at a rate faster than the economy as a whole. It sounds like a simple and compelling investment approach. Clearly investors agree, as there was more than $2.5 billion in the fund as at the end of March 2008.

Its fee of 1.76% means investors are paying Colonial total management of $45 million, although if they can find companies that provide an above-average return through their GDP-plus process then that fee will be well earned. (There is also a wholesale version of the Colonial fund earning fees of another $25 million or so, taking the fees from the fund to about $70 million).

There are several criticisms of managed funds, which I want to examine in the context of the Colonial Imputation Fund. Those criticisms include that:
  • Managed funds generally don't provide investors with good performance.
  • Managed funds often hold a portfolio very similar to the index - so you are paying high fees for index-style returns.
  • Managed funds are tax-ineffective, paying large taxable distributions to investors.
  • Managed funds are an expensive way of managing your money.

There is also some wisdom that suggests down markets are where fund managers will make money for their clients, so we also test that in the case of this fund over the past year.

Criticism 1: Performance

There is a very large body of scientific/academic research that suggests managed funds do not provide superior performance to the average market return. For example, academics Michael Drew and Jon Stanford published a paper in the Services Industry Journal entitled Returns From Investing in Australian Equity Superannuation Funds, 1991 to 1999. They found that "investment managers destroyed value ... underperforming passive portfolio returns by 2.8% to 4% on a risk-adjusted basis".

Underperformance of the average market return is certainly the case for this fund. Based on Colonial's own figures, it underperforms the average market return (ASX 200 accumulation return) over periods of three months, one year, three years, five years, seven years, and 10 years to March 31, 2008.

The underperformance was not subtle either: over one, three and five years it was by more than 3% a year, and was 2.8% a year over seven years. Data to the end of June 2008 shows underperformance of about 3.5% a year over five years, 3.3% a year over three years and 2.75% over one year.

It is interesting to note that this underperformance was actually more than the amount of the fees for the fund (1.76%). So on the most important criterion of all, the ability to make money for investors, the Colonial First State Imputation Fund fails comprehensively.

Criticism 2: Closet indexing

There is criticism that many "active" managed funds actually end up with a portfolio very similar to the index while charging a much higher fee than an index fund. Research by US academic Ross Miller, discussed in a previous Eureka Report article (see Behind closed doors) suggests that 96% of active fund manager returns are explained simply by movements in the overall market.

The following is a list of recently published top 10 holdings at the fund, with index rankings in brackets.

BHP Billiton 
Rio Tinto 
National Australia Bank 
Commonwealth Bank 
ANZ Bank
Westpac Bank 
QBE Insurance 
Woodside Petroleum 

The top 10 companies in the Colonial First State Imputation Fund all came from the top 12 companies in the index. Investors who are paying a combined $70 million in fees might be surprised at how similar their portfolio is to the index.

Criticism 3: Tax-inefficiency

Over the past five years the ASX 200 Accumulation index has provided a return of 16.23% a year. Using figures from the wholesale version of the Colonial First State Imputation Fund, the distributions from this fund have been 14.79% a year. This is not good for investors because higher distributions generally mean higher tax. While the average income from the market would have been 4-5% over this period, the fund has made distributions at three times this rate.

The reason? As a managed fund trades it may create a realised capital gain that it has to pass on to investors in the form of taxable distributions. These distributions of 14.79% a year are mainly distributions of capital gains and not income.

Ideally investors paying tax would prefer to see relatively modest distributions (as close as possible to the income return from the portfolio) with little capital gains distributed.

Criticism 4: Costs

The longest annualised returns available from the Colonial website report that the retail version of the fund has provided a return of 7.34% a year over the past seven years. That means the fund would have earned a return of 9.1% before the fees of 1.76% were taken out. This equates to just over 19% of the fund's returns being paid away in fees.

Do managed funds outperform in poor markets?

There remains a suggestion that in a tough market the skills of fund managers will help outperform the average market return. I don't really understand why this would be the case: if they cannot outperform markets during times of strong market returns how can they be expected to during poor times?

In the 12 months to the end of June, the Colonial First State Imputation Fund provided a return of negative 16.15%, trailing the ASX 200 index return of negative 13.4% by 2.71%. This is a margin greater than its 1.76% fees - so even before fees it was about 1% behind the market.


Managed funds do have their place. For someone starting out they provide a simple and well diversified portfolio capable of accepting small regular investments. They may also provide effective exposure to difficult to invest asset classes such as global property or emerging markets.

However, we have a massive managed funds industry in Australia, suggesting they are used by more investors more often than this definition would suggest. The Colonial First State Imputation Fund typifies the sort of fund that is widely popular yet underperforms comprehensively. An impartial scrutiny of the reality of fund performance might suggest that other investment approaches - such as using index-style funds or direct securities - might often be better for long-term investors.