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 Active funds' dark secret - Eureka Report article 

Active funds' dark secret

By Scott Francis
August 26, 2009

PORTFOLIO POINT: Actively managed funds promise market-beating performances, but often have trouble just keeping pace.

They're the biggest managed funds in Australia, pulling in millions of customers and billions of dollars each year but they have a dark secret: they all fail to deliver on their core promise to beat the market.

It's called "index hugging", whereby actively managed funds promise returns well ahead of the market but in reality only deliver an average market return. The worst examples deliver below-market returns, despite extravagant promises.

A Eureka Report investigation into our biggest and best-known funds finds that index-hugging is rife. We found the big funds don't just reflect the index itself; they actually over-compensate by concentrating more on the top 10 stocks than index funds, which aim to replicate the index. Moreover, in the vast majority of cases, we found the daily price movements of units in big funds was almost in lock-step with market indices.

We found that among five flagship funds in the market an average of 53% of all holdings constituted top 10 stocks, while on the market it turns out that the top 10 stocks constitute 52% of the entire market in terms of market capitalisation.

Though disappointing, the results reflect established patterns overseas, especially in the US - the world's greatest managed fund market - where earlier studies have shown that up to 95% of the returns from active funds mirror the indices they are benchmarked against.

In Australia, most retail managed funds charge a fee of about 1.5% to 2.2% a year. For that, investors expect to benefit from the expertise of a fund manager, who they reasonably assume will put together a portfolio of shares that will provide an above-average market return. For the sake of simplicity, l will refer to these funds that seek to beat the average return by using the skill of an investment manager as "active funds".

There is a significant body of research that questions whether active funds can actually provide an above-average investment return, especially after allowing for fees. For investors who accept this research, they can invest in an index fund at about a third the cost of an actively managed fund. An index fund simply holds all of the assets in the investment index, in the same proportion that they are in the index, and therefore producing a return equal to the index, less their costs.

The point is that active funds and index funds should have quite different holdings and performances. Index hugging, or closet indexing, refers to a fund that claims to take an "active" approach and charge active fees but ends up looking and performing like an index fund.



US academic Ross Miller, in his paper Measuring the True Cost of Active Management by Mutual Funds, considered this problem in a sample of US managed funds. He found that more than 95% of the performance in his sample (152 funds in the period from January 2002 to December 2004) was simply related to the performance of the underlying index, so the funds were charging active fees and basically performing like an index fund. Actually their performance was worse because their higher fees ate away at investor returns.

Of course, there are two sides to every story. A fund manager would defend performance that approximates the market itself with two key reasons, one being the "marketing prerogative" and the other being "problem of size".

The marketing prerogative simply means not wanting to take risks that see the fund underperform the benchmark. Significant underperformance might hurt the fund with investor outflows, and therefore some of the risks taken to try and outperform the market are not worth the possibility of underperforming.

The problem of size is that as a fund grows, it becomes more and more difficult to invest assets in sizeable amounts in small companies. Big managed funds are measured in billions of dollars, and fund managers are forced to invest these larger amounts of money in the larger companies listed on the stockmarket. This makes their portfolio look increasingly like the index: bigger investments in large companies and smaller investments in small companies.

With these considerations in mind, I examined funds from the Big Four banks and the St George Bank-linked Advance Asset Management.

Two forms of analysis have been carried out. The first is a direct comparison of the top 10 holdings of each fund, to see how similar they are to the top 10 holdings in the ASX 200 index. These holdings account for more than 50% of the fund holdings in each case, except for the Advance Fund (Concentrated Australian Share Fund), which only has 42.8% of the fund invested in the top 10 holdings.

The top 10 holdings of each fund were sourced from funds provided by the institutions themselves. Unfortunately, not all were updated to the end of June 2009. In any event, there was very little change in the top 10 holdings in the index between March 31, 2009, and June 30, 2009.

In the first column of the table, I have set out the top 10 holdings from the index as at June 30, 2009. In brackets I have included the weighting at March 31 2009.

For each fund, I have included the top 10 holdings, marking in red where any holding is not in the top 10 in the index, and including the current position of that company in the index. Only one fund did not have BHP as its biggest holding, and all had the Big Four banks in their top 10.

The Advance Concentrated Australian Share Fund is worthy of further note. It aggressively states in its "fact sheet" that its aim is to outperform the ASX 200 Accumulation index by 4.5% pa and its title as a concentrated fund seems to suggest a less index-aware approach. Over the past three years it has underperformed the ASX 200 accumulation index by 4.03% pa, with the fund still seeming to favour large-company, index-prominent shares.

n'Active funds' and the index
Index holdings, at June 30, 2009
BT Australian
Share Fund
Colonial First State Australian Shares - Core
ING Aust
Shares
MLC Aust Share Fund
Advance Concentrated Aust Share Fund
(data in brackets for 31st March, 2009)
31st March 2009
31st of May 2009
30th June 2009
31st March 2009
31st March 2009
Costs: 1.65%
Costs: 1.86%
Cost: 1.80%
Costs: 1.99%
BHP Billiton 13.1% (13.8%)
BHP
BHP
BHP
NAB
Commonwealth Bank of Australia 6.7% (6.6%)
Telstra
CBA
NAB
ANZ
ANZ
Westpac Banking Corporation 6.6% (7.1%)
Westpac
Westpac
ANZ
BHP
Westpac
National Australia Bank 4.8% (5.0%)
ANZ
Woolworths
Santos
Westpac
CBA
Australia and NZ Banking Group 4.3% (4.4%)
QBE (16th biggest)
ANZ
RIO
Telstra
Telstra
Telstra Corporation 4.0% (4.3%)
CBA
NAB
Telstra
CBA
Westfield
Woolworths 3.7% (4.0%)
Rio
Telstra
Westpac
Suncorp Metway (26th biggest)
QBE (16th Biggest)
Wesfarmers 3.0% (2.8%)
Origin (21st biggest)
Woodside (17th biggest)
CBA
Origin Energy (21st biggest)
NAB
Westfield Group 2.7% (2.7%)
NAB
QBE (16th biggest)
Woodside (17th biggest)
QBE (16th biggest)
Macquarie (20th biggest)
Rio Tinto 2.6% (CSL 2.5%)
Metcash (65th biggest)
CSL (18th biggest)
CSL (18th biggest)
Woolworths
Santos (22nd biggest)
% of index in top 10 holdings: 51.50%
Fund % of top 10 holdings: 51.30%
Fund % of top 10 holdings: 55.63%
Fund % of top 10 holdings: 57.50%
Fund % of top 10 holdings: 42.80%
Fund % of top 10 holdings: 58.95%

The second aspect of the analysis is to compare the daily unit price performance of each fund with the daily movement in the index, looking at how related the fund performance is to the overall market performance. The following table shows the day-to-day movements for both the ASX 200 price index, and the same Australian share funds from the previous table.

nDaily Fund Returns - month of July 2009 - compared with ASX 200 price index return
 
Index Returns
BT Fund Returns
Colonial Fund Returns
ING Fund Returns
MLC Fund Returns
Advance Fund Returns
31-Jul-09
1.28%
1.41%
1.07%
1.65%
1.22%
1.18%
30-Jul-09
1.15%
0.94%
1.12%
1.24%
1.07%
0.97%
29-Jul-09
-0.64%
-0.64%
-0.59%
-0.53%
-0.77%
-0.84%
28-Jul-09
0.72%
0.94%
0.84%
1.02%
0.97%
0.99%
27-Jul-09
1.22%
1.20%
1.41%
1.46%
1.37%
0.91%
24-Jul-09
0.63%
0.82%
0.48%
0.63%
0.68%
0.64%
23-Jul-09
-0.11%
-0.17%
-0.03%
0.10%
-0.12%
-0.37%
22-Jul-09
0.44%
0.08%
0.39%
0.72%
0.55%
0.35%
21-Jul-09
0.01%
0.20%
0.35%
0.03%
0.29%
-0.38%
20-Jul-09
1.24%
1.18%
1.01%
0.93%
1.12%
1.03%
17-Jul-09
0.13%
0.14%
-0.14%
0.18%
0.04%
0.11%
16-Jul-09
1.81%
1.72%
1.87%
1.99%
1.90%
1.72%
15-Jul-09
1.48%
1.26%
1.34%
1.59%
1.55%
1.51%
14-Jul-09
3.47%
3.02%
3.10%
3.38%
3.15%
3.30%
13-Jul-09
-1.49%
-1.34%
-1.50%
-1.65%
-1.60%
-1.32%
10-Jul-09
0.82%
0.78%
0.73%
0.76%
0.80%
0.80%
9-Jul-09
-0.12%
-0.05%
0.00%
0.50%
0.17%
-0.09%
8-Jul-09
0.03%
0.00%
0.17%
-0.10%
-0.06%
0.29%
7-Jul-09
-0.44%
-0.70%
-0.43%
-0.49%
-0.32%
-0.48%
6-Jul-09
-1.16%
-1.26%
-1.28%
-1.68%
-1.11%
-1.18%
3-Jul-09
-1.27%
-1.24%
-1.24%
-1.37%
-1.25%
-1.26%
2-Jul-09
0.08%
0.00%
0.33%
0.07%
-0.11%
-0.15%

When some statistical analysis is done of the fund returns compared against the daily index price movements, it turns out that more than 90% of the variation in unit prices of each fund is simply explained by the index return on that day. This is similar to the results Miller found in his study, and is not surprising given that the funds and the index have similar large holdings. These large holdings are the most significant in influencing performance.

Of course, the fact that only one month of data has been examined limits the ability to make broader conclusions about longer-term performance.

The question for investors in assessing the performance of their managed fund should be to compare what the fund is delivering against what the investor expects. If a managed fund is in the portfolio to provide a relatively conservative, index style exposure then funds with large concentrations of large stocks and performance similar to the index might be suitable - although a low cost index fund, ETF or LIC might be a better value choice.

For the investor looking for a fund manager to "take some risks" on their behalf, it might be a worthwhile exercise to compare the holdings of the fund with the index and see what decisions are being made.

Scott Francis' articles in the Eureka Report 

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