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 Australia's biggest losers - Eureka Report article 

Australia's biggest losers

By Scott Francis
February 10, 2010

PORTFOLIO POINT: As investors paid active fund managers at Australia's biggest financial institutions to beat the market, they couldn't even keep up.

In a damning indictment of Australia's $1.4 trillion managed fund industry, not one of the funds from our sample of the best known managers managed to beat the index in 2009.

Last year should have been a grand year for active fund managers at our biggest financial institutions, who should have used the opportunity to put their superior stock-picking abilities, expensive research and cutting edge trading systems to good use.

But in what must come as a complete shock to anyone who has ever handed their money over to a fund manager on the understanding that the fees would be more than covered by the above-average returns they would receive, not one of the 16 funds we've tracked managed to match the ASX 300 Accumulation Index for calendar 2009.

The funds themselves are the same broad-based Australian share funds we first highlighted in 2006 - not small caps or value funds, which should be measured against their respective indices. The ASX 300 Accumulation Index takes into account both capital appreciation and dividends - just like managed funds - to give us a more complete picture.

As we now know all too well, the past few years have been characterised by extreme volatility. Last year the ASX 300 Accumulation Index returned investors about 39.6%, a period where a skillful manager should have been able to add even bigger returns, rather than erode the value of your capital. The stark reality of the situation is that the majority of active funds are destined to underperform.

This is a result that I find surprising: in a year when small companies outperformed large companies by quite a strong margin, I thought at least some of the funds may have been overweight small caps, and therefore eke out some degree of outperformance.

nPerformances - percentage gains in 2009



The big question, then, is why? Why do all of these funds, with all the resources and skills that they have at their disposal, not outperform the average market return?

Part of the answer is that managed funds have a number of structural disadvantages that work against them. These include:
  • The need to hold some cash for investor redemptions.
  • The hidden (market impact) costs of trading.
  • The money flow of investor trading.

Managed funds are generally dealing with investor applications and redemptions on a daily basis. During a period characterised by a rush to cash and margin calls, this is even more true. This means funds must have an amount of cash to dispatch redemptions regardless of their target asset allocation.

For example, the Challenger Australian Share Fund gives its asset allocation as being 99% Australian shares and 1% cash. In a period of strong sharemarket returns, such as last year, holding even a small amount of cash reduces investor returns.

When an investor buys units in a managed fund there is also generally a buy/sell spread, which effectively this means the investor buys the units at slightly higher cost than the actual value of the assets. This extra money offsets the brokerage cost of buying shares for the new investor. However, this is not the only trading cost incurred by a managed fund.

There are other brokerage costs incurred when they trade for strategic reasons, which contribute to reducing the final return for investors. There are also "market impact costs", which are even less widely understood, but no less damaging for investor returns.

When large managed funds - whose assets are measured in billions of dollars - trade they have to buy or sell very large parcels of shares. Because they are buying or selling in large volumes, these funds move the price of the shares against themselves: if they are buying their demand pushes prices up, and if they are selling their demand pushes prices down; considerations that are irrelevant for the individual investor.

This problem of market impact is significant for investors, as it means that as money is invested or withdrawn from the fund they are penalised through the market impact costs of trading.

In the US, where fund turnover data is more readily available, the average turnover of a large cap managed fund is more than 70%. That means that 70% of the entire portfolio is bought and sold every year. This is similar to the turnover rate for the whole of the ASX, so there is no reason to think that portfolio turnover for Australian based fund is any less than this.

This is a significant impact for managed fund investors who are not trading: they are still having their returns reduced through market impact costs. Think of an investor who holds units in a managed fund over a year. They are 100% committed to a buy-and-hold strategy and yet their returns are eroded by market impact costs as other investors buy and sell into and out of the fund.

As an aside, it would be very easy for managed funds to report their portfolio turnover for the past 12 months in their quarterly investment updates. This information would be useful for investors, along with the after-tax investment returns and the capital gains tax position of the underlying investment portfolio, which are exacerbated by portfolio turnover.

These three pieces of information are easy to provide and would be useful to investors - and there seems only one reason not to provide them: for many funds including information will make investing with them seem even less attractive than a straight comparison with the index.

Conclusion

Not finding one managed fund to beat the average market return in a year is surprising. It certainly brings into question the role of active managed funds in portfolios, especially in comparison with the many low-cost index and ETF products that offer access to different sectors and markets.

Ultimately, investors have to decide whether the structural headwinds of a managed fund such as market impact costs, cash holdings and high fees make them an efficient way to access investment markets - especially when their performance fails even the most basic hurdles.

Scott Francis' articles in the Eureka Report 

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