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Behind Closed Doors - Eureka Report Article

April 26, 2006



Behind Closed Doors
By Scott Francis


PORTFOLIO POINT: Many actively managed funds are all too often 'hugging the index' and actively managing only a small portion of capital in order to protect their returns. Compare the investments of your managed fund against the index carefully to avoid paying for a service you aren't receiving.

It's the bane of fund management investing: fund managers who charge big fees for doing little more than tracking sharemarket indices. It's called 'closet indexing' or 'index hugging' and a flurry or recent research has revealed the problem is worse than many investors might ever have imagined.

Among the reasons given for actively managed funds being closet index funds are the 'marketing imperative' and the problems of size. The 'marketing imperative' suggests that managed funds are reluctant to take big positions away from the index because if they do, and the positions don't work out, the fund will have significantly underperformed their benchmark (such as the S&P/ASX 200). This underperformance will be difficult to explain to existing investors and even more troublesome when it comes to attracting new investors. So the safe alternative is to hold a portfolio that is roughly the same as the index, that way the managed fund will get roughly the same return.

The problem of size means that large fund managers have so much money to deploy that they are forced to purchase investments in a large number of companies, just to get all their money invested. For example, Colonial First State says on its website that it has $99 billion in funds under management. Let us assume that one third of this, $33 billion, is invested in Australian shares. The sheer size of this sum of money requires that it is spread over many investments. Particularly it cannot be focused too much in smaller companies, because they are not big enough for large portions of the $33 billion. As such, the fund ends up with a large number of investments, tending to have bigger investments in the bigger companies, much like the index itself.

US academic Ross Miller, in his paper 'Measuring the True Cost of Active Management by Mutual Funds', sets out to identify how much the returns from mutual funds, a US term for managed funds, are a result of closet indexing and what proportion of returns actually come from active management unrelated to the index. He then attributes a reasonable fee for the index fund management based on the Vanguard S&P 500 Index Fund (0.18%) to find out the true cost of the actively managed portion of the fund. That is, he assumes that the indexing investment management cost 0.18% for the portion of the fund managed this way, with the remaining management cost being attributed to the actively managed portion of the fund.

The results are very interesting. For the 152 'large company' mutual funds that formed the sample, on average only 15.55% of the total funds were actively managed. The average MER for the actively managed portion of the funds was 6.99%. On average more than 96% of the variance in the returns of the fund was explained by movements in the index. On average the 'value added' by the active management was negative 9%. This is an investment loss of 2% on top of the fees of 6.99% apportioned to the actively managed component of the fund, clearly demonstrating that in this sample active management destroyed value.

On an overall basis the 152 mutual funds underperformed the index by an average of 1.5%.

It is worth making some comments on the study. Firstly, the data sample was for an 18 month period from January 2002 to December 2004. This is a short time frame from which to be drawing conclusions about performance. Secondly, the results assume the cost of an index fund to be 0.18%, based on the Vanguard S&P 500 index fund available to retail investors in the US. In Australia, the Vanguard Australian Share Fund has an MER of 0.7%. Given this difference in the underlying cost of indexing it is reasonable to assume that the results would not have been as dramatic if this study were performed in the Australian Managed Fund environment. Thirdly, the study does not consider the tax consequences of using an actively managed fund. All performance considered in the study was before tax. We know that actively managed funds tend to have higher portfolio turnover than index funds, and therefore higher levels of realized capital gains, which decreases their tax efficiency.

Overall the study provides a different perspective on the academic literature that widely questions the ability of active fund managers to outperform the index. Its conclusion that the active management of funds does not add value for investors is consistent with much of the existing literature, including research carried out in Australia. It also provides a strong indication that the problem of 'closet indexing' or 'index hugging' is a significant issue in actively managed funds. It is fair to suggest that this 'closet indexing' issue brings into question the value added by the managers of actively managed funds.

It also highlights one of the differences in using an index fund in Australia, with the cost of the Vanguard Australian Share Fund for a retail investor 0.7%, nearly four times the cost of the equivalent Vanguard investment for a US retail investor of 0.18%. It seems reasonable to put these differences down to differences in the scale of markets and the difference in maturity of index funds in the two different markets. According to the Vanguard websites in the US and Australia, Vanguard in the US has $950 billion in funds under management whereas Vanguard in Australia manages $36 billion. Vanguard in the US was founded in 1975 whereas Vanguard in Australia was started in 1996.

The problem of closet indexing is that you end up paying too much for the service being delivered to you. It is worth looking at the investments in managed funds that you own, and considering how similar they are to the top companies in the index. If you are concerned that your managed fund looks like the index, performs like the index but charges more, perhaps you should consider either using a lower cost index fund, or find a manager who takes a genuinely active approach to their investments. Such managers often describe themselves as 'index unaware', will often hold smaller portfolios of 15 to 30 investments and will have performances history often quite different to the underlying index. Of course, you don't need to do one or the other, and may choose to use the combination of an index fund and some genuine active management, so long as you know what you are paying for... and that you get what you expect.