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 Funds' Careful Deception - Eureka Report Article 


May 18, 2007

Funds' careful deception
By Scott Francis

PORTFOLIO POINT: When a fund boasts it has outperformed the index, investors should be asking: which index?


A large part of the value proposition of financial advisers is that they will earn you an investment return that is above the "market average" or index return. The appropriate measure of this index return is usually the index measuring all the investments in a particular asset class. For example, when talking about the return of an Australian shares fund, it would be appropriate to compare that return against the average sharemarket return - say the ASX200 or ASX All Ordinaries index.

But that is not what happens. The investment industry has somehow managed to avoid this comparison. To put it bluntly: the financial services industry has managed to create its own index, by which funds compare themselves not to the market but to each other.

Inside the investment industry they call it a "peer" index. There's nothing wrong with having this index, the problem is how it is used, and with so many managers underperforming the "real" index - any ASX indices - the popularity of peer indices has led to deceptive behaviour.

What is an index?

An index is the collection of all the investments in a particular investment universe. For example, the ASX 200 is the collection of the biggest 200 companies on the Australian Stock Exchange (ASX). (There are a couple of minor adjustments to this; for example, for companies where large parts of the shareholding are tightly held. However, it is broadly true).

Indices were developed as a method of measuring the change in the performance of a market over time. The index measures the change in the companies it covers. For example, you often hear on the news that the ASX200 has risen by 1%. That means that, on average, shares in the top 200 companies listed on the ASX have risen in value by 1%. The biggest six companies in the ASX 200 index at the moment are BHP, the big four banks and Westfield and, given that the Australian index takes into account the size of companies, they have the biggest impact on movements in the index.

Given that indices are used to measure performance, many investment managers measure their returns against the index. Indeed, this is highly appropriate. However there is a twist.


The misuse of peer indexes

In Australia the most popular - and by implication, most misused peer index - is the Morningstar Index. Take a look at the managed fund tables in any newspaper; for example, the Wealth liftout section of The Australian. The tables used in this article were published on May 2, 2007, with managed fund data to April 27. Now look at the returns from ?Unit Trusts Australian Equity - General'. In plain English, this means the returns posted by the "general" Australian managed funds.

The average return for the Morningstar Index related to this category of returns was 14.8% a year for the past for years.

It sounds like a good return, but the average annual return for the ASX300 index over the same period was 17.6%. The return for the conventional market index funds, which do not more than "mirror" the index with the help of a computer program (Vanguard Australian Share Index Fund, for example) was 16.9% a year.

The problem gets more severe when you map it over a longer time frame: The five-year returns from the Morningstar Index (average managed fund returns) are more than 2.5% a year below the true index return (ASX300) in this category.

The Morningstar Index is important because it provides useful information on the average return from managed funds, in this case in the ?Australian Equity - General' category.

However, the point to take from the exercise is that the results are not good. In fact they are very disappointing. Over a five-year period, the average managed fund return in this category has lagged the ASX300 market by about 2.5% a year. This is a significant underperformance over an extended period, and useful for the average investor to know when thinking about investment approaches.

Think of what this means for investors using this table of managed fund performance. An investor in the AMP Capital Investment Equity Fund will look at the table and see that they received a return of 15.94% a year over the past five years. They see that the Morningstar Index return in the same table is 14.84% a year and they might be thrilled that there fund has outperformed the market return by 0.9% a year! Instead of being thrilled they should be angry that their fund has underperformed the average market return by more than 1% a year.

What's worse is that they could have invested in an index fund and received a return of almost 17% a year - 1% a year better. They have paid big fees to AMP for active management, and yet their return over five years is less than the market index return by a significant margin.

I am strongly of the opinion that if you invest in an Australian share managed fund, then your returns should be compared to the overall market return of the Australian sharemarket. In this case the ASX300 sharemarket index. Comparing returns with the managed fund average - with the tendency for managed funds to underperform the market return over time - gives investors a false picture.

Phillip Gray, Morningstar's editorial and communications manager, says it is important that investors use both a peer index and the relevant market index in assessing investment returns. "Investors should certainly use both the market index (as a representative measure of the performance of the overall market in which the fund manager is investing), and the Morningstar peer group index (as a representative measure of how an investor's fund manager is stacking up compared to other options offered in the same space).

Where are these indices misused?

As a financial planner I have used a number of software programs to help manage client portfolios. Many of these generate the reports that clients end up with, and that are used in performing portfolio reviews. Often these use the Morningstar Index as the point of comparison for a managed fund. I can understand this in the case of a "balanced fund", where no true market index exists, but using Morningstar indices to compare an Australian shares fund is likely to significantly understate the index return and misrepresent the performance of a portfolio to a client.

Put simply, investors who read their reports get an overstated idea of the performance of their investments because it has been compared to an index of managed funds, which lags the true market index by some margin.

The following graph and table provides a practical illustration of this problem, and are taken directly from a client report. The fund is the Vanguard Australian Shares Index Fund, which matches the ASX300 index less costs. The annual return from the ASX300 index fund for the five year to the end of April 2007 has been 17.91%. The return from Vanguard Index fund has been 17.56% a year (17.91% a year less costs). However, this return has beaten the Morningstar Australian Equity General (Wholesale), which has returned 16.93% a year over the past five years.

Consider the graph and table below. It looks like the Vanguard index fund has beaten the index. Clearly, this cannot happen as the idea of an index fund is to provide the index return less some costs. Therefore, it cannot expect to beat the index over an extended period.

nVanguard Aust Shares Fund - Returns to April 2007


nVanguard vs the comparative index
Return over
Fund Type Fund Name
6 Months
1 Year
3 Years
5 Years
Your Fund Vanguard Australian Shares Index Fund
16.75
22.11
26.96
17.56
Comparative Index Mstar Aust Wsale NTP Aust Eqty - General
15.79
21.06
25.95
16.93

Conclusion

The Morningstar Index provides us with some important data. It shows that over five years the average ("general") Australian managed fund has failed to keep up with the average market return over this period.

These peer indices, however, become a tool that can be used to distort true investment performance. As we see with the managed fund tables and the software reports, people could be led astray by comparing their returns to a peer index (such as the Morningstar index), rather than the true market index (such as the ASX300). No one ever said it was easy engaging with the financial services industry - and this is another trick to be wary of.
Scott Francis' articles in the Eureka Report 

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