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Funds' Disappearing Act - Eureka Report Article

February 12, 2007

Funds' disappearing act
By Scott Francis

PORTFOLIO POINT: Fund managers tend to trail the index by about 2%. The picture would be worse but for their practice of closing down the poorest performers.

How do managed funds perform against the broader market? It's hardly news that most big-time fund managers struggle to match average sharemarket returns ? index funds have been telling us this for years. But a closer look at recent figures from the managed funds sector suggests the situation is actually worse than previously reported.

On face value, Australia's big-brand managed funds tend to underperform the index by 2%. But that figure blows out to 3% when you include the loss-making funds the larger managed fund groups regularly shut down. It's called "survivorship bias" ? an innocent sounding term, but it's a process that masks some of the biggest failures in the managed funds industry.

In August last year 2006 Eureka Report published its first review of managed funds, Planners' money drain. It looked at the performance of the managed funds run by the largest fund managers, those listed on the ASX 100, and found the performance of the funds lagged the average market return (the index return) by 1.67%

Six months on I have completed the same process again, with updated returns to the end of December 2006, to see how things have progressed. Once again the returns from these funds are dismal. Managed funds underperform by 2.89% over one year and by 1.83% over five years. The results bring into question the quality of advice that people receive from the financial planners who work for these financial institutions. What is more, it highlights the growing importance of understanding survivorship bias and how it can undermine your managed fund investment returns.

The 2007 results

The following table shows the results of managed fund returns in the period to December 31, 2006, with data drawn from either the fund managers' websites, or the Morningstar data base. Those funds that beat the index over any period are highlighted and underlined.

nHow the managed funds performed
Returns to end of
December, 2006
12 Month Return
3 Year Average An Return (%)
5 Year Average
An Return (%)
ASX300 Index Return (accumulation)
AMP Limited
AMP Equity Fund
AMP Blue Chip Fund
Australia And New Zealand Banking Group Limited
ING Australian Share Trust
ING Blue Chip Imputation Trust
AXA Asia Pacific Holdings Limited
AXA Equity Imputation Fund
AXA Australian Equity Growth Fund
Challenger Financial Services Group Limited
Challenger Australian Share Fund
Commonwealth Bank Of Australia
Colonial Australian Share Fund
Colonial Imputation Fund
Macquarie Bank Limited
Macquarie Leaders Imputation Trust
Macquarie Active Aust Equity Trust
National Australia Bank Limited
MLC Vanguard Aust Shares Index
MLC Australian Share Fund
Perpetual Limited
Perpetual Industrial Share Fund
St George Bank Limited
Advance Imputation Fund
Advance Sharemarket Fund
Suncorp-Metway Limited
Suncorp Australian Shares Fund
Westpac Banking Corporation
BT Australian Share Fund
BT Imputation Fund
Average return
Average underperformance
- 2.89
- 1.91
- 1.83

Large managed funds ? those with the biggest team of financial planners providing "advice-based distribution" for their funds ? do not beat the average market return. Long-term underperformance by nearly 2% a year on average is significant. On a $100,000 portfolio it equals nearly $2000 a year and, with the $2000 compounding over time, leads to devastating long-term underperformance.

Survivorship bias

But the results are actually worse than they look, thanks to the subtle but severe long-term impact of "survivorship bias".

Technically, survivorship bias refers to the fact that if we study a five year period ? such as the five years to December 31, 2006 ? we don't actually include any managed funds that have failed. Not surprisingly, those funds that have failed have the worst performance record. By excluding the failed funds we tend to overestimate the returns from the overall market.

This is particularly relevant when analysing the latest returns from Australian funds, because there are five funds from the sample above that are now closed to new investors. This means that they will eventually not be part of this sort of sample, and these funds have an average five-year performance of 12.7%, nearly a further 1% below the relatively poor average managed fund return. Or to put it another way: these funds under perform the index by 3%.

When future investors line up to invest with some of the funds included in our survey they will never know just how bad the performance has been because the fund manager will have quietly killed off the weakest funds in the group. Once those weaker funds are closed down the overall historic performance figures improve ? back to a 2% underperformance rather than a 3% underperformance.

Moreover, it's worth noting that the five-year average managed fund return is better compared to the index return than the three-year return and the three-year return is better than the one-year return. This is an interesting trend. It might be simply coincidence, or it may be evidence of some survivorship bias in our sample, meaning that the longer-term funds in the sample survived better because they provided strong early returns.

According to leading academic papers on this subject, such as Burton Malkiel of Princeton University in Returns from Investing in Equity Mutual Funds 1971 - 1991 published in the Journal of Finance, and Brown, Goetzmann, Ibbotson and Ross's paper Survivorship Bias in Performance Studies published in the Review of Financial Studies, survivorship bias across the samples in their studies was 0.5% to 1.4% a year.

It would be very easy for investors to sit back after three strong years of sharemarket returns and reflect with some pride on turning a $100,000 share portfolio into a $180,000 one. The reality is that such a performance should be considered poor. Over the last three years a simple index investment would have turned $100,000 into a little more than $195,000 and if you have not achieved that then you have cost yourself money.

Similarly, you should assess the performance of your stockbroker, fund manager or financial adviser against such benchmarks because if they are not adding value it is costing you money.

Keep in mind why the sample is of fund managers listed among Australia's biggest companies, because they will be among the best-resourced and staffed ? and yet they routinely under perform the average market return.

A 23% return and a 35% distribution?

One of the most vexing issues relating to managed funds is that they are not "tax managed" ? there is often excessive trading, which means investors end up with less unrealised capital growth and large taxable distributions.

Over the last 12 months, the ASX 300 accumulation index provided a 24.5% return, of which about 4% would be dividends and the rest capital growth. As an investor what you would want from your managed fund would be a distribution of 2-4%, with franking credits and the rest of the return in the growth of the value of your holding. This growth in value is not taxable until you sell your units, so you can defer this tax liability nicely.

There were quite a few funds that had very high levels of distributions, which we might look at in six months' time when we look at the performance of these funds again. However, the prize for a huge distribution has to sit with the AXA Equity Imputation Fund, which had a 34.9% distribution and negative growth of 12.3% over the 12 months to the end of December 2006.

Think of what that means for an investor. In rough figures, if they had $10,000 in this fund at the start of the 12-month period, by the end of the period they would have an investment worth $8770 with a distribution of $3490. This is during a boom time where market growth was more than 20% ? with income on top.

It is not always trading within the fund that makes for much larger distribution; it can also be that if there are large withdrawals from the fund, investments have to be sold and that causes capital gains that have to be passed on to everyone. Although to turn a period of more than 20% market growth into a 12% fall in unit prices is pretty unique.


The inevitability of periods of outstanding investment returns, which we have seen in the Australian market over the past three years, is that there will also be periods when investment returns will be poor. Now is not the time to be complacent about performance. The best-resourced fund managers in Australia are not beating the average market return; worse still "survivorship bias" is masking deeper failings in the industry. The results bring into question the value of managed funds for sophisticated investors. It also raises the importance of keeping track of investment portfolio returns, to make sure you are getting the investment returns you deserve during this bull market.