Do fund managers justify their fees?

Asset consultants, research houses and financial planners sometimes argue that fund managers rarely outperform their benchmark index. The question is then asked why we pay them so much to add so little value. Ever the contrarian, Rob Keavney reckons fund managers are singing sweetly for their dinner.

From time to time one reads that managed funds don't perform as well as their comparative market index, with the implied conclusion that investors will achieve better returns by going direct.

In order to ensure that I have avoided selectivity of periods, in the following I have analysed the period from 31/12/79 which is the full life of both the All Ordinaries Accumulation Index (AOAI) and of the Morningstar Australian Equity Trust Index.

Graph 1 shows that the average retail Australian equity trust has produced a return, after fees, that is superior but similar to the All Ordinaries Accumulation Index.

One would think that this graph alone would debunk the view that managers underperform indices. The simple, demonstrable fact is, over the last 21 years, they have outperformed.

In fact, over the five years to 31/12/2000 65 per cent of all equity trusts in Morningstar's database equalled or beat the All Ords.

However, on average and after fees, they have only outperformed by an immaterial margin. This is not a cause for criticism - it is a logical inevitability.

The majority of shares are owned by institutions. Thus, the AOAI is largely a measure of the returns produced by the stocks owned by the fund managers. The fact that fund managers don't materially outperform or underperform themselves is a tautology.

Rather than comparing the performance of funds to the AOAI, the relevant question is to compare them against the shares owned by investors other than managers, ie direct investors. Although it will involve some approximation, this can be done.

The average MER of the equity trust in the Morningstar Index (which is of retail funds), since 1980, would have averaged more than 2 per cent, but we will use 2 per cent for simplicity and conservatism.

If managed funds, after a 2 per cent MER, have produced a return in line with the index then, before their fees, they must have produced a return of 2 per cent better than the index. Thus, managed funds demonstrably own stocks that generate above average returns. (I should note here that the Morningstar index includes only equity trusts but does not include the performance of, say, Australian equity superannuation funds. I make the assumption that the stocks institutions hold in their equity trusts will not be materially better or worse than those they hold in their other funds. Thus, I am using the Morningstar index as a proxy for the returns of all managed funds.)

Simple arithmetic will prove that if, in aggregate, managers hold stocks that produce above average returns then, in aggregate, non-managers must own stocks that produce below average returns. By definition, everyone cannot be above average.

If exactly 50 per cent of stocks were owned by managers, the underperformance of non-managers would be 2 per cent, balancing the 2 per cent overperformance before fees by managers.

Thus, while recognising that individual cases will vary widely, there is strong evidence to suggest that, on average, direct investors produce inferior returns to the AOAI.

Note that the term "non-managers" includes direct investors, companies with listed subsidiaries, as well as any other shareholders who are not managers of Australian funds. I don't have data to distinguish the returns achieved by these sub-groups from each other.

The proportion of Australian stocks owned by institutions is actually closer to 70 per cent than 50 per cent. However, many of these are wholesale funds with a lower MER. Let's estimate that the average MER of all funds was 1.3 per cent.

Making these assumptions and based on the evidence in graph 1 that, after fees, managers match the index, the mathematically minded can estimate that the average non-managed investor must underperform the index by 3 per cent. (To explain, if managers match the index the stocks they own, which are 70 per cent of all stocks, must exceed the index by the fund's MER, taken to be 1.3 per cent. Logically the other 30 per cent of stocks must underperform by 3 per cent.

The quantum of the margin is arguable. The logic that if one part of a sample exceeds the average, the rest must fall short, is not.

This underperformance will be even more when we take costs into account. The return of a managed fund is after all costs including their fees, brokerage, stamp duty, FID and BAD etc.

A market index is a cost-free, theoretical portfolio. A real world direct investor who owned an index portfolio since 1980 would have paid a large amount in brokerage, stamp duty etc and would therefore have produced a net return of less than the index.

Costs will merely exacerbate the direct investor's underperformance.

Thus we can conclude that most investors who go direct have generally obtained an inferior return to both the index and the average managed fund. Naturally there will be wide variation above and below the norm.

This accords with common-sense. If experienced, trained and highly paid professionals were actually less skilled than the man-in-the-street, it would mean funds management was very different from all other spheres of human endeavour.

If Kerr Nielsen of Platinum, Andrew Brown of Rothschild, Greg Perry of Colonial First State, and their competitors were actually less capable of selecting stocks than baboons picking stocks at random, surely they would be replaced by primates, both increasing their fund's performance and allowing their employers to pay peanuts.

Further, if the average manager justifies its fees, then above average managers more than justify their fees. It is not difficult to identify above average managers.

The following share funds have been very widely recommended for many years by financial planners: Perpetual Industrial Share Fund, BT Equity Imputation Fund, Advance Imputation Fund, Rothschild Australian Equity Trust and Colonial First State Imputation Fund.

If a portfolio of these funds was constructed, it would have produced a very superior return to the AOAI - graph 2 compares this portfolio with the AOAI. The portfolio's return, at each point in time, is the average of each of these funds that existed at the time.

The managed funds return from January 1980 to March 2001 has been 17.7 per cent per annum compared with the index's 13.6 per cent per annum. Since January 1990, the fund's return has been 13.6 per cent per annum versus the index's 10.1 per cent per annum.

Greater diversification and administrative simplicity would be additional benefits from these funds.

This does not suggest that there is no place for direct investors - there will be some excellent direct investors.

I merely wish to establish that, as far as Aussie shares are concerned, most managers are earning their dough. Yet there is a widespread perception that it is "sophisticated" to go direct. I have never seen any evidence for this.