What funds would not like you to know

ARE funds (mutual/unit trust/actively managed funds) the way to go to invest for the long term? There are numerous glossy and enticing advertisements by funds trumpeting excellent returns, but at the same time warning that past performance is no guarantee for future performance.

In the US, more than US$10 trillion is held by nearly 10,000 mutual funds. If you take out money market funds and bond funds, about US$5 trillion is in stocks. Is funds investing safe and does it provide superior returns (relative to the relevant benchmark indices)?

Majority does not beat benchmark indices

Did your fund portfolio beat the benchmark? Congratulations, for you are in the minority. In the book, Wall Street Versus America by Gary Weiss (formerly with Business Week), he said “if you had shares in an equity mutual fund on January 1, 1984, just as the bull market was taking off, and held on to it until December 31, 2003, the chances are better than 90% that your fund failed even to match the performance of S&P 500 stock index”.

Can you imagine – 90%? Even the betting tables at Genting Highlands offer better odds. If you are going to put your money to work by investment pros, you should expect superior performance. Isn't it difficult to believe that only 20% of funds have managed to beat the benchmark?

The fees charged put most funds on the back foot. Actively managed funds usually incur trading costs – front- and back-end loads, advisory fees, advertising campaigns, and commissions payable to sales and distribution channels. We are not even talking taxes yet. The fees accruing to unit trust sales forces in Malaysia is a good example, hence it is very difficult to locate funds that actually provide superior returns from the personal EPF investing scheme.

Another issue affecting returns is churn rate, i.e. the number of times the total portfolio value was bought/sold in a year. Some have a churn rate of less than 50% but some can register churn rates of more than 200%. The higher the churn rate, the higher the fund's brokerage and related fees. On the other hand, a lower churn rate is no guarantee for better performance.

Soft-dollaring

Some funds have a high churn rate because it keeps the brokers/dealers happy, and some would get “soft-dollaring” arrangements if their transaction volume reaches certain predetermined levels (e.g. free terminals, research, online subscription services, computers, monitors, cables, network support, printers, maintenance agreements, etc.)

Depending on the country they are operating in, some of these soft-dollaring are not shown as savings to the actual fund but rather to the fund company's operational revenue and expense columns.

(Soft-dollaring is a new fangled way of referring to kickbacks. While “hard-dollars” refer to expenses coming out of the fund company's pockets, “soft-dollaring” involves using client's cash to pay for things.).

Certain funds even allow their broker to charge “higher commissions” (especially through OTC trades or off-market trades where prices can be negotiated) to get better soft-dollaring deals from the brokers.

Scandals

In the US you have the late trading and market timing scandals in mutual funds. There have been many cases involving sales incentives for brokers to push in-house funds. Some fund managers have been known to receive kickbacks in the form of a percentage of transaction orders given to certain brokers. Front running by fund managers themselves ahead of placing big orders is also a problem (of course by using nominee accounts).

Corporate governance

A fund's board of directors is supposed to look after investors' best interests. Still, some of these fund boards operate too much like an old-boys network. We need stricter oversight. We need the chairman and at least 3 out of 4 members of the board not to be affiliated in any way to the fund management company.

This needs to be strictly enforced. A strong board is possibly the best hope for those who invest in these funds to ensure that these fund management companies “go the right way”.

In many cases, a fund's quick growth can hinder performance. The bigger the fund, the harder it is for a portfolio to move assets effectively. For example, a small-cap fund, which started with RM300mil may register superior performance in the first couple of years.

The company will advertise this fact to lure more investors into the fund. If the fund size expands to RM1bil, it will become increasingly difficult to match the returns of the past as locating decent sized exposure will be more difficult and the fund manager would have to hit more “home runs” now than previously.

Attrition of funds

A large fund management company will launch many funds, sometimes in the same sector or country exposure. If they launch three country funds in Year 1, and another three similar funds in Year 2, and so on, the savvier funds companies will put different stocks into each of these funds. Hence, you may notice that some funds provide superior performance while others do not. As a result, the company may close out the underperforming funds and let the “superior funds” run.

After a few years, these big funds management companies will always be able to tout “superior funds” for advertising purposes. Nobody will bring up funds that have been closed down.

The Journal of Finance (March 1997) reports a comprehensive study by Mark Carhart on mutual funds over the period from 1962 to 1993. He states that “by 1993 fully one-third of all mutual funds had disappeared.” If you were to take into account the attrition, then the 90% under-performance figure by funds cited earlier might have even been worse.

Individuals or committee?

At the risk of sounding like a broken record, investors need to ask insightful questions before deciding which funds to plough their hard-earned money into. Needless to say, the merry go-round performance of fund managers affects their long-term performance. Many funds say that investment decisions are deliberated and made by a committee, thus reducing the dependence on any individual.

Truth is, there are individual fund managers who outperform but it wouldn't serve the fund management company's interest to emphasise that fact, for what if he/she leaves the company? Your query as an investor is – who are the fund managers at the company? How long have they been with the company?

You should even ask for their bio-data and resume. A fund management company with fund managers on short tenures may indicate a general failure to lure and keep good staff. It's a realistic business. To chalk up superior and consistent performance, the company needs a dedicated team led by proven fund managers for a prolonged period. Otherwise, investors may find that they have forked out their savings for some 20 year-olds to play and experiment with!

Random walk

Many investors have wised up to most of the factors that I've mentioned above, hence the proliferation of indexed-funds over the last 5 years. Most of them would rather just trail the index performance as they do not want to be slugged with exorbitant fees. Indexed funds have a much lower fee structure, hence their popularity.

But the fact that 90% fail to outperform their benchmarks lends a lot of weight to the random walk theory which imputes that you cannot consistently outperform the market over the long run. That being the case, instead of active management (which is deemed eventually to be futile under random walk theory) the best way is to track the index.

With that, perhaps one should not rule out too hastily the pros of self-investing as long as they read up adequately and understand the market dynamics and investing fundamentals.

It's either that, or choosing wisely which fund management company to go with.