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The dirty secrets fund managers don’t want you to know

Wednesday 13 September 2017

Industry insights

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I hope to enlighten potential investors about the tricks used by fund managers to ‘window dress’ their performance. Some can be backed out and where possible I have provided the maths below.

Before we begin, let’s define and recap the role of Index Funds. Index Funds are mutual funds seeking to replicate the performance of a specific index. They are available on almost every benchmark imaginable. The primary benefit of an Index Fund is its very small management fee. This means they can replicate the performance of a benchmark very closely on an after-fees basis. It is therefore easy to compare active managers against their applicable Index Fund. An Active Manager is a fund manager attempting to beat the benchmark through stock selection.

Active Managers generally charge a management fee and a performance fee. Regardless of size of the fees charged, the important metric is performance return after fees. An active manager needs to earn back his/her fees prior to being paid for performance. Unfortunately, this is not always the case, so investors need to be alert to manipulations around fees and performance. We discuss the major manipulations below.

Selecting a benchmark index and excluding dividends

This is the most commonly used trick by fund managers. When you hold a stock, you are entitled to the dividends the stock pays. Accordingly, when you buy an Index Fund, you are entitled to the dividends on the stocks in the Index. Dividends can make a huge difference to your long term investment performance. The benchmark used should include the dividends of the index. To illustrate, I include the return on the All Ordinaries Index with and without dividends. The return with dividends is called the ASX All Ordinaries Accumulation Index.

For example, the return on the ASX All Ordinaries Index was 8.5% for the year ending 30 June 2017. The All Ordinaries Accumulation Index, which includes dividends, returned 13.1% for the year ending 30 June 2017. If a fund manager wants to overstate performance they choose the lower hurdle i.e. 8.5% instead of 13.1%. You should ensure that your manager’s benchmark includes dividends.

Quoting performance before fees

To make a clear comparison, fund managers should be quoting their performance after fees. This is a no brainer, however, you may be surprised that some professional managers do not quote their returns after fees. You may adjust their performance by deducting the management fee from their published performance. This will ensure you are comparing apples with apples when you rate the performance of an Index Fund or an Active Manager.

Failure to deduct the management fee prior to calculating the performance fee

Assume a fund manager charges a 1.5% management fee and a 15% performance fee. Assume that the manager delivered a 10.5% return before fees and the benchmark delivered a 9% return. The fund manager could take a performance fee based on 1.5% outperformance. However, if you subtract the base management fee of 1.5% from the performance, the return would only have been 9%, which does not better the benchmark. It is critically important that the management fee is deducted prior to calculating the performance fee. Stay alert to this, it can make a significant difference over the long term.

Performance fees paid quarterly

The payment of performance fees is another area of concern. The most common abuse is to calculate and pay performance fees quarterly. For example, assume a fund’s unit price begins at $1.00, reaches $1.10 by the end of the first quarter, before falling and finishing the year at $1.00. In this example, the unit holder’s investment began and ended the year at $1.00 i.e. their units have not increased in value. If the fund manager charges a quarterly performance fee, they would have paid themselves a fee at the end of the first quarter, when the unit price reached $1.10. However, if they calculated their performance fee annually, no performance fee would be payable. Beware of performance fees paid quarterly!

I hope this allows you to more effectively choose the best fund for you.

Disclaimer:
The information provided in this document is of a general nature only, is not personal investment advice and has been prepared without taking into account your investment objectives, financial situation or particular needs (including financial and taxation issues). Investors should read and consider the investment in full and seek advice from their financial adviser or other professional adviser before deciding to invest.

About the Author
Lachlan Hughes, CFA

Lachlan Hughes, CFA

Chief Investment Officer

Lachlan is the CIO, with responsibility for all investment decisions of the Swell Global Portfolio. Previously Lachlan was a Senior Analyst with NovaPort Capital. During his tenure, the team achieved an annual return of 23.56% over the period from 2009 to 2013, outperforming the S&P/ASX Small Ordinaries Accumulation Index by 15.42% and earning the Lonsec Fund Manager of the Year (Rising Star) award in 2012. Prior to that, Lachlan was a corporate lawyer working with King & Wood Mallesons (Sydney), The Bank of New York (London) and Allco Finance Group.

Lachlan earned the right to use the CFA designation granted by the CFA Institute in 2010. His professional qualifications include a Bachelor of Commerce (Finance) and a Bachelor of Laws.

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