Troubles with Fund Management – An Absolute Return View

This is a reply to Rotten Apple’s post about the “trouble” with the Australian fund management industry. The author of this article is a co-founder of an Australian-based private investment company, Empire Investing, and a former financial adviser and portfolio manager for a boutique financial services company.

It’s all Absolutely Relative

Let me start with a couple of report cards to get some perspective.

Report 1: in calendar year 2010, the S&P/ASX300 Accumulation Index (a broad measure of the Australian stock market that includes dividends) delivered a return of just 1.9 per cent. According to Morningstar, the average fund manager underperformed this index, with less than 20% of the domestic share fund managers able to beat the index. The average “large-cap” manager returned 0.05 per cent.

Report 2: according to the latest Standard and Poors (S&P) Indices Versus Active Funds Scorecard (SPIVA(R)), this benchmark outperformed 71 per cent of active Australian share funds.

Report 3: at least 80% of active Australian Bond funds have failed to meet their relative benchmark, the UBS Composite Bond Index, over periods of 3 years or more.

Report 4: the only area of decent outperformance are the small-cap funds, which are more likely to outperform their benchmark index, the S&P/ASX Small Ordinaries. Over the last 5 years, 70% of small-cap funds have managed to do better than the index, with the outperformance averaging 2.4% p.a. However, this is a relative outperformance for an index that has given overall negative returns so even the small-caps have lost money over the last few years.

So how does all this underperformance show up in our superannuation funds? Well according to APRA’s latest Annual Superannuation Bulletin (released in January), the Rate of Return (ROR) for all super funds that are not self-managed has been 8.9% for the financial year to June 2010. This compares to a 9.4% increase in the S&P/ASX200 Index.

More importantly, the average annual ROR over the last 10 years has been 3.3% – or 2.5% p.a for the retail subset. Ouch. This could explain why retail super funds have seen a nominal decline in assets under management (AUM) since 2007, whilst self-managed super funds have grown their assets by over 21% in the same period.

Lies, Damn Lies and Statistics
Too many stats? Right you are – so here are the take home messages.
First some active fund managers will beat the index – however this is a distinct minority (20%) in the case of the larger managers – where most retail investors have their capital. Most small cap managers do a better job than their index – but their long term returns barely beat bonds and term deposits.

Second, all of the indices followed by equity managers have had negative nominal returns in the last 3 years. So even “out-performing” funds can be losing you money.

Third, non-SMSF super funds have averaged 2-3% p.a below what you can get in a good term deposit or 10 year Australian government bond, the worst performers being retail funds.

A Troubling Problem
So what’s the trouble? Or problem – I won’t demean it by calling it an “issue”.
Providing relative returns to investors in all market conditions whilst not considering the preservation of their capital is the No.1 problem with the funds management industry.

Every other problem pales into insignificance unless this is addressed. I’ll consider the second part, risk management, in a later post.

There are 5 issues I want to talk about:

  • Why active fund managers should only be absolute return focused
  • Alternative performance benchmarks to index following/tracking
  • Alternative transparent remuneration/fee models
  • The concept of Managers as Partners and why this is the best management structure
  • Suggested reforms to the system.

Active can only be Absolute
The research is in, the empirical facts stare us back in the face: the majority of active fund managers cannot outperform their benchmark index. Only a minority have the ability to gain non-relative or absolute returns. At least 70% of the large cap equity fund managers should just convert into Index Exchange Traded Funds (ETF) or Vanguard-style passive index funds.

Or from a client’s perspective, at least 70% of you reading this should go see your financial planner and ask why you are paying 2% per year to get less than the index, an index which you can invest yourself for less than 0.5% a year.

I’ll talk about how I used index funds to create low admin cost portfolios for clients and planners, changing the composition dynamically (e.g upping emerging market exposure, reducing Aussie equities etc) thus cutting out the active manager, in a later post if there is any interest.

Rotten Apple hit it on the head when he said:

Much of the fund management industry is still in thrall to the bizarre concept of “relative returns”. For example, if you are a large-cap US equities fund manager, your returns will generally be measured against a benchmark such as the S&P 500. The fund manager will try to roughly match the composition of this benchmark, while overweighting  (or underweighting) certain stocks that he or she thinks will outperform (or underperform) the market. But this kind of approach leads to a very strange conception of risk, and it generally results in mediocrity.

This mediocrity is exarcebated by the guaranteed, multi-million dollar flow of weekly superannuation contributions into a gross, complex system that has grown out of the simple notion of saving for retirement. This system has created a safe, conservative environment for fund managers and their salesmen – the financial advisors mainly working at the big four bank’s wealth management arms. Large commissions and bonuses are obtained by an industry that “benchmarks” their performance to an index almost everybody else in the business is also following.

Only a small core of contrarian (usually small or micro cap, or macro- based) managed funds break this mold and attempt to gain the returns that really matter: absolute.

So what is absolute return? In essence, it means that year in year out, the fund makes a real return, i.e above zero. The best of this bunch beat the banker, the taxman and inflation. This absolute return should also be reflected in times of boom (e.g 2004-07), bust (2008-09) and sideways markets (2009-10). It should also be attained during periods of inflation, deflation, commodity cycles and high volatility/uncertainty. This is what you are paying a manager for: to get the best possible return on your scarce capital, at the lowest risk.

An alternative to relative benchmarking

So what should fund managers use as a benchmark if at all? How can you compare yourself to others to ascertain remuneration and provide investor’s with a transparent choice?

In my view, funds should provide two clear benchmarks.

  • A minimum standard (watermark) equivalent to a time-appropriate savings rate and
  • A “Required Rate of Return or RRR” as the performance benchmark.

The former, for Australian equity managers at least, should be based on the 5 or 10 year Australian Government bond yield. Funds not attaining this standard should not charge any fee as they failed to provide returns above a risk-free bond. This watermark can be adjusted yearly or quarterly, in line with the bond yield.

The RRR performance benchmark is based on the absolute return principle: as managers, you are employed to attain after-tax returns than exceeds savings and inflation. This means that fund managers should treat their capital allocation decisions like any other business does – by investing only where returns are above your own RRR.

In today’s relatively high inflationary and tax environment, I equate an appropriate RRR to about 10-12% per annum for retail investors. Super funds, due to their very favourable tax treatment, should aim for 7 to 9% over the long term.

For more information on how this RRR is developed, click here.

Management Remuneration

What about remuneration? Those industry super ads – whilst somewhat disingenuous – are a good illustration of the impact of fees. Fees are typically asset based, which encourages building AUM, and they usually apply regardless of performance.

We have considered remuneration structures extensively at Empire Investing, and when we establish a managed fund in the near future, we will likely use the following (or a variation thereof):

  • If performance fails to attain the watermark – as explained above – no fees are charged.
  • If the watermark is passed, but the benchmark RRR is not attained, a flat admin fee is applied (approx. 0.3 to 0.5%)
  • If the RRR is attained, the admin fee plus 30-50% of all returns above the RRR are paid as management fees.

As an example, if the RRR benchmark is 10% and fund returns 15%, then the fund manager is paid 1.8% (including 0.3% admin fee) and the investor gets 13.2%. Transparent and easy to explain: the manager and investor shares in the risks and rewards.

Managers as Partners
Before rampant financialisation allowed the creation of mega-banking conglomerates, commercial and trading banks used to be separate entities owned by partners who managed the business. This robustness – whereby the owners and managers shared in the risks and rewards – encouraged a culture of prudential risk taking whilst maintaining a high reputation and a consideration of succession planning.

Fast forward to today, and the majority of managed funds are owned by the big four banks, fronted by salesmen, who work tirelessly to build AUM.

Only a few funds operate in a manager/partner like manner – sometimes called “boutique”, usually run by dissatisifed former mainstream fund managers. In a recent Lonsec report, 90% of annual management staff departures were from mainstream fund managers, with many leaving to join the boutiques, or start their own.

When an analyst or manager has a sizeable capital stake, their behaviour will differ significantly to your typical financial salesman. Hugh Hendry, a UK absolute return fund manager of “I would recommend you panic” fame, calls this the “pencil in the back”.

Possible Reforms

  • Increase basic financial literacy of the wider population – practical finance should be an integral part of all school curricula, so concepts like compound interest and opportunity cost are widely understood.
  • Eliminate non-performance asset based fees for active fund managers. Only Index ETF’s/passive managed funds should be allowed to charge such a fee, based on administration costs.
  • Active fund managers should disclose and justify appropriate benchmarks, based on a Required Rate of Return (RRR). They should be free to set whatever fee they like above the lower watermark, but may not charge any administration or performance fee below that threshold.
  • Introduce a capitalisation floor , whereby the core team of analysts and managers, in aggregate, must own a minimum amount of Funds/Assets under management (I would suggest 5% as a minimum).
  • Introduce cross ownership rules in financial industry. Banks cannot own wealth management arms, which cannot own superannuation funds and so on.

Our funds management industry may be broke, but it doesn’t mean we can’t suggest possible solutions. Even if we are just wailing at a wall. As regular commenter BB has pointed out this is probably just an academic debate, and like my Research Bonds idea, these reforms will probably never be enacted or considered. I will probably cop a lot of flack from professionals within the industry and my former financial planner colleagues for writing this article. But the reasons above are the raison d’etre for the creation of our investment company.

Latest posts by Chris Becker (see all)

Comments

  1. Our Super industry is a wealth transfer scheme, where financial managers are earning fortune on the expense of ordinary peoples’ future

  2. I “absolutely” agree!! The only problem I see is where would all those north shore fresh out of uni boys go to earn their six figure salaries??

  3. Hi Prince,

    All good points.

    My one criticism would be the following. Under your model, the only time the manager gets any remuneration of note is when they exceed the RRR. This means that they are heavily incentivised to “bet the farm” because they pull off some big fees if it comes off, but suffer comparatively little if it doesn’t.

    About 10 years ago when working for a consulting company, we did a big project looking into all the different models of executive compensation and looking at the different game theory consequences for how they would balance risk and reward. It was interesting stuff.

    Cheers,

    Ben

    • Thanks for your comments Ben – I agree there maybe some element of gaming the system with such a remuneration model, which is why it needs to be incorporated with a capital floor requirement.

      Also, the admin fee – similar to an index fund’s costs – does go someway to compensating the manager if he is “average”. No Maseratis, but no Hyundais either.

      I too have looked into the unintended consequences of behaviour and its fascinating. There is no one perfect solution to this, but anything has to better than a fixed asset based fee.

      • “Also, the admin fee – similar to an index fund’s costs – does go someway to compensating the manager if he is “average”. No Maseratis, but no Hyundais either. ”

        Why not a Hyundai? An ‘average’, index tracking fund manager isn’t really performing any strenuous task or being innovatitve in the slightest. All they are doing is applying worn-out formulas and processes learnt from their degree or peers.

        It’s also an office job, a lot less taxing and a hell of a lot more comfortable than doing a trade. Considering the number of ex-GPS old boy chocoate sauce types (rich but thick) involved in the industry, I don’t see a problem with their rewards structure being maxed out at a Hyundai.

        • Fair call Rusty. I’m just trying to be diplomatic!

          I consider the same reward structure for real estate agents – they should be driving Kia’s and Protons, not BMW’s.

  4. Fees for relative return is huge problem. And can be considered a monumental triumph of marketing by the industry.

    The fact that it’s all about AUM shows when we see an Industry Fund sponsoring a football team. What the??..the only reason i can think for this type of behavior is that scale might lower the insuance fees or something but seems dodgy to me.

  5. The Ancient Investor

    Great article! As a finance man I concur wholeheartedly with your take on the industry problems. With those vested interests piling on it will be an uphill struggle to change the industry. However, I think your first point is the one which we should all push strongly for, empower the consumer (financial literacy) and you will get much a stronger pushback against the ridiculous 2-3% AUM fees the funds charge year in, year out for underperformance.

    When I have taught finance courses at University the average financial literacy in my classes was shockingly low, and that in a group that should be above the population average! There should be some basic units for secondary schools, compound interest, how credit cards work, opportunity cost, rental leases etc.

    Conflict of Interest Note: Yes I run my own SMSF, total running costs per annum 0.15% of AUM.

    • Well the talented front runners can distort things heavily.

      I mean look at Kerr Nielsen’s Platinum International fund.

      He charges 2%+ for it, but it’d be hard to argue it hasn’t been value for money if outcome is what you measure.

      But he was first, and the 2% has become a ‘ballpark’ measure of cost for international funds.

  6. I’ve just had a nasty revelation. Is this non performance on a grand scale a symptom of an economy wide misallocation of capital that is making the country poorer?

    • Firstly, it is actually hard to assess that all funds should capture some sort of Alpha.

      It is a zero-sum game, and the average wealthj gain should be equal to an increase in the ASX/All Ords Index.

      There is a hell of a lot of administration involved in managing funds.

      For strict administrators, you shold expect to subtract a cost for this, this would automatically give you a return below the index.

      Funds have economies of scale however to leverage who efficiently thatn an individual, to add some value back.

      Overall, you can’t really say there is therefore an misalloaction of funds automatically.

      There is a problem with herding however. Performance is SO subjective depending on the criteria used, but make a call correct but early, say Steven Keen, and your credibility gets shot. For exmaple, you can easily say there is a time where investing in nothing, just holding cash is the best investment. Feasably a fund can’t do that, and Super Funds actually most likely have mandates to prevent them from doing this, with too rigid structures to modify this.

      Game Theory says you will then have people herd towards the same behaviour, thus can easily explain away their failure.

      I would answer that Non-Performance is more symptomatic of the rules of the game, and this causes the misallocation of capital.

    • Rusty said: “There is a hell of a lot of administration involved in managing funds”

      True – its about 20-30 basis points for trust/custodial management alone, then add AFSL/ASIC compliance, recoverable expenses and running costs – at least another 20-30 basis points, depending on size.

      So before the fund manager gets paid, you are up to 0.5% or so p.a in admin costs. The reason the index funds can charge this or even a little less is their size – its immaterial to them if they manage $100 million or $500 million – its just a few more zero’s.

      For the smaller guys (hello!) the admin/compliance/trustee costs take up a big chunk, due to the small size involved, which is why you need to chase performance or just go for wholesale investors ($500K min investment) – easier compliance (no PDS required) as well…

  7. I’ll talk about how I used index funds to create low admin cost portfolios for clients and planners, changing the composition dynamically (e.g upping emerging market exposure, reducing Aussie equities etc) thus cutting out the active manager, in a later post if there is any interest.

    – yes please.

    One issue I flag with the main index is big miners & big banks make a massive component of the index. Now if one was slightly bearish on these industries you would need to work around this.

    • I’ll add it to the list – talking about super next time.

      Using ETF’s/Index funds to create your own “active” portfolio is nothing new, other’s have/are doing this.

      We still have a ways to catchup with the US ETF market, but there is a lot of scope to tailor your own “hedge fund” without requiring an active manager.

      But like all things, you better know what you are doing! Investing in the ASX200 is fraught with danger as you well point out – Tim and I have only identified a handful of companies worth putting your money on, and most of the ASX20 and ASX50 is excluded from that lot…..

      Most of the “big guns” in the index underperform badly, but great for traders – the small/mid cap space is the place to be.

      • Oh for sure, active managers are mostly weighted big time to these industries.

        For all the talk about growth in the area I see a very skinny list of ETF options here as you say.

      • A new one started recently: an inverse USD/AUD ETF. i.e if you go long the ETF, and the AUD plummets, you make money….(Betashares Code: USD)

        We still have nothing like the plethora available in the US, which is partially the reason why CFD trading is still strong here (its banned in the US).

        Carbon price permits will be a big ETF I believe…

  8. I have been looking for a fund like this all my adult life…

    – If performance fails to attain the watermark – as explained above – no fees are charged.
    – If the watermark is passed, but the benchmark RRR is not attained, a flat admin fee is applied (approx. 0.3 to 0.5%)
    – If the RRR is attained, the admin fee plus 30-50% of all returns above the RRR are paid as management fees.

    You’ll be swamped, if you don’t go broke that is.

  9. “Increase basic financial literacy of the wider population – practical finance should be an integral part of all school curricula, so concepts like compound interest and opportunity cost are widely understood. ”

    Disagree. I would rather doctors spend more time learning medicine, more engineers learning engineering, than have them clogging up their time and brain with finance. Adam Smith dicusses this, we should all specialise to our optimum by divesting everything else.

    More emphasis needs to be on punitive treatment for inappropriate behaviour.

    I recent times, i see no reason why the death penalty shouldn’t be considered for people like Emmanuel Cassimitis. The message should be ‘You may obtain ill-gotten gain by fraudulent means, but it won’t do you any good, you won’t be alive to enjoy it’.

    There will always be a big enough deterrence to make professionals behave appropriately, and we need to reach those thresholds.

    “Eliminate non-performance asset based fees for active fund managers. Only Index ETF’s/passive managed funds should be allowed to charge such a fee, based on administration costs. ”

    Hmm, in a zero sum game, who will then pay for this?

    Passive funds will consitute nothing but Beta, for every Alpha, there needs to be a corresponding with a negative Alpha.

    Now as overwhelmingly it’s about institutionals, and we can rely on individuals to make up the negative side of the equation, you’ll prune participants every year because of the ‘zero return’.

    Unless analysts/managers live off their fund distributions. You’ll end up then with very few particpants,with VERY large AUM who will be satisfied with the flat admin fee and will hover around the a ‘nth degree’ above the watermark, and kill innovation.

    New participants will likely be extreme in their risk seeking just to capture Alpha, otherwise the reward won’t be sufficient.

    • Sorry, ‘we can’t rely on individuals to make up the negative side of the equation,’

    • Not sure what Adam Smith said, but I don’t agree with your premise regarding specialisation: that’s for insects.

      We should all have a rounded education, personal finance being one of many subjects as well as religion, history, philosophy and ethics.

      Doctors, engineers and others should also have this background education, not just financiers.

      • “Not sure what Adam Smith said, but I don’t agree with your premise regarding specialisation: that’s for insects.”

        We all specialise, it’s just the degree that varies.

        “We should all have a rounded education, personal finance being one of many subjects as well as religion, history, philosophy and ethics. ”

        That’s subjective and can never be resolved. People can add a case for adding music, literature, mathematics, etc, etc. It’s a never ending list to what we ‘should’ know.

        I would rather a doctor focus on being the best doctor s/he can be, rather than dedicating time calculating his portfolio return and its tax implications.

        A trusted person employed to affect this side of their finances I believe is much more effective.

      • You miss my point Rusty – we are talking about a general, rounded education (i.e provided at primary and secondary level) not later for specialisation as a profession.

        The point raised by many here was that the general public – including the doctors and engineers – do not have a very good basic understanding of finance.

        Similarly, most of the public do not understand the basics of history, philosophy and religion.

        • My 3 cents…It is hard for secondary school students to understand Finance which is why it is not taught before university. Instead basic economics is taught which is pretty much useless unless you want to talk about Adam Smith and his invisible hand (but I guess Econonmics is better than forcing us to waste time learning music since I could not sing).

          When I was studying in New Zealand there was some basic accounting taught. I never even had that option here in Australia in High school.

          To understand how to read financial statements and understand all the ratios, trends etc, needs a developed mind. Unless you did 4 unit maths in High school (NSW) which is a minor percent of the high school population, I would say anything less would be insufficient intelligence to comprehend the finance concepts. With finance it is really all or nothing, you cannot just learn part of the theory.

          That is why it is only available at university level as part of a degree or at TAFE as part of a diploma.

          I know some of my friends who did engineering at Uni subsequently do a post grad MBA which had the finance and accounting subject requirements but for Doctors, usually they are too busy to manage their own finance and the cost of an accountant/financial advisor is peanuts to them.

          Time is money, and unless you want your kids not to have a life and follow the Asian model of education, they cannot be too “well-rounded” ie you want them having piano and language lessons all Saturday and tutoring /coaching all Sunday. I guess if you want to read the sunday paper and research investments without having to spend quality time with them, this is actually a good alternative ps Being able to think on your feet under pressure imo is better than a well rounded education.

  10. Prince — Excellent post, and so comprehensive that I don’t know what to write about now in my follow up 😉

    Have you read any of Alexander Ineichen’s stuff? He is the absolute returns guru as far as I am concerned…

  11. Thanks RA. 😀

    Ah yes, the Alpha male – I’ve got his books on my to-do read list, but very interested in the asymmetry trading style.

    My anti-hero is Hugh Hendry – he seems to be doing it for the sh%ts and giggles more than just the money. Its the intellectual challenge of working out all the different pieces – history, economics, politics, high finance, philosophy. Ahhhh…

    One day I want to move into A.B.C investing – Asymmetric, Black Swan, Contrarian – the ultimate 3D chess puzzle.

  12. Sensational article…. Being a former ( now reformed “boutique”FP) I could never find a true ARM ( oops not US Loan type!!) and therefore was always looking for a method of adding value …. the problem is that index hugging EFT’s will give a much better return for most investors ( albeit the fees mean that it cannot actually match the index)…. the other issue is that the “research and Ratings houses ” require that a tracking error be within a certain range to get the approval tick…. this leads to mediocrity as the marketing of the Industry relies on the “ranking and Rating System” for survival…. the largess of the BDM’s in the funds industry comes at a price to the Retail consumer.

    Go for the new model….. I particularly like the RRR and skin in the game… but I believe the minimum should be 50% of investable assets of the Manager( including those of the immediate family and any funds over which the manager has “a controlling interest or vested interest”… and be audited (externally) to verify this annually as part of the audit of the fund… the percentage published….. now that would be putting your money where your mouth is!!! ( and of course could be a great marketing tool especially if the manager had most ( not just the minimum) of the assets in the fund.

    • Thanks Macrobear – its very true regarding Morningstar and the like. It’s very hard – nearly impossible – to get absolute return or other non-mainstream funds put on your APL (approved product list), even if you are a boutique (although I believe the AOIFM has set up a different method of approving products – hopefully it doesn’t mean more agribusiness MIS)…..

      Lorax is right, both Q Continuum (Tim, my business partner) and I have most of our non-super wealth in our business – which is why we treat it like a business.

      If it wasn’t for the 5% in-house asset rule in super, I’d have all of my super in there as well.

  13. John Geering, RIA

    “Spot On” john cage for saying on April 6, 2011 that ” Our Super industry is a wealth transfer scheme, where financial managers are earning fortune on the expense of ordinary peoples’ future.”

    Instead of mediocre mutual funds and asset managers “chasing alpha”, why not place 10%, for examole, of investible liquid assest with our Canadian boutique FX trading firm, which provided clients with an 8.35% MONTHLY return for 2010, compounded = a 125.93% return !

  14. SuperBamboozled

    Gen X Fiz? I wonder if this is me? This is stunning reading, and informative. It tells me what is wrong with the current system…What it doesn’t do is help an econo-numpty (ie me) to try to apply some of this information to their own Superannuation. I’m a 30 something trying to consolidate a sizeable sum spread across 4 funds into something that resembles a reasonable super bet (and at the moment it sure feels like I am simply making a bet on which horse to back – what I need to know is how to read the form!). At the most basic level I have 2 lots of dosh in corporate funds (but from what I can gather one of those is actually a corporate plan within a retail fund?) one in a government fund and one in what I think is retail. If reveiwing the ratings tables is only going to tell me how these institutions are performing against a flawed index, then what sort of questions SHOULD I be asking the respective funds to get an answer that will assist me to make an empowered (and hopefully profitable) choice? For example can I ask whether they made an absolute rate of return on the capital invested over the last 5 years? If I do will they give me that information, or can they be compelled to? As a rank industry outsider – how does one go about identifying an option that will make a real rate of return, without having to go down the SMSF path? I really don’t have the financial savvy (or to be frank the inclination) to go there.At this stage I think this means I need to see a financial planner, but that leaves me feeling like I will be swimming with hungry pirhanas! What sort of questions should I be asking a Financial Planner to avoid the commission trap, and to be able to make a discerning choice about their abilities to best represent my interests? Or is it simply a case of ‘if you want something done properly get financially and economically literate and go do it yourself’? Any hints / tips, recommended reading from what is clearly a well informed mob?