Beware of index share funds posturing as active managers

There has been a lot written about how the fees paid by Australian investors to fund managers are a lot higher than other countries. This includes not only individual investors but also the fees paid by SMSFs. The recent increase in the price of an ASX listed share highlights how these excess fees are being charged and compounds the problem.

Fund managers are divided into two types, active and passive. Active managers are meant to make decisions based on the investment worthiness of a company, and thus charge higher fees, due to the work involved in selecting companies to invest in.

An index manager buys a share index, such as the ASX top 100, and effectively replicates that index. As they are not employing highly paid analysts to research stocks looking for what will produce the best return, their fees are considerably less than active managers.

Active managers are meant to invest according to mandates they set. These mandates can include a sector of the sharemarket, such as the ASX top 100 or the small ordinaries index, and also set other parameters such as investing for dividend yield or capital growth.

In many cases active fund managers not only have a standard administration fee but they can also have performance fees. Performance fees tend to apply once the manager has exceeded a certain benchmark and reduce the investor's returns even further by higher charges.

The problem is many fund managers describe themselves as active but in actual fact make many decisions as to whether they buy or sell a share based not on whether they believe the share is going to increase in value, but on a company having changed its position in a share index.

A possible example of this was the movement in the share price of Seek several weeks ago. In a radio sharemarket update the presenter announced that one of the big movers of the day was Seek. The possible reason given for the large increase was it had entered an index.

Many so-called active fund managers try to manage their business risk by not deviating too far from the share index that their investment mandate specifies and make decisions on buying or selling shares as a result of movements in that index.

If, as the presenter hypothesised, Seek had entered the ASX top 100 this could have resulted in fund managers buying this company due to its changed share index rating forcing up the price. Investors in Australian managed share funds, either as individual investors or through an SMSF, who do not want to pay higher fees for an index share fund masquerading as an active manager need to look for two things.

The first is whether the investment mandate is set too narrowly, such as the ASX top 100 or ASX top 200. In this situation the ability for the manager to make investment decisions based purely on maximising their investors' returns will be greatly limited, and it is probably best to go with an index fund.

The second thing to look for is what the top 10 company shareholdings are for a fund. If the top 10 shares fund are very close to the top 10 shares in the index the investment mandate has set, by not only what share is in the fund but the percentage holding within the fund, this is a bad sign. In many cases this will indicate that this manager is more concerned with hugging index benchmarks than maximising investor's returns.