Manage the risk and get ahead

Managed share funds are pulling in the crowds again.

Unlike last year, more money is flowing into them than is going out, which shows what a forgiving lot we are.

But then there have been some real crowd pleasers too, such as Hyperion's Australian Growth Companies Fund returning 40 per cent in the year to October 31, according to Morningstar.

That's twice as good as the overall market yet it holds just 28 stocks, compared with a fund's usual 50 or more.

It's not alone. More than two-dozen others also proved a good actively managed fund can run rings around a passive or index fund.

Still, index funds, with the advantage of one-third of the fees, will always do better over time than a poor active manager.

In fact, good fund managers will beat a benchmark but not even average ones will, a study by the Australian Prudential Regulation Authority shows.

The trouble is what makes a good fund manager is very hard to tell in advance.

And even if you manage to pick it, there's no guarantee it'll be at the top three or four years away.

On the contrary, it probably won't be.

A case in point is the Prime Value Imputation Fund, which posted a 33 per cent average annual return for five years.

But more recently it has underperformed the market, though not by much.

It can work the other way around, too. History shows one of the poorer-performing funds in one year will be the best the next.

And that can be without lifting a finger. It comes about just by riding the next cycle in the market as the erstwhile best performer drops off.

To put it another way, every dog has its day.

That's why, unfortunately, you can't put too much store on a fund's past performance.

Another complication is gearing. It's no surprise geared share funds have been outperformers since the market bottomed, just as they were laggards in the bear market.

Anyway, even if the returns between an active and an index fund are similar after fees, they may not be after tax.

To be active a fund manager needs to trade, which will incur capital gains tax.

This can create a nasty surprise for unitholders at annual statement time.

You may find a good part of the return for the year has come from short-term capital gains, which are taxed at your marginal rate, or from dividends.

True, that's no big problem at the moment because there's bound to be a bank of realised capital losses after last year that fund managers can draw on.

Even so, a 15 per cent return that turns out to be only a 5 per cent rise in value with the other 10 per cent taxed is hardly going to light your fire.

Yet the better a value manager performs, the higher the hidden tax bill is likely to be.

For an index fund, on the other hand, the tax is low and predictable - usually it'll be whatever dividends are paid.

Mind you, a 40 per cent return that's mostly taxed is still better than 15 per cent untaxed.

By the way, when buying units in an actively managed fund you may well be taking on an embedded capital gains liability that you didn't know about.

But passive or index funds have their problems, too.

Unlike active fund managers who need to watch the bends and bumps ahead, index funds look in the rear-vision mirror.

They have to buy the same stocks, in the same amount, as they appear in the index that's being tracked, even though the fund manager might think the stock is a dog. One consequence is that an Australian share fund would be chock-a-block with banking stocks, which may or may not be a good thing.

And a global index share fund could find itself going down the wrong track altogether.

For example, five years ago it would have invested little in either China or India and so would have missed out on getting in on the cheap at the beginning of their booms.

So if neither form of fund is perfect, what are you supposed to do?

Easy, take the best of each by holding both kinds. Their negative aspects will cancel each other out.

By diversifying both between different markets and types of funds, your investments will be safer.

All right, that still leaves the problem of choosing which funds to purchase and in what proportion.

That depends on the risk you're willing to take and how far out you're looking.

Emerging markets, for example, have been going gangbusters but the returns could be all but wiped out by the strengthening dollar.

Then again, if you're investing for the long term this can be solved by using a managed fund that's hedged, as distinct from a hedge fund, which I'm coming to.

The trick is to mix and match index and active funds.

An index fund will give you a broad, diversified market while an active manager can concentrate on the best opportunities.

Another option is to just buy one of each of the two styles of active funds, value and growth.

While this will give you different fund managers and policies, in such a concentrated market as ours - where it's banks, resources or the bush - the difference isn't going to be all that great.

One year a value fund will do better, the next an active one. But over time there will be little difference.

Mind you, if it's difference you are after, it's difficult to go past a hedge fund, which can short sell.

It's not always a good time to buy stocks and fund managers in traditional funds are hamstrung by the fact they can't short sell stocks that they think will drop.

One hedge fund, the K2 Australian Absolute Return Fund, returned 33 per cent in the year to October and, over the past three years when most funds were dropping in value, it was increasing at an annual rate of 7.5 per cent.

It aims to pass-on most market gains and only one-third of any fall.

So running a hedge fund alongside an index fund would make it much harder to have a year going backwards.

Or it could be a so-called concentrated fund, where the manager invests in no more than 35 stocks at any given moment.

"It's a portfolio of the fund manager's best ideas," says Morningstar's editorial and communications manager, Phillip Gray.

Apart form the Hyperion fund, other concentrated funds include ING's Select Leaders, Zurich Investments's Australian Value Share Fund and the Australian Equity Fund of Fortis Investments.

All out-performed during the bear market despite higher fees.

"On average, high-conviction managers exhibit significantly higher returns than traditional managers," says a research paper by Russell Investment Group.

But a bad concentrated fund will do worse than a bad conventional fund.

Just as you can choose different styles of active funds, the same goes for index funds.

There's the traditional form run by Vanguard and the newer listed versions known as exchange traded funds or ETFs, not to be confused with an ETS.

The beauty of an ETF is it's even cheaper than a traditional index fund and is liquid, so you can get in and out of the investment whenever you want.

In fact you could use an ETF to ride different market cycles by going in and out of them or switching between sectors without having to choose any stocks.

They can be bought and sold just like shares and come in to their own as an easy way of getting into global markets.

A popular strategy for self-managed super funds is to buy an ETF for the ASX100 or ASX200 and then add your own stocks or other managed funds.

There's also a bigger range of ETFs on offer for small investors than traditional index funds since there's no minimum investment.

The three suppliers are State Street, iShares and Vanguard.

They offer products that cover the Australian and world markets.

Fees on ETFs can be as low as the 0.09 per cent charged on Vanguard's VTS, which covers about 97 per cent of all shares in the US, or up to 0.73 per cent on more exotic ones such as the iShares Taiwan index.

The average is about 0.25 per cent compared with the 0.9 per cent average charged by an index fund.

But because you have to pay brokerage to buy units in an ETF, an index fund would be cheaper for making regular instalments and dollar-cost averaging.

Owning several ETFs would be cheaper and safer than actively managed funds; the two Vanguard international funds, VTS and VEU, would give you some 5600 shares in 47 countries with an average management fee of 0.17 per cent a year.

HOW THEY FARED, YEAR TO OCTOBER 31

AUSTRALIAN SHARES

Best Hyperion Australian Growth Companies, 40.4 per cent (Active)

Macquarie Australian Pure Indexed Equities, 22.3 per cent (Passive)

Worst Vanguard Australian Shares Index, 19.1 per cent (Passive)

Manifest Australian Equity Fund, minus 26.8 per cent (Active)

INTERNATIONAL SHARES

Best K2 Select International Absolute Return, 29.4 per cent (Active)

Vanguard International Small Companies, 23.6 per cent (Passive)

Worst Vanguard International Shares, minus 15.3 per cent (Passive)

Legg Mason Global Equity, minus 21.6 per cent (Active)

Source: Morningstar

TRUSTS BACK ON TRACK

LIKE the recession, fire sales by distressed property trusts have been more a fear than a fact.

Instead of selling, they've been writing down property values and raising capital.

The global financial crisis may even have done a small favour for real estate investment trusts (REITs), the renamed listed property trusts.

For their own good it forced them to cut their debts and go back to basics. But it's also prevented construction, so there isn't a glut of new properties to depress prices or rents, or increase vacancy rates.

REITs provide an instant property portfolio, an essential counter-balance to holding shares.

While they're offering yields as good as in their heyday, with some into double digits, this is no thanks to higher distributions.

On the contrary, these have been slashed; it's the plunge in REITs' prices that's bumped up the return.

Most are trading below the already-written-down value of their assets.

"Listed property trusts that were potential sellers last year are now potential buyers," says the head of investments strategy at AMP Capital Investors, Shane Oliver.

Although rising interest rates are bad news for REITs, the critical comparison is the 10-year bond yield, which has fallen slightly in the past couple of months despite the Reserve Bank jacking up the cash rate.

Analysts are predicting 2010 will be a good year for REITs as the market will move on from asset valuations to yields.

Certainly the outlook has improved greatly, especially for retailing REITs such as Westfield and Colonial First State Retail, which have strong balance sheets.

"While demand for industrial space is still soft, the net absorption of office space moved into positive territory in the September quarter, consistent with signs of economic recovery," Oliver says.

Morningstar says asset values are unlikely to drop any further and has upgraded its ratings for some REITs.

Even office property is coming good.

It had been hit by the supply of new space just as banks and other financial companies were downsizing as the credit crisis hit.

The most diversified of the REITs is Stockland, which has commercial, residential and retirement village properties.

At the other extreme are specialist funds covering only aged care, agriculture or hotels.

Dexus and ING Office "are arguably the best value" due to "attractive earnings yields and big discounts to net tangible assets", says an analyst at Morningstar, Adrian Atkins.

As is the case with managed share funds, the best way to reduce the risk is have a portfolio of different REITs.

If you don't want to build one up yourself, there's always Vanguard's Index Australian Property Securities Fund, which invests in 26 listed property securities in retailing, office, industrial, tourism and infrastructure.

It charges 0.9 per cent a year for the first $50,000 invested, then 0.6 per cent for the next $50,000 or 0.35 per cent for more than $100,000.