Managed funds' sweet & sour

In reviewing managed funds it is important to go right back to the basics and cover some rudimentary points.

Index funds

Index funds provide the most effective way to get exposure to an asset class. An index fund replicates the index by physically holding direct investments or may use derivatives, and is able to re-weight to index changes quickly. Each year the performance of the index fund will be similar to that of the index minus whatever management fee the index fund is charging.

What you are obtaining by investing in an index fund is a guarantee. The guarantee provides very important security as you will never underperform the index by more than the management fee, however you will never outperform it either. There are not many guarantees with investing, so get onto this one!

Note: Index fund fees should be low '” less than 0.7% per annum, because they do not have the same cost structure as active managed funds and do not pay for researchers and expensive fund managers. They simply follow the index.

What are managed funds?

Managed funds are pooled investment vehicles similar to that of index funds; however they have active management. That is, they are managed by an individual or a team that decides what to buy and what to sell, normally with the goal of outperforming the index by a margin, or using industry speak, to add “alpha”.

When evaluating the success of any managed fund it is important to understand the performance of the index. However, we can take this further because you can’t actually invest into an index; you need to invest into a fund that follows the index. So we will use Vanguard’s range of wholesale index funds as our measuring stick. We are sure many of you are saying, 'What about ETFs, or other lower-cost types of index funds?’ All these are valid points; however, given that Vanguard is the biggest in the world, and its founder, John C. Bogle, was the grandfather of indexing, we think it is appropriate to use their funds.

Here are some common questions you should ask as an investor before investing into a managed fund.

What is the difference between wholesale and retail managed fund? Retail managed funds are designed to cater for individual investors with minimum investment amounts ranging from $1000; some offer regular savings plan options. Wholesale managed funds are designed to cater for professional investors with significantly higher minimum investment amounts, typically in excess of $25,000, per fund. The fees charged by a wholesale fund are usually lower than a retail fund, however the investment strategy applied by a manager to retail and wholesale funds is normally the same.

What is an MER? The management expense ratio (MER) is a measure of the ongoing fees and charges payable expressed as a percentage. This allows investors to compare the fees between various managed fund investments. This ranges from index funds at about 0.5% pa to some very costly hedge funds at 4% pa.

What are entry and exit fees? Some funds charge entry fees as a percentage of the amount invested. These are normally retail-based funds and the fees are deducted from the initial capital invested in the fund. Wholesale funds typically don’t charge entry or exit fees. Some managed fund investments attract an exit fee on withdrawals. This may be a percentage of the money withdrawn or a flat fee. (Tip: Try to never pay entry fees).

What is a Buy/Sell Spread? When an investor buys or sells units in a fund, the investment manager trades the underlying assets of that fund to either invest the money or provide cash for the withdrawal. This trading generates transaction costs, such as brokerage, which are paid for by the fund. The buy/sell spread is the difference between a fund’s entry price and exit price and is a cost incurred by investors each time they invest or withdraw funds. The buy/sell spread is retained by the fund and contributes towards the transaction costs associated with the fund buying or selling assets. The spread ensures that those investors joining or leaving the fund contribute towards these transaction costs and other investors who are not joining or leaving at that particular time are not disadvantaged. A buy/sell spread is expressed as a percentage of the net value of the fund’s assets.

How can I withdraw my money and how long does it take? To withdraw capital from a managed fund you need to provide a request in writing to the fund. The fund will take the withdrawal price as at the day they receive the request, and the funds will be paid to you within seven to 14 working days. Note that some funds only do withdrawals on a monthly basis so the time frame will be longer.

What are distributions? Managed funds make regular payments to unit holders in the form of distributions. A single distribution payment is generally a combination of:

• Income: Earnings made by a fund's investments in the form of interest (from cash or bonds), rent (from property) or dividends (from shares).
• Realised capital: Money made when the value of one of the fund's investments has risen and is subsequently sold for profit offset by any realised losses.
• Currency gains: Gains that are the result of currency fluctuations relative to the Australian dollar (in the case of funds with international assets). Tax credits such as franking credits and foreign tax credits can also be included in the distribution.

Why does the unit price go down after a distribution? The income that is distributed to investors accumulates in each fund’s unit price. Once the distribution has been paid, the ex-unit price (the after-distribution unit price) drops by the cash amount of the distribution. For example, if the distribution unit price was $1 and the cash distribution 5¢ per unit, the ex-distribution unit price would be 95¢.

OK, we have some of the basics out of the way. Let’s now look at the managed funds that performed the best over 2005-06.

The Australian sharemarket returned 23.93% (ASX S&P 200) over the period, bringing together three fantastic years on the Australian market, with an average return of 23.94%. Growth managers appear highly in the top 10 performers, Fidelity Australian Equities fund topping the list, closely followed by Dean Fergie’s boutique outfit in Opis Capital. It is interesting to see BT Funds Management back near the top. After the dreadful period in 1999-2000-2001, their five-year return looks very impressive against the benchmark. Also of interest is that Perpetual is ranked sixth, even though it is a value-based manager.

It has been proven that a larger percentage of small companies funds compared to their larger share fund cousins can outperform their relative indexes on a regular basis. However, the S&P/ASX Small Ords Accumulation Index has been putting up a fight recently, as it’s three-year average return is a huge 26.56% pa. A number of managers have been able to substantially add to this. The Macquarie fund has had a fantastic year, with a return close to 40%. Coming a close second was the Smallco fund, and so it should, because the managers are charging an MER of 2.15% and an outperformance fee on every dollar over zero of 18.64% (that is, 18.64% of investment profits, calculated every six months). Then comes the Ausbil fund, which is actually a mid-cap fund. It should be remembered that not all small companies funds are the same. You can divide this asset class into three: mid caps, (ASX50 to ASX150), small caps (ASX150 to ASX300), and micro caps (ASX300 to ASX 1500). All these three sections of the small-cap universe have slightly different characteristics.

Funds that invest into listed property trust are up against it because five individual stocks '” Westfield Group, Stockland, Macquarie Goodman Group, GPT Group, and Centro Properties Group '” consume nearly two-thirds of the whole index. Outperforming the index (creating alpha) means moving away from these five main holdings and few are willing or prepared to do this. Therefore, in listed property trusts you get returns that are closely linked to the index.

The best performing fund manager of 2005-06, was Colonial First State (CFS), which is ironic as its entire six-person property securities team, including long-serving head Stephen Hayes, was poached by IOOF-owned fund manager Perennial Investment Partners. CFS appointed John Snowden (formerly running the UBS property securities fund) to the manager’s role. John is an exceptional manager and should be able to continue his good management ability.

With interest rates rising over the past three years, bond funds have had a hard time (remember: when interest rates move up, the value of the bond falls) because the three-year return of the index is only 3.32% pa or, if you like, close enough to inflation. Therefore, it is of no surprise that all the funds in the top 10 run a strategy of “inflation-plus” or “bank bill-plus”. This strategy is not affected by interest rates increasing. However, note that when interest rates fall the opposite is true and traditional bond funds will outperform.

Once again, Platinum and Hunter Hall appear very close to the top of the performance tables, which has been a very common sight over the past 10 years. The Hunter Hall Global Ethical Fund returned 31.59% over the 12 months, outperforming the index by nearly 11%. Second is the Hunter Hall Value Growth Trust, which technically shouldn’t be in this list because it holds some Australian shares (15%). Then comes the Zurich fund followed by the two Platinum Asset Management main stream funds. The list shows what quality managers can do. We rate all of the managers on this list very highly.