Why The Big Funds Underperform

The press are carrying articles today talking about the performance of the biggest Super Funds. Here are the biggest 20 funds by size showing the size, number of Members, average balance and growth in member numbers or otherwise. I know there is this generally accepted view that fund managers always underperform and if you look in the Herald Sun today (or the Money Magazine at any time) you will see the performance of some of these big boring low imagination Industry and non-Industry Super Funds. The median performance was up 7% in the last year, and as expected, the performance is below the total return from the All Ordinaries (includes dividends) of around 11% over the last financial year because most of them are balanced funds (don’t just hold equities). In a bull market for equities all balanced funds should underperform and should outperform in a bear market (because the fixed interest and cash outperforms when equities are falling). The top performing large funds have come in with a return of +8-9%. The worst large fund performance was +4.3%. That’s the big funds. They are so large ($145 billion for Australian Super) that their job is not to actively manage an equity portfolio and outperform, their main function is to provide access to a mixture of asset classes including cash, bonds, international shares, Australian shares, property (REITs mostly) and by virtue of the fact that they have billions to invest they are in the game of delivering the average return from all asset classes not extraordinary returns…less fees. So of course, if the game is to deliver the average return less fees, almost all of them underperform the equity market, particularly in a bull market. But don’t let that dismay you, that is the deal, you pay your fees and they’ll deliver the average return from each asset class in whatever mix you choose, and for those fees you don’t have any investment responsibilities, you can lead a life of leisure. All you have to do is open an envelope once a year (or log into your website 24/7) and see your performance less fees. All your days, evenings and weekends are yours, investment stress free. Not a bad deal in my humble opinion, although there is one condition, and the funds know this, and it is their mantra – the average performance is OK whatever it is, but just DO NOT @#$% up. I spoke to the trustee of one of the large industry funds last year and his casual comment was that the market had been up 12% last year (financial year 2018/2019) and that his fund had been up 8% and that he reckoned that was OK. 12% less fees in a balanced fund (not all equities)…8% is about right. The point being that the big funds expect to underperform, it is acceptable, just so long as they don’t underperform by a lot. Now this may seem unsatisfactory to you, but let me tell you, the equity market return, which the media uses to set your expectations for your investment returns each year, is a very tough benchmark for you or a fund manager to match in a bull market. Let alone an index like the All Ordinaries Total Return portfolio that effortlessly, and in theory only, compounds all dividends, and effects index component changes without costs…that’s close to impossible to match. But this is the benchmark for most people’s expectations below which lurks nothing but dissatisfaction for the engaged investor. So the message to you is to lower your sights a bit, fund managers are bound to underperform the All Ordinaries Total Return Index, for the following reasons:

• Because they are not 100% invested in equities – the moment a fund (a balanced fund for instance) is not 100% fully invested in equities, they will underperform the equity indices in a bull market (they should outperform in a bear market).
• Because they hold some cash - The moment a fund manager holds a dollar of cash they are no longer fully invested in equities and will underperform the equity indices in a bull market (they should outperform in a bear market). Wilson Asset Management, for instance, will tell you that over the journey they have held around 30% cash at all times. If so they will underperform by 0.3% every time the equity market goes up 1%.
• Beacuse they don't perfectly compound dividends at no cost - If fund managers do not perfectly compound dividends without any costs, they will depart from the index. Almost none of them can/do.
• Because they don't perfectly replicate the index changes at no cost - If fund managers do not perfectly replicate the changes in the index stocks without any costs at all, they will depart from the index. It is impossible to do without cost.
• Because they have dealing costs - If fund managers have any dealing costs at all, they will underperform.
• Because they charge fees - If a fund manager charges you a fee, they will underperform.

The bottom line it is almost impossible for a fund manager to perform in line with a total return index, it is a wonder so many allow themselves to be benchmarked to one and why so many new funds now don't - some laughably now benchmark their equity funds to the RBA cash rate...hilarious...and pay themselves an outperformance fee on that...staggering. Next I’ll look at Listed Investment Companies – you will be astonished at their performance. SO WHY NOT BUY AN ETF The immediate response to this is that the STW ASX 200 Exchange Trade Fund (Click here for details) performs in line with the ASX 200 total return index so why not just invest in that? And here’s the proof…it does – the orange line is the SPDR ASX 200 Exchange Traded Fund over the last ten years compared to the All Ordinaries (not ASX 200 but close) Total Return Index. Its smack on (before fees – management costs are 0.19% pa). This is the performance off the STW website: “Total returns reflect combined capital growth and distribution performance assuming all distributions are reinvested; and are shown net of fees. Distributions are assumed to be reinvested under the Dividend Reinvestment Program (DRP). Fund returns do not reflect the brokerage fees or the bid/ask spread that investors pay to buy and sell ETF securities on the Australian Securities Exchange. Investment return and principal value will fluctuate, so you may have a gain or loss when units are sold. Current performance may be higher or lower than that quoted. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.” So why wouldn’t you just invest in this instead of a big balanced fund? The answer is that you could (or a similar ETF – there is a list here). People like you have put $3.8bn into this fund so someone likes it. But the difference is that the performance shown in the chart does not include paying out dividends. The default option with this ETF is that all dividends are reinvested in the ETF and the performance of the ETF assumes that. You can elect to take cash dividends – there are four dividends a year with the last four dividends paying around 4.74% plus (@80%) franking bringing it up to 6.3%, but then the performance of the ETF will be the same as the ASX 200 non accumulation index. Things you need to know about this ETF:

• This ETF is “aggressive” in normal investment parlance. It is 100% invested in equities. It is invested in one asset class. You are at the mercy of the equity market, which can be volatile and can have ‘moments’.
• It is a bull market only investment. When the market falls over, you will wear it 100%. So you could probably trade this and try and catch the bull market bits and sell in the bear markets which is easier said that done but a lot easier than buying and selling a portfolio of 20 plus stocks. You might make one trade every ten years, or five a year, either way, it would be a lot less hassle than stocks.
• If you take the dividends rather than reinvest them then STW will not achieve the same compounding return in the chart above.
• If you want income you can get a higher yield elsewhere and this yield is not fully franked.
• There are still fees, the performance numbers are before fees, but they are lowish at 0.19%.

For some of you not in retirement, investing your Super in something like STW might well be an option – you’ll certainly do better in a bull market being fully invested, and if you don’t take the dividends it does a good job of compounding them for you and turning them into capital.