Can active managers outperform the index?

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FPG Research asks can active investment managers outperform the market after tax and expenses, and can they do so on a consistent basis? This is the second part of a paper prepared by Janet McLeod.

Thursday, July 23rd 1998, 12:00AM

by Philip Macalister

The first part of this report concluded that five actively-managed New Zealand equity funds were able to outperform the NZSE30 Gross Index after adjustments for tax and fees, while three passively-managed funds selected for comparative purposes were not able to outperform the index.

 

The second part of this report assesses the performance of the five selected trusts using risk/return, style, and fee analyses.

The five active funds used in this study are the;

• Armstrong Jones New Zealand Share Fund
• National Mutual New Zealand Leaders Trust
• NZ Funds Management New Zealand Equity Trust
• Tower New Zealand Equity Trust
• WestpacTrust NZ Share Index Plus Trust.

The passive funds used in this study are the;

• AMP Investment Tracker Fund
• New Zealand Guardian Trust NZGT30 Fund
• Tower Tortis NZ Fund.
• (To find out why these funds were selected please see the earlier report).

 

Risk/return analysis
Another way to assess the performance of actively-managed funds is to measure the amount of risk taken for the return achieved (risk/return analysis).

There are two types of risk associated with managed funds. One is the product's unique risk, that is, the risk directly associated with the product itself. The impact of this on an investor's portfolio can be minimised through diversification.

The other risk is market risk, sometimes also known as systematic risk. This is the risk associated with investing in the market, and may be influenced by a wide range of economic factors. Market risk is less likely than specific risk to be minimised through diversification.

Table One below shows the measurements of risk for the five selected actively-managed trusts and the NZSE30 Gross Index. Rolling annual returns were used to calculate betas, standard deviations, and the mean returns for the products.

The Sharpe Ratio measures the excess return achieved for each unit of risk taken, where the standard deviation of returns is used as the measure of risk. The Sharpe Ratio therefore looks at the unique risk of the product. The Treynor Ratio measures the systematic or market risk of the product's performance.

Table 1: Selected actively-managed New Zealand equity trusts and NZSE30 Index (Adjusted)
Risk/return measurements

Product	Mean % pa Return	Standard deviation	Beta	Treynor Ratio	Sharpe Ratio
NZ Funds Management	10.65	6.18	0.95	3.12	0.48
Armstrong Jones	10.25	5.62	1.10	2.33	0.46
Tower	9.51	5.21	1.10	1.65	0.35
NZSE30 Gross Index(Adj.)	8.48	6.53	1.00	0.79	0.12
WestpacTrust	6.73	4.87	1.19	Negative	Negative
National Mutual	5.91	5.23	1.16	Negative	Negative

This table shows that negative ratios were calculated for two of the products (NM and Westpac). This means that over this time period, these two managed investments achieved a risk-adjusted performance less than that of the market.

Graph One below illustrates the risk/return performance of the five selected actively-managed investments, and the NZSE30 Gross Index (adjusted for income tax and average ongoing fees). The products' rolling annual returns over the four year period are plotted against the standard deviations (volatility) of the products' returns over the same period.

Graph One: Selected actively-managed New Zealand equity trusts and NZSE30 Gross Index (Adjusted)
Risk/return rolling returns over four years

Graph One shows that all five selected managed investments have taken less risk to achieve their return than the NZSE30 Gross Index over the four years examined. Three of the products (Tower, AJ and NZ Funds) achieved higher returns than the NZSE30 Gross Index, and did so with less volatility (less risk) than the index representing the market as a whole.

A passive managed fund (or in this case, an index) is unable to protect an investor from the market. By its very nature, passive or index investment means that the investor is exposed to the full risk of investing in the market (market risk). This means that the passive investor's returns reflect all the highs and lows of the market's performance.

Style analysis
It could be argued that performance relative to the NZSE30 Gross Index is not necessarily the best way to establish the performance of these managed funds. It is generally agreed that over 90 percent of investment return is determined by the asset allocation of a portfolio.

Boustridge and Young (1996) carried out investment style analysis on a number of New Zealand managed funds. Their conclusions were that very few active investment managers were able to add value to their products' total and risk-adjusted returns.

Gronweller, Rose & McLeod (1997) carried out style analysis on New Zealand equity unit trusts, and showed that only five out of 18 selected products were able to produce positive alphas over the three year period measured.

Three of the actively-managed investments analysed in this article (AJ, NZ Funds and Tower products) were able to produce positive alphas. This indicates that these three products were able to outperform their individual style indices as well as the NZSE30 Gross Index.

Fee analysis
Sharpe (1991) advises that an investor should look at three things when selecting an actively-managed investment: the product's expense ratio, its turnover rate, and some measure of past performance. Sharpe goes on to state that if he had to look at only one aspect, he would choose the expense ratio.

Entry fees for equity unit trusts generally range between three and six percent. This is not, however, necessarily what the investor is charged. These fees are often negotiable and may be rebated back to the investor.

Ongoing fees fall into two categories. The first is those which are charged against the investment pool on a regular basis (such as the management fee and the trustee fee). Other expenses such as audit fees, legal fees, and marketing and distribution expenses are also often paid directly from the investment.

The management expense ratio takes all expenses and fees into account, and is probably the most effective measure of a managed fund company's efficiency when comparing relative costs between different managed investments.

Table Three below summarises the fees and expenses for the five selected actively-managed equity trusts and the three passively-managed trusts at the time the analysis was undertaken.

Table 3: Selected actively-managed and passively-managed New Zealand equity trusts
Fees and charges at 30 April 1998 (A=active, P=passive)

Product	Entry fee %	Ongoing mgmt fee % p.a.	Ongoing trustee fee % p.a	MER1% p.a.
Armstrong Jones NZ Share Fund (A)	5.0	1.5	0.08	1.80
National Mutual NZ Leaders Trust (A)	5.0	1.5	0.10	1.152
NZ Funds Management NZ Equity Trust (A)	6.0	1.5	0.10	1.65
Tower NZ Equity Trust (A)	5.5	1.5	0.10	1.102
WestpacTrust NZ Share Index Plus (A)	5.0	1.25	0.10	1.152
AMP Investment Tracker Fund (P)	6.0	0.75	0.03	N.Av
NZ Guardian Trust NZGT30 Fund (P)	5.5	0.75	0.00	N.Av
Tower Tortis NZ Fund (P)	5.5	0.75	0.07	N.Av

^{1 MERs are calculated to the managed investment company's financial year end. Those shown are at 30 April 1998 (latest available).
2 MERs are lower than management and trustee fees combined, as fees are negotiable for larger investments.}

This table shows that there was little or no difference between the entry fees for the active and passively-managed funds. If anything, the entry fees for the passive investments were on average higher than those for the actively-managed products. (MERs were not available for the selected passively-managed investments, due to their shorter performance histories).

Ongoing fees for active funds are generally higher than those for passively-managed investments. This is due to the costs of active investment management which include transaction costs, extra overheads, and research.

When data on MERs for New Zealand passively-managed funds is available, it will be interesting to assess the costs of managing a passive investment in New Zealand relative to the United States, where passive management fees range from less than 0.25 percent to more than two percent.

Conclusion
Three of the five selected actively-managed funds, the New Zealand Funds Management New Zealand Equity Trust, Armstrong Jones New Zealand Share Fund and the Tower New Zealand Equity Trust, consistently outperformed the market as represented by the NZSE30 Gross Index over the four years examined by total returns and risk-adjusted return.

Style analysis revealed that these three managed funds were also able to outperform their individual style indices as well as the NZSE30 Gross Index, while fee analysis showed that the passive managed funds selected did not charge lower fees than the actively-managed products.

This article is not an investment recommendation. Past performance is not necessarily an indicator of future outcomes.

*Denotes a non-annualised return.

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