Pre-script: I’m reposting a series of posts from a few years back on Unit Trusts. There are four. This is the third.
So to briefly recap, after spending a bit of time analysing your risk tolerance, you’ve decided on where you place yourself in the Unit Trust universe. And having placed yourself in the right risk category, you now have to pick an investing house. But before I address the factors that should influence your decision, I need to give you a background to some terminology.
Let me start with: Finance Houses are almost all active investors…
Active Versus Passive Investing
Unit Trusts are into active investing because that’s where the money is. But this is best explained by starting with passive investing (ironically).
Here’s a chart of the S&P 500:
A passive-style investment fund would try to give you the same return of a particular market index (like the S&P 500, or the Nasdaq, or the JSE All Share Index). And this is a relatively simple process – you don’t need a fund manager and a team of analysts: you just need a computer and a trading program.
The trading program/algorithm regularly checks that the proportion of investments in the fund are similar to the proportion of shares contained in the index. And when it’s out of whack, the trading program does some buying and selling to “rebalance” the portfolio. It’s not perfect (in order to “replicate” the index, the fund would have to own all the shares in the market), but it comes pretty close.
So a passive-style investment fund, which has no fees other than trading costs and possibly a small management administration fee, will deliver the “market return”.
Then along comes an active fund manager, and he says to you:
“I can do better than the market. Here’s the deal: give me your money, I’ll invest it, and when I do better, I’ll take a bit of the outperformance (my performance fee). Obviously, the administration fee will be higher than a passive fund’s administration fee. But unfortunately, I need to have a team of analysts, and I need to have a salary while I’m waiting for my investments to pay off.”
That’s the definition of active investing: trying to give you a return greater than the market return. That is:
- Passive investing: aims to give you the market return.
- Active investing: aims to give you better than the market return.
Here’s that idea as an equation:
Total Return = α + Market Return
That “α” or “alpha” is the extra return given to you by the fund manager. He does this by taking on a bit more risk in some areas (higher risk, higher return!) – not always dramatically, just where he/she believes that the extra return relative to the extra risk is “cheap” (in risk terms).
Now obviously, that alpha can be negative (when the fund manager fails to do better than the market). And odds are, it’ll be negative half the time (it’s the part that everyone forgets: if you have every single fund manager trying to beat the market return – they’re all competing with each other; so in order for one to win, another must lose!).
But the goal is to get the alpha positive for most periods (ie. it’s positive over time). So in finance jargon, we’d say that a fund manager is awesome when his track record has a positive rolling alpha.
So let’s go back to the S&P 500 example:
- It opened a year ago at about 1,310
- It sits today at 1,640
- That makes for a return of 25.19% for the year.
In this situation, an American Unit Trust fund manager would be saying to you “25.19%? Ha ha ha – I could totes do better than that.” And a really good fund manager would. It’s just, you know, not always that easy to tell if they’re good before you give them your money.
Also – it’s not just a simple case of the fund manager managing to get a return higher than 25.19% – he has to generate that return after he’s deducted his fees.
Which brings me to:
Fees: the All Important
- Management Fees
- Performance Fees
These are intended to cover the costs of administering the Unit Trust Fund. These would include things like:
- the cost of the Unit Trust Call Centre
- the accounting fees relating to the fund and fund reporting
- the fund manager’s salary
- the salary for the analysts that work on identifying opportunities for the fund
- compliance costs (Unit Trust are quite heavily regulated)
- overheads (the fund offices, computers, Bloomberg subscriptions, etc)
- transaction costs from trading
- audit fees
So you’ll be charged an annual “AUM fee” – meaning that a small percentage of the Assets Under Management (AUM) gets deducted each year toward covering the costs of administration. It’s typically quite small: 2% or less. But basically, +/- 2% of your money each year will automatically be lost in fees.
It’s not that unreasonable though – have a look at your bank statement and see how much of your bank balance you lose each year to bank charges…
The argument is: if the Unit Trust Fund outperforms the market (represented by a “benchmark return” – such as the S&P 500, or some similar index for the type of unit trust you invest in), then the Finance House should get a share of some of that outperformance.
For example, let’s say that the American Unit Trust Manager from the example above manages to earn you a 30% return. His “outperformance” is therefore 30% – 25% = 5%. So if his performance fee is set at 20% of the outperformance, then he’ll take an extra 1% (20% of 5% outperformance) as a performance fee.
Again – this seems pretty reasonable. Of course, it does mean that if a fund tanks really badly in one year, and then does really well in the next year – it’s going to be earning a performance fee for just recovering from its bad year. But this is usually addressed by some kind of mechanism whereby a fund will only charge performance fees when its overall return since inception is higher than the benchmark’s return since the same date (known as a “high watermark” clause).
Some Conclusions about Active Investing
What all this should tell you is that an active investing fund manager has to achieve the following return:
minimum required return = management fee + performance fee + market return
And that has to be consistent over time. The empirical evidence says that active fund managers, on average, don’t achieve that over time – and that it makes more sense to invest in a passive fund.
That seems intuitively true as well: as I pointed out earlier, if you have fund managers vying with each other to beat the market return, and the market return is determined by the average outcome of their trades with each other, then only half the fund managers can win.
However – that is not to say that some fund managers aren’t more skilled at winning most of the time.
The trouble is finding them.