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July – December 2018

Paying the high price of active management: A new look at unit trust fees

unit trust fees

DC. Janse van Rensburg and Prof Niel Krige

  • OCT 2018
  • Tags Insights, Coaching, existential leadership
17 minutes to read

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DC. Janse van Rensburg and Prof Niel Krige

Are the high fees of actively managed unit trusts acceptable?
All over the world, investors are debating whether actively managed funds provide superior returns net of fees when compared to exchange traded funds (ETFs). It has been shown that numerous actively managed American unit trusts are in fact “closet” index funds which charge fees much higher than that of exchange traded funds tracking the same index. This trend is also evident in South Africa.

Are high fees still justifiable in the case of actively managed unit trusts? What is the true cost of active management?

The cost of active management is termed the active expense ratio. To determine the cost of active management, and using the method described by Ross Miller (2007), a selection of unit trust portfolios were split into a passive component, which is the portion of the portfolio that is equivalent to investing in one or more index-tracking funds, and an active component, which is the portion that is uncorrelated with the benchmark. In addition, by isolating the active component of the unit trust, performance measures such as alpha can be adjusted to determine the effect of active management on performance (termed the active alpha).

Using Miller’s method, the active expense ratio and active alpha can be calculated without any knowledge of the underlying assets in the unit trust portfolio. The approach uses the R2 (R square) of the unit trust (performance variance that can be explained by the benchmark) to determine the active expense ratio and active alpha of the fund. According to Miller, the active expense ratio, as a gauge of fund costs, is a better measurement than the traditional total expense ratio (TER) because the explicit cost of indexed alternatives is recognised.

… numerous actively managed American unit trusts are in fact “closet” index funds which charge fees much higher than that of exchange traded funds tracking the same index

What does the literature say?

Some researchers found that, on average, it is not worthwhile investing in actively managed funds. One study found that systemic risk factors could account for 82% of return variances in US funds over a period of 40 years up to 2003. The high percentage of returns being attributed to indices shows that there is very little room for active management to add value to the portfolios beyond that of market indices.

A number of studies found that the level of active management in portfolios has declined throughout the world. In one South African study, active management declined from 55% to 15% over the period being investigated, with the researchers concluding that there was no evidence of successful active management to justify the higher fees charged by fund managers. The increase in exchange traded fund (ETF) investments has led to a decrease in active share investment. As a result, many unit trusts are now seen as closet index funds. Some studies reported that the level of active management is higher in the developing markets than in the developed world.

In reality, many actively managed unit trusts have returns closely correlated with comparable ETFs, but the fees charged are significantly higher.

A number of studies found that the level of active management in portfolios has declined throughout the world.

How was the study conducted?
This study started off by dividing the fund management expenses of actively managed South African general equity unit trusts into active and passive management portions. This was done to calculate the implicit cost of active management. The active expense ratio of a unit trust can be calculated by using the published total expense ratio (TER) of the unit trust, its correlation relative to its benchmark and the expense ratio of a comparable exchange traded fund (ETF) tracking the benchmark of the unit trust.

This study focused on actively managed South African equity unit trusts available to retail investors for the period March 2007 to February 2015. Unit trusts were included in this study if they had data available for at least 36 months, if at least 80% of their assets were invested in equities, and if they were only sold to individual investors. No fund-of-funds unit trusts were included. The active expense ratios of these unit trusts were calculated on the basis of three-, five- and eight-year analysis periods.

The Association for Savings and Investment South Africa (ASISA, 2015) published data for 841 unit trusts classified as South African unit trusts on 31 December 2014. After applying the criteria listed above, the three-year unit trust sample included 87 unit trusts, the five-year sample 72 unit trusts, and the eight-year sample 52 unit trusts. The unit trusts were classified as either Financial funds, General funds, Industrial funds, Large Cap funds, Mid and Small Cap funds or Resources and Basic Industries funds.

The published fact sheet of each unit trust was sourced from the website of the managing company and scrutinised to obtain the benchmark, TER and inception date of each unit trust. To analyse the performance of the unit trusts, the individual unit trust Net Asset Value (NAV) prices were sourced from the iNet BFA database. The NAV price calculated at the close of business on the last working day of each month was used for unit trust performance calculations.

The month-end NAV prices for each benchmark, corresponding with the date of the unit trust NAV price data, were also sourced from the iNet BFA database. In the case where a benchmark was not a JSE Index, the fund was regressed against the different benchmarks used by the category peers. The JSE Index that produced the highest R2 value was then used as the benchmark for this particular unit trust. The 91-day Treasury Bill rate was used as a proxy for the South African risk-free rate.

The monthly performance of the unit trusts was calculated based on raw percentage returns between the start and end of the month being reviewed. The increase in NAV per unit in the unit trust was then calculated.

It has been argued that unit trusts bundle alpha and beta which, simply stated, means that an actively managed unit trust is a combination of a pure hedge fund (the alpha component) and an index tracking fund (the beta component). The relative size of the alpha and beta components can be estimated by regressing the historical returns of the fund with the historical returns of the benchmark, after subtracting the risk-free rate from both returns. The results of the regression analysis indicate what proportion of the performance of a unit trust can be attributed to passive investment choices and what proportion to the active choices of the unit trust manager.

Through the regression analysis, the coefficient of determination (R2) represents the component of the total returns of the fund that is as a result of index returns. The value given by 1-R2 therefore indicates the returns of the fund as a result of the actively managed component.

The active expense ratio can be calculated by only having access to the values for the coefficient of determination (R2), the TER of the unit trust being evaluated and the TER of the comparable ETF. The active expense ratio increases with both an increase in R2 relative to the benchmark and an increase in the TER of the unit trust. When the cost of investing in an ETF increases, the active expense ratio will decrease.

Similar to the active expense ratio calculation, the active alpha can be calculated by only having access to the values for the coefficient of determination (R2), the alpha of the unit trust being evaluated and the TER of the comparable ETF.

… there was no evidence of successful active management to justify the higher fees charged by fund managers

What did the study find?

The results show that most of the South African unit trust funds have actively managed portions in excess of 30%, or relatively low coefficients of determination when compared to the benchmarks. The exception is the Resources and Basic Industries category, where the R2 value exceeds 90%, indicating a lower actively managed portion in these funds. The Mid and Small Cap category contains the unit trust funds with the highest actively managed portion compared with the rest of the funds classified as Equity funds.

The different unit trust categories have similar mean TERs (sample average of 1,61%), but the active expense ratios differ significantly. The active expense ratios in the three-year analysis range between 1,53% and 8,71%, with a mean of 4,14% and a median of 3,99%. In the five-year analysis the active expense ratios range between 1,69% and 7,39%. The mean is 4,29% and the median 3,96% . The eight-year active expense ratios range between 1,01% and 7,22%, with a mean of 4,25% and a median of 4,28%.

Although the South African actively managed unit trusts have higher published TERs than their American counterparts, the active expense ratios are lower due to a higher degree of active management being employed in South Africa.

The results show that active management contributed positively to the average performance of the funds. The funds in the three-year analysis have active alphas ranging between -2,11% and 3,45%, with a mean of 0,69% and a median of 0,76%. The active alphas in the five-year analysis range between -1,38% and 3,41%. The mean active alpha is 1,09% and the median 1,05%. The eight-year active alphas range between -0,79% and 3,25%, with a mean of 0,93% and median of 0,81%.

The results also indicate that the actively managed portion increased over the past eight years. This is due to the fact that the sample average R2 values decreased from 81,36% over the past eight years to 79,19% over the last five years and 74,64% over the last three years.

However, it should be noted that the increase in active management did not, on average, result in improved unit trust fund performance. This is seen from the overall fund alphas being close to 0% for all the analysis periods. It can be concluded that the unit trust fund managers were hardly able to earn back their fees as reflected in the mean fund alphas.

Although the amount of active management has increased over the eight years, it would appear that the quality of the active management has decreased. This is evident from the results observed in the three-year analysis; a significant number of funds had large negative active alphas, compared to only four funds with negative active alphas in the eight-year analysis. It is also evidenced by the fact that the mean active alpha decreased from 0,93% in the eight-year analysis to 0,69% in the three-year analysis.

Some studies reported that the level of active management is higher in the developing markets than in the developed world.

Impact of fund size

To determine whether fund size had an effect on the degree of active management, the three-, five- and eight-year individual unit trust R2 values were compared with the fund sizes (expressed as total assets under management). The results for all the review periods indicate that the large funds have high R2 values, therefore low active management. Smaller funds provide a higher degree of active management (lower R2 values).

Based on this study, most of the largest South African unit trust funds (over R6 billion of assets under management) have higher active expense ratios than mid-sized unit trust funds. However, there is no direct correlation between fund size and active expense ratios: the smaller funds (less than R100 million) generally also have higher active expense ratios than mid-sized unit trusts.

The largest South African unit trust funds have positive active alphas when compared with the small unit trust funds (which tend to have negative active alphas). The mid-sized unit trust funds have a large spread of active alphas, ranging from -2,0% to 3,5%.

… it should be noted that the increase in active management did not, on average, result in improved unit trust fund performance.

Conclusion

This study used a practical way to calculate the true cost of active portfolio management. This was done by splitting the expenses of an actively managed unit trust into a passive and active portion.

The study showed that the mean total expense ratio (TER) of the sample of actively managed South African equity unit trusts was 1,60%, 1,61% and 1,61% respectively in the case of the three-, five- and eight-year periods of investigation. In contrast, the mean active expense ratios amounted to 4,14%, 4,29% and 4,25% in the case of the three-, five- and eight-year periods of investigation.

These active expense ratios are lower than those obtained in comparable American studies, despite the fact that mean South African TERs are higher than those of the American funds studies. This is due to a higher degree of active management employed in the case of the South African unit trusts.

This study shows that the mean active expense ratio is more than 150% higher than the comparable mean reported TER in each period of investigation. In addition, the mean South African TER of approximately 1,60% compares unfavourably with the comparable American TER of 1,20%. Finally, unit trust managers were hardly able to earn back their fees as reflected in the mean overall fund alphas being close to 0% for all analysis periods.

These facts strengthen the case for investing in ETFs rather than in actively managed South African equity unit trusts.

  • Miller, R. (2007). Measuring the true cost of active management by mutual funds. Journal of Investment Management, 5(1), 29-49.
  • Read the original article here: Janse van Rensburg, C., & Krige, J. D. (2018). Paying the high price of active management: A new look at unit trust fees. Studies in Economics and Econometrics, 42(1), 23-39.
  • Prof Niel Krige lectures in Portfolio Management and International Finance at the University of Stellenbosch Business School.

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