Fund Companies Behaving Badly

Much as we would like to think investment houses consisted of a bunch of deadly serious security analysts and portfolio managers spending all their time zealously looking out for the interests of the investors, this is not the case. Like any other business, fund management companies need to spend time and money promoting themselves and their capabilities.

The trouble starts when the tail starts to wag the dog. The best firms strike a good balance by focusing on delivering results for investors and using their marketing to call attention to their strengths in a responsible way. At the other extreme, the marketers run the show—these firms tend to roll out new funds in hot asset classes and advertise their best short-term results loudly, even though they know it has little bearing on the quality of the investment (Tip of the day: Next time you see an ad for one-year returns, run in the other direction).

A few such tactics have caught our attention recently in the UK, and not in a good way:

Emphasising Short-Term Performance
Focus on short-term results is a signal that something isn’t right. Any investor worth his or her salt knows that short-term results are about as meaningful for predicting future performance as what a fund manager eats for breakfast--that is, not useful at all. By and large, fund companies in the UK do a good job of emphasising longer-term returns, but this isn’t always the case.

One recent case-in-point concerns Neptune, which raised our eyebrows a bit with a press release hyping the strong one-year returns of its Russia and Greater China funds. The release is posted prominently on its web site for private investors, with the following headline: “Top Performance in 2006 by Neptune Russia & Greater Russia and Neptune China”. It goes on to say that out of all funds across IMA sectors, the two funds mentioned were the top- and second-ranked performers, and cites their high absolute returns. One-year returns tell investors next to nothing about management skill or the possibility of outperformance, and it’s entirely inappropriate to compare the funds to anything but similarly focused offerings. In fact, Neptune’s Russia & Greater Russia fund was one of the worst performing funds in the Morningstar Russia Equity category in 2005. Just as we wouldn’t condemn it for that, we certainly wouldn’t invest in it based on its big 2006 return.

Neptune is not alone in this, either: A recent ad for Scottish Widows Investment Partnership’s property funds carried a headline regarding one offering’s 45% one-year return. The ad carried the required disclaimer that past performance is not a guide to future performance, but if this is the case (and it is), then why is SWIP pushing a one-year return? Even a recent release from the usually very responsible Fidelity pushed the fourth quarter performance of its new Global Special Situations fund—a meaningless period if there ever was one.

Risk, What Risk?
In a more general vein, far too many fund ads in the UK emphasise past returns without discussing much, if anything, else. Given that past returns in isolation are a poor predictor of future results, this strikes us as questionable at best. Some disclosure of cost rankings would be nice—or perhaps even competition on that basis. A clear discussion of the risks involved in a particular investment, the experience of the manager running the fund, and general portfolio characteristics might also be helpful. In fact, the Neptune release above doesn’t even mention risk, despite the exceedingly volatile nature of the markets of focus for the two funds mentioned. Presumably, something like, “These funds are amazingly risky and you shouldn’t put any money in them you can’t afford to lose,” wasn’t quite as catchy. SWIP also falls down on the risk front, merely referring investors to the fund’s prospectus for a discussion of risk.

Yield, yield, yield . . .
Again, this is something that many fund houses do, but that doesn’t make it right. You can look in almost fund-related publication and find ads for income funds that hype yield at the expense of almost everything else. Buying a fund on yield alone is just asking for trouble—first, if a fund’s manager isn’t up to the job, the fund’s total returns may be poor, and your capital growth can suffer immensely over time. Second, there is no free lunch, and if funds—particularly fixed interest offerings--are generating materially higher levels of income than a relevant peer group, they are probably taking on more risk to do it.

Trend du Jour
You can spot this one easily. Responsible fund companies offer funds in an area they think represents a good long-term investment opportunity, and where they have meaningful value to add. However, others focus more on gathering assets simply by rolling out funds in hot asset classes. In 1999 and early 2000, these types of firms rolled out technology and internet funds. In the UK presently, we’d be sceptical of anyone just getting around to launching a China fund, Russia fund, or a property fund (sadly, the trade magazines for financial advisers are chock full of ads for new property funds currently). Unless it’s a firm with a deep, specialist knowledge in the area, coming out with these kinds of offerings after huge multi-year runs smacks of nothing so much as a naked grab for assets.

Benchmark Games
Fund companies often provide a benchmark against which investors can compare the fund’s performance. This can be more or less useful, depending on the relevance of the benchmark selected. There, is however, plenty of room for fund companies to try to make themselves look better. One recent example is provided by HSBC. The firm runs an S&P 500 tracker called HSBC American Index. The 30 November fact sheet for the fund states that its tracking error over the past three years is 0.19% on an annualised basis. The performance section of the sheet also shows the fund tracking the index nicely over the past three years, up 16% on a cumulative basis, or slightly better than the index’s 15.7% return.

So what’s not to like - after all, the tracker is beating its index, right? Plenty, as it turns out. First, the index being used is the S&P 500, but the index returns printed on the fact sheet are much lower than that index’s total returns (i.e., returns with income reinvested) over the relevant periods. In fact, HSBC appears to be showing the index’s returns without income reinvested and doing the same for the fund.

Indeed, if one looks at the fund on a total return basis, the results are much different, and they aren’t favourable. Over the three-year period cited above, using total returns with income reinvested, the fund’s accumulation shares returned 17.85% on a cumulative basis (the income shares returned 17.80%). Over the same period, with income reinvested, the index returned 22.24% on a cumulative basis. In other words, the fund’s fact sheet says that it beat the index, but in fact, once reinvested income is included, the fund actually lagged the index by nearly 1.30 percentage points per year on an annualised total return basis.