FINA2209

Financial Planning
Week 3: Indirect investment and performance

measurement

Dr. Elizabeth Ooi

elizabeth.ooi@uwa.edu.au
Housekeeping
• Reflective exercise 1 due this Friday at 5pm.
– Submission point now open on LMS (under instructions)

• Next week’s lecture (week 4) will be in SSEH: [ 102] John

Bloomfield Lecture Theatre. From week 5 onwards, we will
be back in here (Ross Lecture Theatre).
Today’s objective
• Financial planners generally don’t help clients to invest
directly (in a share portfolio). They instead focus on indirect
investment (through managed funds)

• Features of managed funds- this information will be in the

product disclosure statement (PDS) of the fund.
– Best interests duty: “Know your product”
– RG 168 Disclosure: Product Disclosure Statements
(http://asic.gov.au/regulatory-resources/find-a-
document/regulatory-guides/rg-168-disclosure-product-
disclosure-statements-and-other-disclosure-obligations/)

• Performance measurement of managed funds

Direct vs Indirect

• MFs are ‘managed investment schemes’

(NOTE: so are Ponzi schemes…)
– Investors pool money and get an interest in the
scheme (unit holders have a right to distributions)
• A managed fund is characterised by the:
– Asset type (categories), Style, Management
structure, Tax structure
Characteristics of
Managed Funds
• Pooling allows:
– reduced investment costs, access to expertise,
diversification...(more on this later)
• The managed fund structure provides access
to:
– One or all of the asset classes
– Sub-categories of asset classes
– A particular asset mix
• Managed funds can be listed or unlisted
• Regulated by ASIC & APRA (Superannuation)
Managed funds: pros and cons
• Advantages
– Able to access investments with only a small amount of
funds
– wide range of asset classes and investments
– Funds are managed by a professional fund manager
– Consolidation of reporting- master trusts/wrap accounts
– ‘Ready-made’ diversified portfolio…Really?
• Drawbacks
– Fees (types and ranges)- entry, exit, switching,
management, investment, etc.
– Lack of control over investment- can’t time capital gains
– Lack of transparency?
– Which is the most appropriate fund? Too many choices
Fees
– Management Expense Ratio (MER): ongoing fee to cover the cost of managing your
investment. MER can vary substantially (0.5 to 4% pa).
– Indirect Cost Ratio (ICR) - ratio of management costs not deducted directly from
investors account to average net assets of fund.
• NB. Indirect Cost Ratios are supposed to be the new standard rather than MER.
ICR includes all indirect costs such as performance fees. However industry (and
text) continue to prefer MER.
• Either ICR or MER used to compare the effectiveness of fund managers
• ICR & MER estimate how much of contributions is used toward the operating
costs of the fund vs. invested
– Entry fee: between 1% and 5% and will reduce the amount of your initial investment.
– Contribution fee: similar to entry fee, charged on future contributions.
– Performance fee: fee paid to fund manager if the investment return is better than the
target return.
– Withdrawal fee: fees charged by fund for each withdrawal.
– Termination fee: fee charged for closing the account.
– Switch fee: fee charged when investor change their asset mix.
– Adviser service fee: some funds managers pay financial planners ongoing fees for
every year a client’s funds remain in their managed investment scheme.
The Indirect Cost Ratio (ICR)
Enhanced fee disclosure regulations 2006, RG 97

• Ratio of management costs which are not deducted

directly from investors’ accounts to average net assets of
the fund
– Indirect costs vary widely but can include investment-
related legal, accounting and other operational and
compliance costs.
• ICR’s are used synonymously with Management Expense
Ratio (MER)
• ICR & MER estimate how much of contributions are used
toward the operating costs of the fund vs. invested. That
is, they measure the effectiveness of fund managers
Unlisted/Passive: Equity Vanguard

Unlisted/Active Equity

ETF/Passive Index - Equity

Unlisted Managed Funds
• Open ended funds which issue & buy back units from
investors
• Unlisted funds do not pay tax in their own right if they
distribute income to unit holders
• Unit price is a function of Net Asset Value (NAV)
– NAV = Fund assets – Fund liabilities
Number of units issued

Assets
Cash $ 30 M NAV=$300 M – $35 M
Bonds $ 60 M 16 101 324
Equities $120 M
Property $ 30 M = $16.46
International equities $ 60 M
Liabilities
Debentures (loans) $ 35 M
No. of units issued 16 101 324
Listed Managed Funds

• Investors buy or sell units or shares on the ASX

• Main types are:
– Listed investment companies(shares: closed structure) (LICs)
– Listed investment trusts (units: closed & open ended) (LITs)
– Real estate investment trusts (units: closed ended) (AREITs)
– Exchange traded funds (units: open ended) (ETFs ETPs)
• Track and duplicate the performance of a particular market index

Source: http://www.asx.com.au/products/managed-funds/market-update.htm
Investment Structures
• Master trusts
– Pools money, access to range of different fund managers
and investment options. Record keeping and
administrative services.
• Wrap accounts
– Investments held in name of investor and can be
transferred between different providers without CGT (in
specie transfers)
– Benefits
• Investor only deals with one organisation
• Managed funds can be accessed at cheaper wholesale MER’s
• Consolidated reporting of performance, asset allocation and tax
– Drawbacks: Cost - Investors must pay for the product/service
Categories

Multi-sector:
Vanguard growth
Vanguard balanced
Sector specific:
Fidelity Select IT Services Portfolio
Asset class:
Vanguard High-Yield Corporate Fund
Sub-asset class:
Vanguard small-cap index fund
ICI Pru Select Large Cap Fund
Management Styles
• Different management styles may be more suited to different
investor risk profiles
– Active
• Regular trading (Tactical, Fundamental, Technical, ….
Top-down approach, Bottom-up approach, Absolute
Returns, market timing)
• Value (focus on income generating potential), Growth
(Focus on assets potential capital growth or gain)
– Passive
• Seek to replicate rather than attempt to outperform
benchmark or index – limited changes
• Should be cheapest asset class exposure
• Performance determined by the asset class invested
Passive
• Efficient markets hypothesis:
– As new information arises, the news is incorporated into the price of
securities.
– The market is so efficient at incorporating all known information that no
amount of analysis will give you an edge over the millions of other
investors out there.
• - Markets can still be irrational but only in the short term (overvalued tech
stocks in 1999, real estate in 2006). Over the long term, prices will
accurately reflect underlying value.
Key takeaway:
• Financial markets do not allow investors to earn above-average returns
without accepting above average risks. (E.g. $100 bills are not lying around
for the taking, either by professionals or amateur investors.)
A student and a finance professor are standing around having a chat. The
student spots a $100 bill lying on the ground and goes to pick it up. “Don’t
bother” says the Professor. “If it were really a $100 bill, it wouldn’t be there.”
Active
• In 2014, investors withdrew $98.58 billion out of actively managed
U.S stock mutual funds and invested $71.34 billion into index funds.
Total assets in ETF funds reached $2 trillion.
• The case for actively managed funds- It is very difficult to beat the
market… but not impossible if you are (some kind of) special.
1) High-frequency trading (HFT) 2) Or, concentrate on parts of
involves ultra-fast fibre-optic data the market that are less
connections between trading systems efficient  Continued over the
and stock exchanges, giving a page
minuscule speed advantage over rival
traders. This millisecond advantage,
allows HF traders to see other buyers’
orders before they are executed.
Does passive investing make
markets more or less efficient?
LESS EFFICIENT:
“The paradox of the indexing process is, of course, that if everyone ignores
valuations and buys portfolios that blindly match the market, asset prices become
extremely inefficient, which only amplifies the opportunities for "active" managers
who profit from these discrepancies to outperform.”
From “ http://www.afr.com/personal-finance/robo-financial-planners-take-active-v-
passive-tussle-to-new-levels-20150306-13xjv2#ixzz4bqiu1tcZ

This is saying that the increase in passive investing will lead to less price discovery
making markets LESS efficient.

MORE EFFICIENT:
Unskilled investors do not have to incorporate their lack of skill into their
investment decisions. They do not have to suffer from uninformed picks. With
index funds, they get a superior return (superior for them).
The effect of unskilled investors taking up passive investments is that the average
skill of the rest of the market increases, without these investors. Those active
investors deal with less noise and less price inefficiency caused by unskilled
investors. They are able to partake in price discovery with more accuracy, making
markets more efficient.
Best of both
(passive and active) worlds
• For what types of companies is information
most readily available?
– U.S. large-cap stock  more media attention,
analyst coverage, research etc.
• Build a “Core and Satellite” mutual fund
portfolio (a common investment philosophy)
– Large cap stock index fund (e.g. S&P 500)
represents the largest component of the portfolio
(30-40%)
– The rest is made up of other types of funds (e.g.
small-cap, foreign stock, bonds, sector, money-
market funds etc.) in smaller portions.
Make sure things add up!
Regulator fines Spaceship for false and misleading conduct
(Shapiro, 2018, AFR)
“ASIC was particularly concerned with a statement on the
Spaceship website that said the fund would "fight to get you the
very best assets in your portfolio ... We will measure companies in
our portfolio based on their ability to provide defensibility of profits
and high levels of product differentiation." However, ASIC argued
that, given the fund had 79 per cent of its assets in index-tracking
funds that "involved no qualitative analysis of the underlying
companies", there was little opportunity to pick specific assets.”
“The start-up super fund has also been called out for its relatively
high fees and low returns relative to the risks it takes.”
“Spaceship and trustee company Tidswell Financial Services
have each paid a $12,600 penalty”
Performance

• How do you judge the performance of

someone who invests your (your client’s)
money?
• What is your client’s objective?
– How do they feel about risk and return?
• What was the mandate for investing?
What actually is the return?

• What are we wanting to measure?

– The performance of the individual’s portfolio?
– The fund manager’s performance?
– The performance of the market?
• And what benchmarks / standards / norms
should we be using to judge performance?

‘Some methods of calculation that are frequently used are

clearly wrong, but there is no single “correct” method’
(Williamson, J.P., 1979. p.15)
Measuring Performance/Returns

• Suppose Two Fund Managers A & B both start the year with
$100m in assets invested identically: they have exactly the
same assets
• Over Yr 1 these assets grow by 2%.
• At the end of Yr 1 each fund receives a contribution from
investors:
– $50m to Fund A
– $10m to Fund B
– They again invest the new money identically.
• No further contributions are received.
• Over the second year assets grew in value by 10%.
• How have they performed?
22
How have they performed?
• This could have been described this way:
– Fund A starts with $100m and by the end of Yr 1 the fund is valued at
$152m which includes an inflow to the fund at the end of Yr 1 of $50m.
By the end of Yr 2 the fund is valued at $167.2 m
– Fund B starts with $100m and by the end of Yr 1 the fund is valued at
$112m which includes an inflow to the fund at the end of Yr 1 of $10m.
By the end of Yr 2 the fund is valued at $123.2 m

T0 T1 T2

$102m
Fund A $100m $152m $ 50m $167.2m

$102m
Fund B $100m $112m $ 10m $123.2m
How have they performed?
• Over the two year period each fund has grown by:
1/2
167.2
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐴𝐴 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 1 = 29.30% 𝑝𝑝. 𝑎𝑎.
100
1/2
123.2
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐵𝐵 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 1 = 10.99% 𝑝𝑝. 𝑎𝑎.
100

T0 T1 T2

$102m
Fund A $100m $152m $ 50m $167.2m

$102m
Fund B $100m $112m $ 10m $123.2m
How have they performed?
• We could calculate an Internal Rate of Return (IRR) by
comparing the money (cash flows) invested and how long it
was invested for
−𝟓𝟓𝟓𝟓 𝟏𝟏𝟏𝟏𝟏𝟏. 𝟐𝟐
−𝟏𝟏𝟏𝟏𝟏𝟏 + 𝟏𝟏
+ 𝟐𝟐
, 𝑰𝑰𝑰𝑰𝑰𝑰 = 𝟔𝟔. 𝟕𝟕𝟕𝟕𝟕 𝒑𝒑. 𝒂𝒂.
𝟏𝟏 + 𝑰𝑰𝑰𝑰𝑰𝑰 𝟏𝟏 + 𝑰𝑰𝑰𝑰𝑰𝑰
Money Weighted Rate of Return
−𝟏𝟏𝟏𝟏 𝟏𝟏𝟏𝟏𝟏𝟏. 𝟐𝟐
−𝟏𝟏𝟏𝟏𝟏𝟏 + 𝟏𝟏 + 𝟏𝟏 + 𝑰𝑰𝑰𝑰𝑰𝑰 𝟐𝟐 , 𝑰𝑰𝑰𝑰𝑰𝑰
= 𝟔𝟔. 𝟏𝟏𝟏𝟏𝟏 𝒑𝒑. 𝒂𝒂.
𝟏𝟏 + 𝑰𝑰𝑰𝑰𝑰𝑰
T0 T1 T2

Fund A $100m $152m $167.2m

-$100m -$ 50m $167.2m
Fund B $100m $112m $123.2m
-$100m -$ 10m $123.2m
How have they performed?
• We could also calculate the “average” of the “Holding Period”
returns
• Holding Period return: – what return received on money
available?
– Take out the contributions as part of the return
𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑨𝑨 𝑹𝑹𝑹𝑹𝑹𝑹[ 𝟏𝟏. 𝟎𝟎𝟎𝟎 (𝟏𝟏. 𝟏𝟏)]𝟏𝟏/𝟐𝟐 −𝟏𝟏 = 𝟓𝟓. 𝟗𝟗𝟗𝟗𝟗 𝒑𝒑. 𝒂𝒂.
Time Weighted Rate of Return
𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 𝑩𝑩 𝑹𝑹𝑹𝑹𝑹𝑹[ 𝟏𝟏. 𝟎𝟎𝟎𝟎 (𝟏𝟏. 𝟏𝟏)]𝟏𝟏/𝟐𝟐 −𝟏𝟏 = 𝟓𝟓. 𝟗𝟗𝟗𝟗𝟗 𝒑𝒑. 𝒂𝒂.
T0 T1 T2
2%

$102m
Fund A $100m 2% $152m $ 50m $167.2m
10%
$102m
Fund B $100m $112m $ 10m $123.2m
10%
What else?

• Returns are only one factor

• What else is important to your
client?
–RISK – but what risk is important?

–What about skewness?

• Is your client concerned by a REALLY
big loss?
Recall the
Portfolio Theory/CAPM world

E(Rp ) = R f +
[E (R ) − R ]
m
σ f
p
σm
E ( Ri ) = R f + ( E (Rm ) − R f ) β i
Standard deviation
• Variability of distribution of returns
• Total risk

Beta
• Sensitivity of returns to market returns
• Systematic risk
Measuring/Assessing Managed
Fund Investment Returns
• Tracking error – not a performance measure but a summary statistic-
standard deviation of the differences between the fund return and
return on the benchmark
- Measure of how closely returns of managed fund follow benchmark
• Say the benchmark is the All Ords.
– Low TE = tracked the benchmark closely
– High TE = invested differently to the benchmark
• Sharpe ratio – reward for total risk
– A measure of the risk adjusted performance of a fund (excess
returns)
• Alpha/ Treynor ratio- reward for systematic risk (compared to CAPM)
– A measure of how sensitive portfolio returns are to market returns
• Information ratio - (excess return / tracking error)
– What has been the reward for straying from the benchmark?
Sharpe Ratio

Risk-adjusted returns

Where SIp = Sharpe index/ratio

Rp = return on fund or portfolio
Rf = risk-free rate of return
σp = SD of fund returns (net of risk free)
Treynor Ratio /Alpha

Risk-adjusted returns
TR = ( R p − R f ) / β p

Alpha = R p − [ R f + ( E (Rm ) − R f ) β p ]

Where Rp = return on fund or portfolio

Rf = risk-free rate of return
βp = Systematic risk of fund/portfolio

Something to ponder about: What else might Alpha represent?

Exercise

• Three funds gave the following results

over the past 10 years:
Fund ROR Beta SD
A 0.13 1.1 0.14
B 0.1 0.9 0.20
C 0.17 1.2 0.30

The average risk-free return was 8% pa, the average

market return was 12% pa, and standard deviation of the
market was 15% pa. Rank the funds according to the
Sharpe and the Treynor measures, and explain any
difference in rankings.
Exercise-solution

Fund Sharpe index Rank Treynor index Rank

A: 0.36 1 0.045 2
B: 0.10 3 0.022 3
C: 0.30 2 0.075 1

A and C swap places under the two measures.

Sharpe ratio = It would seem that C is poorly diversified: that it has

significant unsystematic risk, relative to A.

Treynor ratio = C is generating a better return for the higher systematic risk
it has but it has higher total variability in returns – its SD is higher.
Exercise

• Now estimate the “alpha” (Jensen’s Alpha)

for each of the funds. How do the rankings
based on alpha compare to those in (b)?
Explain any differences or similarities and
what might be the reason.
Exercise-solution
Fund Alpha Rank

A: 0.006 2
B: -0.016 3
C: 0.042 1
• Rankings are consistent with the Treynor index – it has the same
measure of risk.
• However, the basis of comparison is now quite different, since each
fund is now being rated against what we expect an investment with
the same level of systematic risk would have earned (according to
the CAPM)"the market".
• So C gave a ROR 4.2% higher than would be expected by its beta
risk.
• With Alpha we are getting an “absolute” measure in terms of
percentage points whereas for the Treynor ratio it is per unit of
systematic risk.
How else can you judge
performance?
 Case
Lou is 34 and received advice five years ago (exactly) which recommended, based on his stated
objectives and risk tolerance, that he adopt an asset allocation reflected in the values for six
managed funds below. Aside from the allocations, additional data summarising the
performance of the funds over the past five years is also presented.
Lou considers that his risk tolerance has not changed over the period and his personal
circumstances and objectives have also remained unchanged. He has sought advice today
(11/08/2021), specifically:
(a) Whether his current overall asset allocation reflects his objectives and risk tolerance;
(b) What you can advise as to how the investments have performed
Value 5 year annual
11/08/16 return (p.a.)
1. Aust. Equity Fund $40,000 -3.5%
2. Int. Equity Fund $20,000 -4.0%
3. Aust. Fixed Interest $15,000 8.0%
4. Int. Fixed Interest $10,000 9.0%
5. Aust. Property $10,000 2.0%
6. Cash $5,000 5.0%
 Case

(a)
•Start with previous allocations
•Look at today’s value
•Then current allocations
•So if Lou’s risk tolerance hasn’t changed, the portfolio would have to
be rebalanced

Value % 5 year annual Value %

11/08/16 return (p.a.) 11/08/21
1. Aust. Equity Fund $40,000 40% -3.5% $33,473 32%
2. Int. Equity Fund $20,000 20% -4.0% $16,307 16%
3. Aust. Fixed Interest $15,000 15% 8.0% $22,040 21%
4. Int. Fixed Interest $10,000 10% 9.0% $15,386 15%
5. Aust. Property $10,000 10% 2.0% $11,041 11%
6. Cash $5,000 5% 5.0% $6,381 6%
$100,000 $104,629
 Case
(b)
Now TE and IR are given. Interpret TE and IR.

Cash has lowest tracking error - to be expected.

LOW TE = Australian Equity, Australian Fixed Interest  Passive?
HIGH TE = International equity fund, International Fixed Interest fund  Active?

Information Ratio - IEF and AFI have highest return for risk
All funds earned excess return relative to benchmarks
IFI has not generated a big reward for its large variation from the benchmark

Value % 5 year annual Value % Tracking Information

11/08/16 return (p.a.) 11/08/21 Error Ratio
1. Aust. Equity Fund $40,000 40% -3.5% $33,473 32% 1.0% 0.8
2. Int. Equity Fund $20,000 20% -4.0% $16,307 16% 8.0% 1.5
3. Aust. Fixed Interest $15,000 15% 8.0% $22,040 21% 2.0% 1.4
4. Int. Fixed Interest $10,000 10% 9.0% $15,386 15% 10.0% 0.1
5. Aust. Property $10,000 10% 2.0% $11,041 11% 5.0% 0.3
6. Cash $5,000 5% 5.0% $6,381 6% 0.1% 1.0
$100,000 $104,629
Criticisms of mutual fund
performance measurement

• Jonathan Berk: Are Mutual Fund Managers

Skilled?

https://www.youtube.com/watch?v=a41LhZE5Iec
Summary

• Diversification and convenience are key benefits

of managed funds
• Fund managers can adopt either an active or
passive style of management
• Fees vary significantly as does performance
• What are the various performance measures
– How to calculate, interpret?
• Justify what you/your client is paying for