The stock market, over the last five years, has witnessed a phenomenal growth: the KSE 100 index generated a return of 321.3pc from January 2012 through December 2016 while smaller stocks performed even better.

The equity mutual fund industry has also thrived over the last couple of years and fund managers claim to have outperformed their benchmarks significantly.

To examine how funds have performed relative to passive benchmarks, two benchmarks have been considered. The KSE 100 index and an equal-weighted index, which is simply a portfolio that invested an equal amount in each of the largest 100 stocks listed on the stock exchange on January 1, 2012. This portfolio is dubbed the ‘Monkey Portfolio’.

Since most investors can’t beat the market over time, Burton Malkiel, a Princeton professor, conjectured in his bestselling book that ‘a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.’ (If a large number of monkeys select such portfolios, their average performance will be very close to that of the equal-weighted index.)

Comparing fund returns to the return of the Monkey Portfolio basically asks whether funds can outperform a portfolio of randomly selected stocks.

Mutual funds in Pakistan tend to tilt their portfolios away from the index heavy weights towards smaller stocks. For example, as of February 2017, only one of the top 10 holdings of NIT (the largest fund in Pakistan) overlaps with the top 10 holdings of the KSE 100 index. So the Monkey Portfolio, which also has a small size tilt, is probably a more reasonable benchmark.

At first glance, the average fund performance looks really good… However, the Monkey Portfolio performed significantly better than all but one fund

At first glance, the average fund performance looks really good — 10 of the 15 funds outperformed the KSE 100 index, some with a significant margin. However, the Monkey Portfolio performed significantly better than all but one fund. (The returns of the Monkey Portfolio are gross of trading costs, but these costs are unlikely to exceed a few percentage points since the portfolio has minimal turnover it only reinvests the dividends received.)

Only one fund appears to have ‘investment skill’ relative to the easily implementable Monkey Portfolio. An examination of the Fund Manager Reports of AKD Opportunity Fund reveals that the fund is heavily tilted towards small stocks; therefore, most of the fund’s outperformance is likely explained by the outperformance of small stocks over the time period.

Many fund managers also misrepresent their benchmarks and claim significant ‘outperformance’.

In their fund manager reports, NAFA Stock Fund, JS Large Cap Fund, JS Value Fund, JS Growth Fund, Lakson Equity Fund, and First Habib Stock Fund compare a large part of their historical performance to the KSE 30 index.

KSE 30 index does not include dividends since it is not a total return index. The dividend yield of the index has averaged over 5pc, so comparing fund performance to the KSE 30 index severely overstates fund outperformance over the benchmark.

UBL Stock Fund compares its historical performance to a blended benchmark of 85pc KSE 100 index and 15pc MSCI ACWI until September 2016, even though it only invests in local stocks. These are very questionable practices.

It is strange that the SECP has allowed such misrepresentation. Many retail investors lack the ability to calculate the appropriate benchmark returns that a particular fund should be compared to and therefore rely on the data provided by the fund manager.

The SECP also made it extremely difficult for entrants to introduce new products like small cap or equal-weighted index funds.

Existing asset management companies (AMCs) are probably unwilling to launch such low fee passive products that can generate similar or higher returns compared to their current funds.

A new AMC is required to have a minimum of Rs200m of equity and a mutual fund is required to launch with a minimum Rs100m of assets.

These are rather uncompetitive barriers to entry compared to developed markets. For instance, there is no minimum AUM requirement to start a mutual fund in the US. An investment advisor is required to have a minimum Rs30m in equity. It is a lot easier for an individual to become an investment advisor in the US.

In 2015, the SECP approved regulations for Private Funds — investment vehicles designed for qualified investors — which have lower capital requirements. However, Private Funds are at a severe tax disadvantage relative to mutual funds so it is unlikely that anyone will launch one in Pakistan. If the SECP wants the Private Fund industry to take-off it should allow them the same pass-through tax treatment as mutual funds.

Therefore before you decide to invest in a mutual fund and pay the manager a two per cent management fee, you should ask yourself a couple of questions. Can I replicate the performance using a self-constructed ‘index’? Is the manager misrepresenting his benchmark to make his performance look good?

The SECP should require managers to state proper benchmarks. It should also encourage a more competitive environment by lowering capital requirements for new funds/investment advisors and by putting private funds and mutual funds on an equal footing.

ua_82@yahoo.com

Published in Dawn, Economic & Business, April 3rd, 2017