Compare one active fund's long-run return after fees with its stated benchmark and with an index fund alternative.
To test an active fund's record, set its long-run return after fees beside two others: the benchmark the fund names, and an index fund following a similar index. Then calculate how far the manager has to beat the index each year, before costs, for you to end up level with the index fund after costs. With those figures on one sheet you get a straight answer about how one fund has done so far.
Wei Ling is testing the Asia equity fund she has owned for three years. She is using the conditions for an active fund that she set down in Lesson 6.3, "When an active fee might be worth paying". She is slightly nervous about it. She likes the fund and the people who sold it to her, and she would prefer not to learn that she has been paying too much.
Start with the fund's most recent factsheet and go to its performance table. Copy the returns for the longest periods it shows. Five years, ten years and since launch are the usual ones. Take the annualised figures and leave the cumulative ones aside. An annualised return is the average return per year, while a cumulative return is the total gain over the whole period. Annualised figures are on the same yearly scale as fund costs, so you can set one directly against the other, and the hurdle calculation later depends on that.
Look at the basis the returns are on. Most factsheets quote them NAV to NAV, which means after the fund's running costs have been taken but before any sales charge. If you paid a sales charge when you bought, your own return was below the NAV-to-NAV figure. Write the basis next to your numbers. Lesson 1.3, "Find the facts in a fund's three key documents", explains how to check it.
Wei Ling's factsheet gives her fund a ten-year annualised return of 5.1% NAV to NAV (an example figure). Over the same ten years the benchmark returned 6.3% a year.
A comparison with the benchmark only tells you something if the benchmark resembles what the fund owns. The fund's factsheet breaks its holdings down by country and sector, and the index provider's website does the same for the index. Put the two breakdowns side by side. A fund holding mostly Asian technology companies and banks, measured against a broad Asia ex-Japan index, is fairly matched. A fund measured against a narrower or weaker index, or against cash, is not.
Benchmarks can also change. Some funds move to a different one partway through their lives, and the factsheet may then plot the current benchmark across the entire history. The prospectus or the annual report usually records any switch.
Wei Ling's fund uses an Asia ex-Japan equity index. Its top holdings and country weights look broadly similar to that index, so she treats the benchmark as fair.
The benchmark is an index. An index carries no costs and you cannot buy it. For that reason the third column on your sheet is an index fund or ETF that tracks the same index or a close one. From that fund's own factsheet, take its return after its own costs for the same period.
Wei Ling finds one that follows a similar Asia ex-Japan index. Over ten years it returned 6.0% a year after costs, and its expense ratio is 0.30%.
Dollar amounts make the difference easier to see. In a spreadsheet, the FV function shows what S$10,000 grows to over ten years at each rate. For Wei Ling's fund, =FV(5.1%, 10, 0, -10000) returns S$16,444.75. For the index fund, =FV(6%, 10, 0, -10000) returns S$17,908.48. Holding the index fund would have put her roughly S$1,464 ahead, before her sales charges are counted. Sales charges widen the gap between an active fund and an index fund beyond what the NAV-to-NAV figures show.
Take the index fund's yearly cost away from the active fund's yearly cost. The result is the cost gap, and it is also the hurdle: roughly how far, on average, the active manager has to beat the index each year before costs for an investor to match the index fund after costs. If the fund beats the index by less than this before costs, you are still behind the index fund.
Wei Ling's fund has an expense ratio of 1.75%, which she found in module 2. Her cost gap is 1.75% minus 0.30% = 1.45 percentage points a year. Her manager has to beat the index by about 1.45% a year before costs for her to draw level. Beating it by 1% before costs would still leave her behind the index fund.
A sales charge pushes the hurdle higher. Spread the charge across your holding period to find its yearly effect, then add that to the cost gap. Lesson 2.4, "List every charge on one fund", shows how to do the spreading.
Record the hurdle on your sheet. Of all the numbers you collect, it is the clearest single one for judging whether the fund's past record has been good enough, and whether you expect it to be good enough from here on.
Set up three columns: the fund, its benchmark and the index fund. Give the sheet these rows:
five-year annualised return ten-year annualised return return basis yearly cost dollar outcome on S$10,000 over ten years yearly outperformance needed to cover the extra cost
Underneath the sheet, write a short verdict. Wei Ling's says that across ten years the fund trailed its benchmark and a comparable index fund after costs. To draw level it would need to beat the index by about 1.45% a year before costs, and it has not managed that so far. She adds that the verdict describes what has happened and forecasts nothing, and that what she does next is her own decision.
Your own test sheet and verdict come next, in the activity below. Pick one active fund and take its returns from the latest factsheet. Check its benchmark, find a comparable index fund and work out the hurdle. Then write your verdict underneath.
Fill in the active fund test sheet. Then write two sentences on whether the fund has earned its fee so far.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).